Why AIG is The Villain

When the housing market collapsed and faulty loan activity was exposed, it was only logical that the mortgage lenders, like banks, would be demonized for their risky behavior. But, in recent days, AIG, an insurance company (not a bank or mortgage lender), has been demonized even more; especially by our Congress.

I think a lot of people are mad at AIG (American International Group) because they received billions of dollars in taxpayer bailout money and they think AIG acted irresponsibly by giving out some bonuses. But, I don't think any lay person, who is now mad at AIG for those bonuses, really understands why an insurance company received that amount of bailout money in the first place; and, why they were said to have been "too big too fail".

If you listened closely to the Congressional hearings that were being conducted to grill AIG's interim CEO over the coals, you would have heard many angered references to the Financial Products Division of AIG and their receipt of $168 million in bonuses. But, again, most of us probably don't really know what the Financial Products Division did to warrant such anger.

AIG is basically an international insurance company that could insure almost anything in the world. 99 percent of what they do is regulated by some form of government; depending on what country or state they are selling their insurance products in. Normally, all their insurance activity has to be supported by a sufficient amount of cash reserves to guarantee that there is enough insurance payout money available in the event of a mass catastrophic loss of insured items. For example, when Katrina hit, a company like Allstate, because of state and Federal regulations, had enough cash reserves to cover all the insured properties that were lost to that specific catastrophe.

Not all of what AIG did as an insurer was actually regulated, however. This was especially true when it came to insuring mortgage loans, business loans, and many other types of loans. Not that they did anything illegal; but, in essence they were not being fiscally responsible.

The Financial Products Division was a very small division of AIG. It was heavily involved in the unregulated activity of insuring loans between two parties where the party receiving a loan might have had less than a good credit rating. Under normal circumstance, that kind loan would not have even happened if it wasn't for AIG providing an insurance on that kind of loan.

To facilitate these somewhat questionable loans, AIG insured that loan by using a product or vehicle called the Credit Default Swap or CDS. The first Credit Default Swaps were initially hatched up by JPMorganChase in the late 1990's. The fact that CDS's were exempt from any regulation stems back to the "Enron Loophole" that was created when Bill Clinton signed into law the Commodity Futures Modernization Act of 2000. That law was originally authored by Republican Senator Phil Gramm and, under the "derivatives" sections of that law, any CDS's were freed of any regulatory oversight.

In a normal mortgage loan environment, a borrower goes to a lender, like a bank, and says that they want to buy a house. The lender, then, in deciding whether or not they want give out a loan for that house, wants to know what the price of the house is; what the amount of down payment will be; and, what ability the borrower has to fulfill the terms of the loan. Up until the invention of the CDS, the lender assumed all the risk for giving out that loan. If the borrower defaulted on the mortgage, the house, which had been used as collateral for loan, would be taken and resold to recoup the money that the borrower lost on the deal. Even in the best housing market, a home loan that was defaulted on generally represented some amount of loss for the lender.

Now enter AIG with their CDS's. For just a small percentage of the interest payments that the lender will receive from the borrower on that home loan, AIG says that they will protect the lender against any losses that could result from the borrower defaulting on their loan. In effect, that insurance product, the CDS, would make the lender whole when there was default. The lender, then, becomes free of all risk. In essence, the real risk has been transferred to AIG. This transference of risk is technically what is called a "Swap" as the name Credit Default Swap so implies.This fact, alone, facilitated many more loans than should have been because lender risk was being eliminated. What has also been swapped at the same time was the borrowers credit rating for AIG's once-formerly excellent AAA credit standing. So, on paper, the lender looks as if they are only giving out loans to the best credit-rated borrowers. But, that was only an illusion. It is also important to note that AIG was fully exposed on their portion of the loan guarantee because the collateral for the loan remained, contractually, with the lender.

In a booming housing market, the CDS is a great profit-maker for an issuer like AIG. As housing values increased, AIG's risk would continue to lessen; and, ultimately, would go to zero. Yet, they would still get income. Over the life of a 30-year mortgage, it's nothing but a win-win for AIG. But, when the housing market collapsed and housing prices fell by as much as 50 percent, AIG was then on the hook for massive amounts of money as foreclosures rose. Further, they applied CDS's to all kinds of non-home loans and those loans, too, became a liability as this recession increased the number of bankruptcies .

But, it was worse than that. AIG wasn't the sole seller of CDS's. Banks also bought into the AIG/CDS scheme and they, too, started selling CDS's to each other for every kind of loan under the sun. Hedge funds, also, got into the game. So, as a result, you had everyone from AIG to world Banks to world Hedge funds who were covering each other's butts and none of them had enough cash to bailout the other when things started to unravel. It was a massive interconnected web that could easily collapse under its own weight.

That's why, when, last year, Hank Paulson and Tim Geithner originally started to look at the possible failure of AIG, they only saw a massive ticking, time bomb. But, this time bomb was a lot more like the small conventional charge that could easily be used to initiate a chain reaction that was akin to that in an atom bomb. And, that is why AIG could not be allowed to fail.

AIG is a big company with over 100,000 employees; worldwide. Most of what they do is both a regulated and quite ethical business activity. Even in the Financial Products division, I don't think that the majority of those people, who were selling and bundling the CDS products, were actually aware of how exposed the world was to their activities. After all, the housing market was just clocking along with ever-increasing house value. For sure, I hardly think that any of those employees of the Financial Products Division sought out AIG in some twisted belief that they could personally destroy the world's economy. Instead, they were just recruited to blindly do a job. I'm quite sure that they, like most of the employees in any corporation, didn't have any big-picture view that was greater than their own day-to-day activities. So, to demonize the employees of the Financial Products division is somewhat misplaced. The true villain in this mess is the management that allowed CDS's to happened without the substantial funding that was needed to cover all the expenses associated with a deflated housing market and a recession. That was the greed and that is where the anger should be aimed. Further, the fact that CDS's were even allowed to be sold all stems back to laws that were put in place in 2000. So, our Congress is to blame for not thinking through or actually reading the bill that Phil Gramm put forth and that Bill Clinton signed. And, Bill Clinton is at fault for signing something that his staff of experts -- now all part of the Obama Administration --- should have better understood.

Lastly, I have attempted to give you the most simplistic explanation of a CDS's as I could. The actual CDS products got more and more complex over time with different financing structures and various forms of hedging and leveraging. Because of these complexities and because of all the tentacles that have jutted out from this kind of insurance product, no one really knows the exact amount of risk that is associated with them. Currently, it is estimated that there is a worldwide risk of $45 trillion dollars; but, it could be a lot more than that. While Obama/Geithner want to impose regulation on these kinds of products, I am quite sure that the industry, itself, doesn't want to ever sell another one of them; seeing the extreme risk that they can carry. For this reason, I think excessive regulation isn't warranted. All that is really needed is to mandate some form of substantial loss reserves for the company selling the CDS.