Not Just AIG, But the Entire Financial System

Seriously, this New York Times article on AIG, is a quick and layman accessible recounting of what went wrong there, and now that the Taxpayer is laying out another $30 to prop them up, with the approval of the ratings agencies who made this problem possible in the first place, it bears reading.

What we see is a metaphor for the entire rotten "Anglo-Saxon" system of unregulated hyper-capitalism.

AIG does not exist any more, what's there is a simulacrum of a going business, fueled by zombie juice amounting to over $150 billion of taxpayer dollars, with the promise of more federal support, but that's not the important part.

The important thing is are not just talking recklessness and incompetence here, we are talk real and deliberate crimes, and even now the authorities don't have the slightest inclination to prosecute.

What took AIG down was a division that wrote credit default swaps (CDS), lots of them, and then, when they came due, they were bankrupt.

A CDS is a piece of paper that allowed them to insure all sorts of dodgy documents, but lacked the regulation, and the reserve capital requirements, of real insurance.

They wrote them because people were willing to pay them to write them, and people were willing to pay them because it allowed them to "lease" AIG's AAA rating (see the ratings agencies linked above) for their financial instruments.

The result is that if AIG is allowed to die, instead of remaining in its undead state, everything blows up:

.... Yet the government feels it has no choice: because of A.I.G.’s dubious business practices during the housing bubble it pretty much has the world’s financial system by the throat.

If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.

I don’t doubt this bit of conventional wisdom; after the calamity that followed the fall of Lehman Brothers, which was far less enmeshed in the global financial system than A.I.G., who would dare allow the world’s biggest insurer to fail? Who would want to take that risk? But that doesn’t mean we should feel resigned about what is happening at A.I.G. In fact, we should be furious. More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin.

“They were the worst of them all,” said Frank Partnoy, a law professor at the University of San Diego and a derivatives expert. Mr. Vickrey of Gradient Analytics said, “It was extreme hubris, fueled by greed.” Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet — and this is the part that should make your blood boil — the company is being kept alive precisely because it behaved so badly.

They fail because if AIG fails, then their CDS contracts are worthless, and they have to account for their assets at their actual value, and overnight they become insolvent.

So, AIG is Sheriff Bart from Blazing Saddles, holding the gun to his own head, saying, "Hold it! Next man makes a move, the n***** gets it!"

Of course, this isn't criminality (though it should be), this is Republican economics, privatizing the profits while socializing the losses.

The criminality is further down in the article:

....A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.

....But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets — housing — could only go up in price.

That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.

(emphasis mine)

So they sold insurance, and never had any intention on paying off, because if they had, and remember that AIG is (was) at its core an insurance company, even absent regulatory demands, they would have put aside something in the way of capital reserves.

This is the same as selling phony stocks. AIG, or more at least its everyone in a position of responsibility in its financial practices unit in London, where the swaps were written and sold, and everyone involved in supervising these activities, up to and including the CEO, and probably the board of directors, knowingly sold a fraudulent product.