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How AIG's Collapse Began a Global Run on the Banks

NaughtyGeek

Golden Member
May 3, 2005
1,065
0
71
I'm very curious to hear what our local finance guys have to contribute to this. By this author's statements, we've yet to see the worst and we really don't know how deep the rabbit hole goes. This crisis is global not as a result of other economies dependence upon the US economy as some say, but rather exposure to FRAUDULENT insurance contracts written by AIG. I also find the first quote ever so ironic considering the background of the individuals put in charge of recovering our economy from this mess.

AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.
Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.

Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.

So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.

"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.

Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.

Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.

Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year ? long before the actual profit on the contract was made.

With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.

It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.
Linky
 

mshan

Diamond Member
Nov 16, 2004
7,868
0
71
I think it actually started with the collapse of LEH, specifically hedge funds apparently couldn't get their money out of an AIG arm in England when they went into bankruptcy. (can't find NY Times article that said this right now).

That is what I think started the cascade into AIG, then Black Wednesday in the credit markets.

I think really, really, really rich people started a run on their banks.
 

zephyrprime

Diamond Member
Feb 18, 2001
7,505
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The triggering event was the pseudo-nationalization of fannie and freddie. Nationalization of those companies was one of the recognized triggering events that was written into all those CDS that AIG sold to guarantee fannie and freddie.

However, that event was just the straw that broke the camels back. The ultimate cause of this is a combination of things that have allowed the US to become too dependent on debt. The prosperity of the last 20 years was largely founded upon debt. It began way back when after WW2 when the free world came to focus on the US as the financial center of the world. This in itself didn't have negative effects but what happened was that the US started abusing its privilege of being the issuer of the world's reserve currency. Reagan was the first one to really figure this out. Then we let China get away with it's non-free trade policies and currency manipulations because corporations were greedy for cost savings. Then we insisted on maintaining our expensive military empire all around the world. The only was we could do that and also afford our expensive entitlement programs was to go into debt. As we acquired more and more debt we needed lower and lower interest rates. These low interest rates allowed for the advent of modern hedge funds who invented these crap securities. Merton and Scholes conceived of a new way to price risk so the financial world thought we could now control risk (turns out we couldn't). These crap securities and low interest rates created the housing bubble and we are now suffering the bursting of that bubble.

It turns out our financial institutions own a lot of the debt which is now worth only a fraction of its notional value. Those financial institutions are bankrupt. Unfortunately, those institutions are also dragging down other companies with them like AIG. In turn, AIG is dragging down other institutions with them as they go under.
 

Thump553

Lifer
Jun 2, 2000
11,905
1,245
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I agree with mshan, the collapse was triggered by the failure to bail out LEH. Granted, the CEO of LEH is a first class dick with golden parachutes up the wazoo whose incompetent and recklessness was tragic, but the fact is Lehman was three times the size of Bear Stearns, which was bailed out this spring as being too big to fail.

When the feds walked away from LEH it started a crisis of confidence that the US was not going to backstop this downfall, and that crisis has continued to snowball to today.
 

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