Word: aig
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There's an uproar about whether the government should let AIG fail, a debate re-energized by the latest revelation of bonus payments going to AIG's executives. In fact, there's a good case to be made that AIG should fail, and it has nothing to do with bonuses...
...rescue of AIG is warping the banking system and unnecessarily extending the credit crisis. This misguided effort stems from a lack of transparency and some basic misconceptions about AIG's business. (Read "Obama's Challenge: Containing the AIG Bonus Outrage...
...take a moment to review how AIG made money and why it's now losing so much. Most of AIG's losses have been attributed to its failing positions in credit-default swaps (CDSs). Essentially, AIG is swapping cash flows with other institutions: those banks pay AIG a small sum on a regular basis, and then under certain conditions - like mass foreclosure or corporations' defaulting on their loans - AIG pays out a large sum. In other words, AIG sold insurance; its problem is that it is paying out too much...
...course, it's a bit more complicated than that because of the funky nature of AIG's insurance. Other types of insurance do not carry the same risks because when one claim pays out, it does not snowball. AIG's insurance on foreclosures and other defaults is not like insurance for accidents and disasters; while earthquakes in California are not correlated with earthquakes in New York, foreclosures are spiraling out of control together, fueled by a widespread recession...
Moreover, investors and banks that hold credit-default swaps do not necessarily own the tranches of mortgages and bonds that the CDSs insure. AIG may have even written multiple swaps over the same mortgages and bonds. It would be as if an insurance company had sold earthquake insurance on one house to multiple investors. When the house falls, so does AIG...