Can someone explain just why AIG is failing. They’re an insurance company. Were they insuring bad mortgages, houses lost in natural disasters or something I’m not connecting to?
Why is AIG in crisis?
1) CDS: Unlike most other insurance companies, AIG plunged into the market for credit default swaps, which are contracts that act like insurance by protecting investors against default in a range of assets, including subprime mortgages and corporate bonds. Swap buyers make regular payments to sellers like AIG, who in turn have to make payouts if a default or bankruptcy occurs. As the risk of default on the assets has increased, AIG has had to write-down the value of the protection it sold and post collateral to its counterparties.
2) MORTGAGES: AIG also has other businesses that are exposed to the troubled housing market, including a unit that makes mortgage loans to consumers and a unit that promises to make payouts to lenders if a borrower can’t pay the mortgage.
3) INVESTMENTS: Like any insurance company, AIG funnels premiums paid by policyholders into myriad investments aimed at generating profits to fund future claims. Amid the upheaval in the markets, some of those investments have fallen in value.
http://blogs.wsj.com/wallstreetcrisis/2008/09/16/questions-and-answers-on-aig/
AIG is/was the 6th largest company in the entire world - and the largest insurance company.
They had their hands in everything, including the issuing of insurance to investment firms, heavy interactions in the derivatives market, offering protection against loss in most municipal bonds, etc., etc., etc.
This was a no-win situation that has been building since the early 1990's. AIG declaring bankruptcy would have created widespread economic collapse among a lot in industries across the world. Instead the Fed stepped in, and now we'll only have widespread economic collapse across some industries across the world.
Insurance companies used to just insure houses from say, fire and flood.
The housing bubble lead to new securities that were based on home loans. So you bought a bond and as long as everybody paid their mortgages, you got interest on the bond. Some bonds were based on risky mortgages and the people buying these risky bonds bought insurance on the bonds, in case people stopped paying mortgages. That way, they got interest on the bonds, but if the bonds defaulted because people stopped paying the mortgages, they still got paid off on the bond by having them insured.
AIG decided to start selling insurance on the risky mortgage bonds. Housing crashed. Many people quit paying their mortgages. The risky bond holders lost money on their bonds and AIG had to pay off on the insurance on the bonds. They lost tens of millions of dollars. They lost so much money that the rating agencies like Moody’s and Fitch downgraded their company ratings, which downgraded the bonds they held.
I don’t know what happened next except that the downgrade on AIGs ratings required them to make an immediate payment of $40 billion or go bankrupt. I don’t know if the $40 billion was payable to the insured parties, or to whom.
AIG couldn’t raise the massive sum and was going to have to declare bankruptcy, which could have ultimately lead to a world-wide depression. It gets very complicated, since a lot of AIG’s debt was held by China and Russia. The key is, if AIG defaulted on China’s debt, then China might retaliate by dumping US dollars or US T-bills. Something painful like that — the kind of trigger than can set off a worldwide panic and cause a depression.
That is the way I understand it but since I am NOT a financial genius, I’ll leave it to them to correct all of my many mistakes, I am sure. But I do appreciate that when folks ask a question that has a complicated answer, I do my best to try to explain it in layman’s terms most people can follow. I give up a little precision for clarity, but understanding some information clearly is better than not understanding a very accurate and precise post.
Hopefully someone will correct and clarify the errors or omissions in my explanation. It is the best I can do.
I forgot to answer half your question.
No, it wasn’t Ike or any insurance related financial problem that crushed AIG. They were very solid on the insurance side. The did not have unusually high payouts or anything of the type. It was merely these derivatives that ultimately bankrupted them. They were actually a very healthy corporation, but got caught in a money squeeze, kind of like if you lost your wallet or purse. You have the money in the bank but you can’t get to it in time to prevent a catastrophe, so you end up taking the catastrophe.
Imagine a robber telling you to give him $100 and he’ll go away or don’t and he’ll kill you. You don’t have a hundred, so he kills you. All the money you have in the bank or in your 401(k) or your home equity does you no good because you need that $100 at that moment or you will die. That was AIG. They had money in the bank but not on them, and it was pay up or die.
But no, it was not insurance problems that crushed them. It was the massive losses from derivatives because the housing bubble collapsed. If you see the term CDS for Credit Default Swap, that is what killed them. They lost a lot of money on CDS’s, not fire or flood or car accidents.