Crisis Coverage: Why AIG?

It appears the Fed has bailed out AIG with an $85 billion loan and an 80% stake in the company plus a bunch of other provisions like replacing management. This is good news in that the feared crisis is back on hold for now.  But why did they save Bear, Fannie/Freddie and AIG, but not Lehman?  AIG is an insurance company and not an investment bank right?  As usual, the true nature of what happened is a bit murkier.

The Fed saved Bear because its collapse happened rather suddenly and the markets were not prepared.  Had it ceased operating suddenly, the markets would likely have been in a tailspin causing a panic.  Here is where the damned if you do, damned if you don't play comes in:  Failing to save Bear may not have had a domino effect or may have resulted in "only" a brief dislocation in the market.  If this were to be the case, then the rest of Wall St. would have been duly warned to get its house in order quickly.  If you are the head of Lehman, do you say "hey, we can ride this out without major changes and come out the other side with our whole business intact and lots of profits and if we get into trouble, the Fed will bail us out" or do you say "holy crap, we need to act now before its too late!".  I'll give you one guess which option Lehman chose. 

This dilemma is known as the "moral hazard".  It means that market participants will take on more risk than is prudent because they believe the downside will be limited by the government.  By "saving" Bear, Lehman wrongly decided that it didn't have to get in shape; rather it could retain its excess risk and try to profit from it later on (remember more risk, more reward- when it works out that is).  Lehman had a long time to act and it failed to get things in order.  It appears the Fed tried to reestablish the risks and take away the notion they will save everyone by letting Lehman fail.  Since the market had ample warning of Lehman's impending demise, investors were able to adjust and absorb the dislocation.

AIG on the other hand, falls into the "too big to fail" camp as did Fannie and Freddie.  Now AIG was not orders of magnitude larger than Lehman, but it's role in the market is very different.  AIG is an insurance concern, but one with dozens of different businesses with hundreds of subsidiaries.  What does an insurance company do?  Insurance companies absorb risk for a living. The odds of your house burning down are small, but if it happens it is an unreasonable and unbearable loss for you- low probability but high severity.  An insurer will cover thousands of houses of which a small percent will actually burn down.  The collective premiums pay for your loss and provide the insurer with reserves and profits to compensate for taking the risk.  Insurance is really that simple in principle.

One of AIG's businesses is called Credit Default Swaps or CDS, which are effectively a form of insurance, albeit very lightly regulated.  If an institution is worried about getting paid- say GE is worried about United being able to pay its aircraft leases- they can purchase CDS or insurance on United.  It is basically an insurance policy on United's credit.  To complicate matters, Wall St and insurance companies used Wall St and other insurance companies to insure against eachother.  With AIG in the center of this madness, had it failed, the effects would ripple through the whole system, non-financial companies included.

How could this "ripple of evil" come to pass? (Pardon me, but I couldn't resist a Lewis Black reference). Insurance is used to hedge other positions because it makes the insured whole.  Let's say your investment bank bought a bunch of bonds guaranteed by, ohh I don't know, say Ambac.  And Ambac gets into trouble.  You are required to "mark to market" all positions each day, which means the value of those bonds should decrease.  If you have insurance in the form of Ambac CDS, the value of the CDS rises to offset the fallen value of the bonds, keeping the portfolio whole.  Whoever is the counterparty of the CDS, that is who wrote the insurance, must post collateral.  (This posting of collateral process is slow and choppy even after years of warnings because there is virtually no regulation in the CDS market).  Say AIG needed to post this collateral, but can't come up with it because of the crisis.  This necessitates you mark down the CDS and both your bond and CDS fall in value.  If you are levered 20:1, it only takes a mere 5% fall to wipe out your equity, which necessitates a margin call on the investment bank.  You can see the domino effect here, selling begets selling whch begets more selling. 1929 anyone?  And that is how AIG could destroy the world.  Evil, I know.

Just like an insurer can go bust because it's reserves are not enough to pay for a truly rare event- say Hurricane Andrew destroying south Florida for example, when a truly rare financial storm hits as it is now, AIG couldn't weather the storm.