Why AIG Scares Me

The demise of Lehman Brothers and Bear Stearns hurts, but the demise of AIG could be devastating to the world’s financial structure.

While AIG provides traditional insurance products, such as life insurance through American General Life, it is active in many non-traditional areas that have far-reaching effects throughout the economy.

AIG has been active in creating profitable niche areas of insurance that would befuddle the normal human brain. It has taken insurance practices that were only undertaken by private insurers like Lloyds of London, and brought them mainstream. One of these areas is what is known as Credit Default Swaps (on mortgage backed securities). In a credit swap, a company would pay AIG to guarantee the income stream of their mortgage portfolio. There are other things to guarantee, but let’s use this for our example.

AIG’s financial strength has allowed them to provide income guarantees effectively and profitably. AIG had the resources to make these guarantees, as well as the credit ratings to make their guarantees matter. This all works well until there are radical changes in the nature of the investments that AIG guaranteed.

Let’s say that a mortgage pool is owned by a bank. The bank has contracted with AIG (hedged) to guarantee the income stream of the mortgage portfolio. If the mortgage pool defaults, AIG has to come up with cash to make up the shortfall. AIG has reserved liquid assets against this risk, so everyone is happy. The bank manager feels secure, because his return is “guaranteed” and his profits have skyrocketed. AIG feels good, because they have earned money insuring a risk they don’t expect to incur.

Let’s continue this hypothetical scenario:

Let’s assume that large pools of these mortgages have defaulted. AIG has been forced to make payments. As the defaults grow, AIG uses more of its reserve. It becomes apparent that the initial reserve was not enough, so AIG scrambles to come up with more liquid assets. At the same time, the financial rating organizations, such as Standard & Poor’s, Moody’s. Fitch and A.M. Best all figure out that AIG has problems. They recognize that AIG has not set aside sufficient assets to cover their shortfall. In addition, it appears that defaults will continue to occur, causing a need for even greater capital. This causes AIG’s financial stability to suffer. So, the rating agencies downgrade the financial ratings of AIG. Big problem for an insurance company.

The new downgrades do many things. They cause AIG to need even more liquid capital, as their long-term profit outlook has soured. If this capital is not available (as it may not be) it could force AIG to become insolvent, and unable to meet its contractual financial obligations. They also have to pull assets away from more profitable activities and make them safer.

The downgrade in AIG's financial rating also causes a similar downgrade for other companies. If AIG’s guarantee is meaningless, other companies must then reflect this on their own balance sheets. Let’s say that I am this bank who has borrowed lots of money to purchase mortgage securities. I feel okay about this, because I have borrowed at 3% and I am earning 6% on my mortgage portfolio. For the sake of simplicity, let’s assume that I pay AIG 1% per year to guarantee my cash flow. I still net 2% on money I have borrowed. I have borrowed a mere $1 billion, but I make $20 million in enhanced profits, on top of my normal banking profits. If my mortgage portfolio stops paying interest, and AIG cannot make up the difference, I now have a worthless security as my collateral for my bank’s loans. My creditors get nervous, so they call in their loans. Now my bank is in trouble. To raise cash, my bank must now call in its business loans or sell assets. Good companies are forced out of business. Stocks get cheaper because of selling pressure. Investors lose money. My own stock plummets. Etcetera, etcetera.

The failure of AIG could cause many strongly capitalized, “conservative” companies to face financial difficulties, even collapse. It could cause many well-run companies to have liquidity crunches, not because of business mistakes they have made, but because of a credit swap negotiated in the Isle of Man, Paris or the Cayman Islands has gone sour.

AIG has insured hundreds of billions, if not more. So, if they collapse, expect this to reverberate through the markets like a California brush fire, with no end in sight except for some Pacific cliffs. Let’s hope that our economy (or Federal Reserve) doesn’t have to jump off.