It was announced yesterday that an additional $30 billion in government aid would be made available to AIG after they posted a $61.7 billion loss, the largest quarterly loss in history. They are not being handed the money yet but the Fed put it on the table so that the ratings agencies- who were on the verge of downgrading AIG’s rating, making what they do have useless- would back off. 

This is the fourth trip to the lending trough for the company that the government already owns nearly 80%. But the government didn’t have much of a choice on this one. It isn’t that AIG is too big to fail but that it is too intertwined to fail. I’m going to get into that more below but if you want to check out what the government has put into AIG (much) and what it is getting in return (little), Baseline Scenario is dissecting the situation. 

The insurance portions of AIG are fine (actually, they’re turning a profit). But AIG got up to some seriously shady (and well known at the time) behavior regarding mortgages that led to this point.

Before the housing bust, AIG was rated AAA- the highest rating, which is supposed to signal low risk and allows the institution stamped with it some liberties. AIG gamed the system by spreading the “wealth” to mortgage-backed securities by insuring them with policies called credit-default swaps (CDS). The CDS meant that AIG would absorb any losses that might hit that security. Any security insured by AIG would get its AAA rating. Wall Street loved this because AIG was absorbing the risk and giving the package a higher rating for resell. AIG benefitted through fees and what they considered a low risk deal, since- like many others- they thought the housing bubble would keep inflating. Because they considered their risk so small, they didn’t keep enough funds on hand to pay off the policies were something to happen.  And something happened. 

The Fed had to bailout AIG because these CDS policies are holding the European financial system upright. AIG used their rating “game” to help banks make their balance sheets look better than they were by selling the banks CDS. The AAA rating meant the bank could keep less capital on hand and the banks took advantage of this by having far less than they actually needed based on their authentic balance sheet. As of September of last year, AIG “had written coverage for over US$ 300 billion of credit insurance for European banks.”

If AIG failed, it could take Europe with it. The astonishing thing here is that these behaviors were being conducted somewhat openly and no one tried to stop them.