How the AIG fiasco works

NY Times:

Every day, insurance companies sell policies to homeowners to cover the cost of damage in the case of fire. Why would those companies agree to pay out in full to a policyholder even if a fire had not occurred?

That is the type of question being asked about the federal government’s bailout of American International Group in which the insurance company funneled $49.5 billion in taxpayer funds to financial institutions, including Deutsche Bank, Goldman Sachs and Merrill Lynch. The payments, which amount to almost 30 percent of the $170 billion in taxpayer commitments provided to A.I.G. since its near collapse last September, were disclosed by the company on Sunday.

The company had resisted identifying the recipients of the taxpayers’ money for months, citing confidentiality agreements.

But instead of quieting the controversy, the disclosure of the amounts paid to A.I.G.’s customers has created still more questions and unease over the insurer’s rescue, arranged by the Federal Reserve Bank of New York and the United States Treasury.

Critics argue that the government’s decision to pay buyers of A.I.G. credit insurance in full and across the board was an inappropriate use of taxpayer money. In addition, these people say, options not pursued by the government could have allowed taxpayers to benefit from future gains or at least have done a better job of limiting the potential for losses.

The criticism surrounds the action taken by the government on credit insurance that A.I.G. had written and sold to large and sophisticated investors, mostly financial institutions. The banks that did business with A.I.G. bought credit insurance to protect against possible defaults on debt securities they held or had underwritten.

But when A.I.G.’s credit rating was cut last year, the company was required to post collateral on these insurance contracts. The need to quickly deliver cash that it did not have created the downward spiral that brought it to the brink.

What upsets some people is that the government paid the counterparties in full even though the underlying securities had not experienced widespread, or perhaps even any, defaults.

“It is inappropriate to be giving money to A.I.G. for them to give it out to their counterparties equally,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn., and an expert in insurance. “If we decide that another bank will be in trouble because A.I.G. fails, then we should decide explicitly that the bank should be supported. We should not simply give everybody 100 cents on the dollar.”

When the government bought the underlying securities to cancel the insurance, the taxpayer became the owner of these pools of debt issues. Because the government chose to pay par or 100 percent of the face value, the taxpayer has downside risk if the securities lose value but virtually no upside.

Even if none of the debt securities in the pools experience a default, the taxpayer is likely to receive no more than par — what the government paid — when they mature.

Had the government negotiated for a lower price, say 75 cents on the dollar, the taxpayer might have been able to reap gains down the road.

The top three recipients of money from the government related to the credit insurance A.I.G. had written are Société Générale, a French bank, at $11 billion; Goldman Sachs, at $8.1 billion; and Deustche Bank, at $5.4 billion.

...

AIG was selling credit default insurance. By doing so it was lending its then AAA credit to securities that would have been worth less without that credit insurance. When its financial situation changed and it was no longer a AAA credit it was in default of its agreement and required to come up with the cash. Since it had been selling the insurance for only a few cents on the dollar, it was required to come up with other assets to insure the securities that had been hedged with its products. Even with all its other assets it did not have enough and that is when the Fed stapped in to provide the cash that is being used. Funding tose policies was a way of protecting the banks which seem to be the idea behind the bailouts.

There was and is a lot of anger directed toward AIG for its irresponsible conduct. But it was not in a position to renegotiate its agreements short of a bankruptcy. What it could have done is tell the banks that it now had sufficient funds to guarantee the derivatives they held and would fund at the time they went into default. That would have avoided having to take possession of the securities at this time.

CNN also explains the AIG business.