Yesterday we were pretty impressed with a breakdown of the demise of Lehman Brothers we happened upon on Google Finance. So we tracked down the guy who wrote it, using our hard-nosed reporting skills (his e-mail address was on it) and asked him if he could do the same thing with this whole AIG thing for us. Google Guy doesn't actually work in finance, it turns out (he has a super-secret job that we can't actually tell you about), but that's probably just as well, because if he did, we probably wouldn't be able to hear him through the sobs. Anyway, his name is Chris DesBarres, and his so-easy-to-read-it's-practically-Pat-the-Bunny explanation of what the hell happened with AIG is after the jump.
Chris DesBarres Explains It All
One year ago, most financial analysts would have laughed you out of their cubicles if you told them that AIG, one of the world’s largest insurers, would suffer a crisis forcing them to the edge of bankruptcy that only a government takeover could avert. This credit crisis, however, has affected the financial sector in ways that nobody dreamed of. In AIG’s case, it became the victim of what are known as credit default swaps, or CDS's.
CDS's are sort of like insurance against bad debts. You know that deadbeat cousin you have? Wouldn’t it be nice if you could purchase insurance against that $2,500 you gave him, just in case he ended up not being able to pay you back? That’s kind of what a CDS does.
In this case, a company making loans buys a CDS from an insurer like AIG. They pay AIG a premium, and in return AIG will cover most of the cost of the default just in case the loan does not get paid off. CDS's let companies extend more credit because they diminish their risk. This extension of credit, probably up until the beginning of this week, was generally regarded as a good thing for the economy because it enabled companies to invest, grow, and create jobs. CDS's were one of the tools that facilitated this credit expansion.
Unfortunately, as the housing market crumbled, the value of the contracts AIG issued went down, and AIG had to pay out on the insurance it had sold. As a result, the company took $18 billion in losses, its stock price dropped 94 percent, and it had to raise more capital to make good on its obligations.
Then on Monday the deathblow came: AIG had its credit rating downgraded by Moody’s and Standard & Poor’s. This obligated AIG to come up with $14.5 billion in collateral almost immediately. A thorough search of all of AIG’s couches, car seats, and pockets came up with far less than that amount.
Some private-equity firms tried to reach a deal with AIG to provide it with enough capital, but that fell through. At that point, the federal government decided that the consequences of an AIG failure would be too dire to stomach.
But why did the government save AIG and not Lehman Brothers, which they let die on the side of the road?
The financial structure of the U.S. has been compared to a house of cards, but I think of it more like the game Jenga. This game consists of a tower of blocks, and each player has to choose a block to remove without allowing the entire tower to come crashing down. Some of the blocks can be moved, some can’t. AIG could prove catastrophic.
The government feared that an AIG failure would allow the credit crisis to spill into “safe” investments like money-market accounts. Credit lending would become much riskier, and relatively healthy firms would be even more reluctant to lend money to struggling companies. Even though AIG’s subsidiaries that offer health, auto, property, and worker’s compensation insurance are by most accounts safe and solvent, the bad publicity would no doubt drive consumers away from AIG products, which could quickly make those subsidiaries insolvent.
While the AIG takeover has clearly not stopped the stock market’s slide, this move seems to be part of a broader government strategy to build firewalls around segments of the economy like mortgages, money-market accounts, and insurance, which are the true backbones of the debt-financed consumer economy.
The threat of financial catastrophe is by no means behind us: Two of the nation’s largest banks, Washington Mutual and Wachovia, are facing their own liquidity issues. Will the government save them? Stay tuned…