AI-G-WHIZ

It seems that I can no longer prepare my articles until the wee hours of the morning. Yesterday morning, I was planning to write about the details of the Fed meeting (they left rates unchanged at 2%). By the afternoon, I was conducting research on bankruptcy of insurance companies (great information at www.nolhga.com). Late last night after learning that the government provided AIG with an $85 billion bridge loan to prevent the mammoth company’s failure, I figured the writing would have to wait.

At 6:00 am on Wednesday morning, here is what we know. After a weekend when government officials allowed Lehman Brothers to fail, the Federal Reserve reversed course and determined that mega-insurer AIG had far too many tentacles across the financial system and could not allow the company to fail. The underlying problem is that AIG played a big role in underwriting insurance contracts on esoteric debt instruments that were originally connected to the housing market.

As a reminder, banks wrote mortgages and sold them to investment banks, like Lehman Brothers or Merrill Lynch. The investment banks then packaged the mortgages into securities and sold them to (mostly) institutional investors. To protect investors against defaults, AIG sold insurance on those securities (credit default swaps). These unregulated insurance contracts required AIG to cover losses suffered by buyers in the event the securities defaulted, putting AIG on the hook for losses associated with billions of dollars of risky securities that were once viewed as safe.

AIG posted collateral to guarantee that it could repay investors if needed. The contracts specified that if AIG’s credit ratings were cut, it was required to post more collateral. Credit agencies cut AIG’s ratings on Monday, pushing AIG to the brink of bankruptcy. Here is the problem: if AIG would have failed, it would have set off a dangerous chain reaction where institutional investors would have then been forced to sell the bad stuff, driving prices even lower. AIG was simply too connected to various key markets, including: credit derivatives, mortgages, corporate loans and hedge funds. Additionally, there is a vast consumer component to the AIG story because the failure of AIG would affect millions of insurance policyholders, retirement plan participants and investors with money market funds with AIG. Simply put: AIG was just too interconnected to fail.

The world’s financial system could not easily absorb an AIG bankruptcy so the Fed acted. (It would have been nice if the ECB stepped up, considering that at midyear, ¾ of AIG’s credit default swaps were held by European banks, but that is another column.) Under the plan, the Federal Reserve will extend a two-year loan to AIG, of up to $85 billion and, in return, will receive warrants that can be converted into common stock giving the government nearly 80% ownership of the insurer, if the existing shareholders approve. Finally, AIG will continue to operate during this period so if you own an AIG product, try not to drive yourself crazy. In essence, the government has provided you with a big safety net and hopefully, a better night’s sleep.