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First of all—what is AIG?
AIG is American International Group, the largest insurance company in the world. It’s not just an insurance company, however; its business is divided into four divisions: general insurance, life insurance and retirement services, financial services, and asset management. It was started in 1919 in Shanghai.
How did it (almost) collapse?
Like many other banks, AIG lost a lot on its mortgages, including $18.5 billion in the past three quarters—all part of the subprime collapse. Its share price has dropped 79% this year. But bad became worse this Monday when AIG received a downgrading of its credit rating. What’s a credit rating? All securities are given a rating that tells you how much risk is associated with your investment into that security. Depending on the rating, the company must have a certain percentage of money on hand. The ratings, given by agencies like S&P and Moody’s, are a lot like school grades – A’s are good (need less money on hand), B’s are okay/bad (need more money on hand), and C’s are junk (need even more money on hand). So S&P & Moody’s downgraded AIG, which meant it needed to post $14.5 billion in collateral to support its trading contracts. AIG couldn’t sell its assets off quickly enough to get that money. Seeing its impending doom, AIG tried to rally the rest of the banks (JPMorgan & Goldman) to lend them the money.
That didn’t work, so the Fed had to step in order to keep it from total collapse. The Fed has promised to lend up to $85 billion to AIG.
But I thought the Fed wasn’t going to bail anyone out anymore.
Well, yes, that’s what they said. And they definitely stuck to their word when they let Lehman slide to its demise this weekend. However, AIG is more than just an investment firm. It’s such a huge insurer (the largest in the world in terms of assets), and was such a huge player in the Credit Default Swaps (CDS) market, selling off risk to other financial players around the globe. If it collapsed, it would have shaken the global financial world.
What are Credit Default Swaps?
Okay, say I invest $10M into a bond for General Motors, but I’m now afraid that GM may see financial trouble. Instead of just selling my bond off, I can enter into a sort of insurance policy with a big bank, say AIG. I pay AIG a small premium every quarter. If GM remains fine, then AIG does nothing. If GM does see financial trouble and I lose money on my bond, AIG will pay me what I lost on my bond. Likely, this will be a lot of money, relative to the small premiums I pay. Once this happens, the contract of the “swap” terminates. This is all fine and great, except for the fact that the CDS market isn’t regulated—thus I could enter into a contract with a bank that doesn’t have the resources to cover the loss of my GM bond. The CDS market totals $62 trillion, in which AIG plays a central role. Since just about every bank, insurer, and institutional money manager has some sort of exposure to CDS, they all have some sort of exposure to AIG. Hence, the necessary bailout.
How does the bailout work?
Well the Fed doesn’t just hand over the money when they do these bailouts. It has promised a two-year loan for up to $85B. In return, it gets a 79.9% equity stake in the company in the form of warrants (a warrant is basically a call option issued by the corporation—allowing the Fed the option of buying common stock in AIG at a specific price) called equity participant notes. Interest on their loan is at Libor (the London Interbank Offered Rate—it’s basically the London equivalent of the US Federal funds interest rate, and is often used as a benchmark for short-term lending) + 8.5 percentage points. That’s about 12% (now), which is very high interest.
So AIG has to make good on the loan in the two-years either through general operations (not likely) or through sale of its various assets or branches of business. AIG has about $1.1 trillion worth of assets, and the Fed plans to sell them off in an orderly manner.
Why so much money?
Though AIG only needed $14.5 billion after the credit downgrade this week, the $85B loan was designed so AIG would be left with little debt and it could take on whatever the next few quarters has in store.
Does this matter to me?
Yes—now you own part of AIG! Well, kind of. That $85 billion is comprised of your tax dollars. Yep, your tax money is now going to protect bad investments. Investments that packaged up your debt into various securities, and sold it off to another party, who sold it off to another party, who sold it off all over the world.
However, since the Fed is LENDING the $85B to the corporation (unlike the Fannie & Freddie deal) the government could make some serious money off the high interest rate. That is if, by some sort of divine intervention, the market, and thus AIG, rebounds. The Fed is making it clear that the taxpayer will only see positive effects of the bailout.
But will the taxpayer be affected?
Who knows. It may be true – the Fed and the Treasury may make some money off AIG due to the high interest rate, but will I ever see that money? . It’s certainly a good way to assuage the public’s fears.
Will the bailout work?
It should. See, certain branches of AIG are doing just fine. Its aircraft leasing business, for example, is the second largest in the world and is estimated to bring in between $7 and $10 billion.
And who’s to blame?
That’s for next time.
Be sure to read more of what Diana learned today here.
