Maybe its the All In Group, or American Insurance Giant?  Whatever it is, The Fed decided they were too big to fail.  Two months after President Bush said we would not bail out private industry, we’ve bailed out the largest portion of the mortgage market (Fannie/Freddie) and now the largest insurer on the planet.

It’s sad these days that I now have a format for explaining why a bank failed.  I shouldn’t have a template, but I do.  You know the drill, I ask the questions I think you would ask.

What Happened?
I’ve explained in the past how insurance companies make money.  In short, the money they make from premiums is invested.  Insurance groups, like hedge funds, pension funds, banks, and foreign investors bought into the whole subprime thing.  Now the AIG fall was inevitable, but it was set off by the failure of Lehman Brothers.  When a company buys a mortgage backed security, they must asses a “value” in order to report it as an asset on their balance sheet.  The “value” includes an expected return.  When Lehman fell, investors looked at AIG’s books and found AIG had “valued” their similar investments by as much as 2x.  So think about it, Lehman fell at a fair value of say, $400 for a securitized mortgage.  AIG had a similar mortgage valued at $800 (note: figures made up).  Was this greed or ignorance?  Likely ignorance.  The problem with these securitized subprime loans is that no one really had a grasp on the actual value of them.  Between no one buying and everyone defaulting the value is next to nil.

So They Declared Bankruptcy Right?
Almost.  They threatened to.  First they were allowed to try and accounting trick to raise extra cash, but investors didn’t buy into it.  So the Feds came in to try and broker a deal with other banks to loan AIG $75 billion.  Turns out no one wanted to help them.  The government decided AIG was too big to fail (perhaps rightfully so) and bailed them out.  Now we own most of AIG.  In exchange for stock, the Treasury will loan AIG the cash they need to stay afloat.  Like buying Fannie and Freddie, the government could make a profit.  Could is a key word though.

Why Did AIG Get Hit Harder Than Banks?
Like other institutions, its turns out AIG didn’t have enough cash to cover their assets.  Their problems were doubled by the little product known as mortgage insurance.  Remember if you don’t put 20% down on your house, your mortgage payment often includes a premium that protects the bank from lost money if you default.  AIG was a big provider of these loans.  In essence, AIG could have been both insuring your mortgage from default, and collecting the monthly payments as a mortgage backed security investor.  That’s like doubling down.  If you lose your house, AIG is hit twice as hard.  If you make your payments, AIG gets twice the kickback.  Brilliant.

What is the Lesson this Time?
As your spiritual guide through the temples of Wall Street, I cannot tell a story without teaching a lesson.  Companies combine to improve efficiency.  Company A has $100 in expenses and Company B has $100 in expenses.  Since they make the same product, they learned that combining themselves would only create $150 in expenses.  The savings of $50 is profit.  But there is a line that can be crossed, when a company gets too big.  AIG was too big for its own good.  The left hand didn’t know what the right hand was doing, and the entire world relied on the company for some type of business.  This meant the failure of AIG could disrupt the flow of the economy as businesses try and find new sources.  The government stepped in to smooth the transition.  AIG will shrink many times in size, but now it will happen slowly, and business people can take a bit more time to find a new source for their insurance or investor services.  The Lesson:  There is such a thing as too big.  Fannie, Freddie, AIG, and Jabba the Hutt were too big.  It was their undoing.

Below are two articles that talk about the fallout:
Market Watch
Chicago Tribune

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics.

categories: banking, economics, government, loans