House of Cards, part 6

Joe Nocera of the NYT has a good story today explaining the situation around the bailout of AIG, entitled, appropriately enough, “Propping up a House of Cards”.  It appears that AIG sold all sorts of ‘financial insurance’ without going to the trouble of keeping any decent reserves in case they had to pay out.  Banks and others bought this insurance, making it appear that they were adequately covering their mortgage risk.  Here’s Nocera:

When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.

Second, in many of its derivative contracts, A.I.G. included a provision that has since come back to haunt it. It agreed to something called “collateral triggers,” meaning that if certain events took place, like a ratings downgrade for either A.I.G. or the securities it was insuring, it would have to put up collateral against those securities. Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them. And again, it assumed that the triggers would never actually kick in and the provisions were therefore meaningless. Those collateral triggers have since cost A.I.G. many, many billions of dollars. Or, rather, they’ve cost American taxpayers billions.

Unfortunately it appears that the domino effect of letting AIG fail would be a devastating series of losses around the world.  So we’ll continue to prop up AIG among others.  Limited liability for shareholders, but the liability for taxpayers appears to be unbounded.

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  • Jim  On March 2, 2009 at 9:36 am

    W’s decision to not let the market work may be the most harmful decision to the U.S. that could have been made. Not only is it not solving the problem – AIG is continuing to require billions and when it will stop nobody knows – but it has set a precedent that is being taken advantage of by the current administration, and will probably be abused by all future administrations until the real collapse fixes the problem.

  • Curt  On March 2, 2009 at 12:16 pm

    Two points on this.

    1. I’m not convinced that they had any other choice. Given the interconnections of AIG to many other banks, not stepping in could have led to a complete financial failure and meltdown… not something most Presidents want on their resume.

    2. Yes, any new precedent should be watched very carefully, whether you agree with the direction or not – we always need to think about what ends the power could be put to in other hands…

  • Curt  On March 2, 2009 at 4:31 pm

    An AIG followup from Nocera:

    Turns out that so far we really don’t know…

  • Jim  On March 3, 2009 at 9:59 am

    “Pretty unsatisfying, isn’t it? Gobs of tax money is going to bail out unnamed companies — and yet we aren’t allowed to know who they are, and are supposed to take it all on faith.”

    This is why you comment in comment 2 above – “I’m not convinced that they had any other choice.” – is one I disagree with: they had another choice – let the company fail and take the consequences! I don’t like this, but in the long run with the atitude of government explained by Nocera it would be a lot easier than what we face in the future!

  • Curt  On March 3, 2009 at 12:27 pm

    It’s true that they literally had another choice, but I suspect they felt it was just untenable. Or perhaps they could have let certain companies fail, but then some of the ramifications would have been so bad that they would have had to step in right away. Would that have been a better course? – I don’t know… either way it’s a big mess, that’s for sure.

    Let’s remember too that big money interests certainly did not want AIG to fall over, as that big domino would have toppled many others… between that and not wanting to be seen as ‘fiddling as Rome burns’ is powerful motivation to ‘do something’ for better or worse.

  • Jim  On March 3, 2009 at 2:57 pm

    Time will tell us whether W’s choice and BHO’s continuation of the policy was good in the long term.

  • Curt  On March 4, 2009 at 10:23 am

    If only things were that straightforward… folks still argue over what worked or didn’t during the Great Depression, and I suspect people will be arguing over current events for many years as well. But we will indeed see how things play out.

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