Comments (9)
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Great article.
I think the bailout will work but we (the public) will never see any of the money the government will ultimately make from the deal. I’m not a fan of bailouts but something had to be done in this case simply due to the impact a collapse would have had.
posted by J on 9-19-2008 at 12:12 pm
Thanks for the article – though something that seems to have escaped everyone’s mind – AIG is NOT a bank! More importantly it is nothing like those other companies (mainly banks) that have gone into bankruptcy because it technically is not in debt – simply because of insurance laws and being downgraded they need to have a certain percentage of liquid assets in case they need to pay out claims. Though yes they made a bad decision to enter into the mortgage and credit stuff they cannot be compared to any other company because they are global – meaning if the Treasury had not bailed them out and they had declared bankuptcy (again only technically) analysts believe the fall out would have been similar to the Great Depression. Thanks at least for pointing out that the Treasury did not simply give AIG the money – which every news organization and most people leaving comments on other web sites seemed to completely miss mentioning! The newly appointed CEO is planning on paying back the loan in less then a year.
posted by Katie on 9-19-2008 at 12:23 pm
Here is a nice thought…when the Fed took over the failing Savings and Loans under the Resolution Trust Corporation, they actually made a profit in the end. It’s funny that we think the government is so incompetent with money, yet we accept the fact they need to come in and rescue/reform the financial industry.
posted by Marty on 9-19-2008 at 12:56 pm
Katie, what are you talking about? Your post is gibberish.
1) The first line of this post indicates AIG is an insurance company. I haven’t heard anyone refer to AIG as a bank.
2) Also, AIG has debt. In the form of insurance policies. If someone calls in a claim and AIG needs to pay that claim, thats a debt. AIG couldn’t raise the capital it needed to meet its debts, which is essentially bankruptcy.
3) you note: “Though yes they made a bad decision to enter into the mortgage and credit stuff they cannot be compared to any other company because they are global”
um, lehman brothers was a global company. So was Bear Sterns. Are you suggesting they can’t be compared to banks because AIG is not the one who made the shity loans, but rather they are the ones who insured the derivatives based on the those same shity loans?
4) Also, I’m not so sure you realize how Mr. Liddy plans on paying back our government’s loan, but its going to involve breaking AIG apart and selling off all the peices.
posted by Cornelius Starr on 9-19-2008 at 3:04 pm
one thing which is not mentioned in most news articles or that people do not adequately consider. The Fed is loaning 85 Billion dollars to AIG, but where is that money coming from?
Most people seem to think that the either the government has an unlimited amount of money for these things, or that it has something to do with “the taxpayers”, neither is correct in this case.
The Fed plans to issue $100 billion worth of treasury notes to pay for this. All fine and dandy, except for the unthinkable.
All of the various companies that got into this mess did so by acquiring what they were told by the rating agencies was AAA debt, which they one day discovered nobody wanted to buy and they were stuck with.
What if, just what if one day, investors decide that they are no longer willing to buy more US debt? Where does that leave the Fed in their plans?
With uncontrolled budget deficits and a declining dollar, people may begin to question the true value of US debt.
posted by TheBear on 9-19-2008 at 3:36 pm
Thanks for the article! For people like me who are incompetent with the financial situation, it is a reassurance. With all the articles the media has put forth, it makes it seem so much worse than it is.
posted by NicoNicoNico on 9-19-2008 at 4:52 pm
I bought 500 shares of AIG yesterday. I’m confident they will rebound.
The insurance part of AIG is secure. Other divisions and subsidiaries of the company, such as their airplane leasing part are the areas having problems. Hopefully the new CEO will lead them back in the right direction.
posted by Lynne on 9-19-2008 at 5:22 pm
You know, the article would be much easier to read if you did have oversize ads for Dove covering the headline and first paragraph.
posted by gmsc on 9-19-2008 at 6:00 pm
Cornelius
First off – you are obviously not reading properly – first sentence after :”How did it (almost) collapse” it states: “Like many other banks, AIG lost a lot on its mortgages”.
Secondly, my relative is the Canadian CFO so despite what you may have read through the media you do not have the right information. Most importantly they are not similar to Lehman Bros or Bear Sterns for the exact reasons you said I mentioned, and obviously they have to sell off some of their assets to pay of the bridge loan – and the airline sector of their business – they own the planes that they lease to companies – that subsidiary is worth over $5 billion dollars.
You can speculate all you want but the fact is the media is not aware (or not presenting) what is really going on so I guess I can’t blame you for not understanding the situation.
posted by Katie on 9-22-2008 at 3:46 pm