Tuesday, March 03, 2009

So When Did AIG Become FDIC Insured Anyways?

Our government sank another $30 billion into AIG this week, for a grand total of some $170 billion since the beginning of this crisis. We've been told AIG is "too big to fail." It's becoming we've lost too much money for it to fail. Any hope that we would make money off this "investment" (remember the good ole days of October 2008) has in my opinion has died.

Let's recall what AIG did to get in such trouble. It wasn't health insurance or providing your grandmother with an annuity, nor their aircraft leasing business. It was their Credit Default Swaps (CDS), basically insurance on an investment, such as a corporate bond or mortgage-backed security. Say you bought some debt of GM (because you wouldn't want to buy one of their cars), thus lendig them money to use (they really need it), but you were afraid they would default. You could get a Credit Default Swap, a contract where you the buyer would pay a small fee to cover that bond to the seller (like AIG), and if the company defaulted paying back the bond you receive a payment. Basically insurance on the bond, but the key being its not regulated. There were no rules over how much money a seller of CDS had to have on hand to cover losses, as there are in regulated insurance. Indeed, there were no rules that you even had to actually own a bond of the company you were buying, if you thought a company would fail you could bet against it. So, there were more CDS than the underlying assets they were insuring.

As I mentioned, CDS's were not regulated. Your normal commercial bank where you have a checking and savings account, is regulated (I would say well-regulated but if you've watched the news...) and FDIC-insured. (Federal Deposit Insurance Company) So, should the bank fail, your money in your accounts would be safe, up to $100,000 at a bank before the crisis, now $200,000 or so. But these credit default swaps that AIG and other banks were making were not regulated like insurance companies, or banks, and not FDIC insured. Like buying stock, there's a risk the CDS will fail. But somehow, we (or at least the government) has got this mentality that we can't let AIG fail because all these credit default swaps would fail. So what? That would be horrible if people lost money on their bad investments. Investors should have been aware they were buying unregulated insurance and could lose. The problem in my opinion is not that AIG is too big too fail but that their product (CDS) has now become too important to fail and is being treated like an FDIC insured bank account where the government will back it, despite AIG and the investors never having paid anything to cover them when they were profiting. If only they had bought credit default swaps on their credit default swaps. Will we the taxpayers keep sinking money into AIG to cover ever investor's loss covered by a credit default swap? Probably.

This raises another question, which could be a post in itself. These large banks (I won't name them) that keep getting bailout money, why doesn't the normal FDIC process apply here? The accounts are FDIC-insured, so although they can fail the account holders would be protected. If a bank is good it shouldn't need money, and if its bad it would reach a point where its about to not be able to cover its accounts, in which case the Feds would step in, wipe out the shareholders, prop the bank up, and reorganize it and eventually re-privatize it. Fair and simple. The way the media portrays it if the banks failed the account holders would lose, which is not true. And yet, there has not been much talk about the FDIC since October.