What makes one company worthy of a substantial and unprecedented federally funded loan while other businesses are left to crumble in their wake? Many people may be asking questions like this, with all of the coverage regarding failures in the stock market, corporate bailouts, and politician’s claims that the proverbial “sky is falling.” What does it all mean? Why did AIG receive preferential treatment from the government while Merrill Lynch and Lehman Brothers were made to fend for themselves? The answers lie in a deeper understanding of AIG’s true place in corporate America and how it facilitates business from every industry.
American International Group (AIG) is known to most individuals for their quirky commercials advertising their personal insurance services for things such as boats, automobiles, and homes. However, AIG is a highly diversified corporation with subsidiaries touching nearly every facet of American life. As one of the world’s largest insurers, one of their main sources of income is dealing with what is known as a credit default swap (CDS). Essentially, a credit default swap is insurance for a financial institution against any individual or business that they have loaned money to from defaulting on their obligation. In other words, if you go to a bank and take out a loan to purchase a vehicle, that bank can then pay a premium to AIG in exchange for a guarantee that if you are to default on the loan, the bank will still be paid from AIG. This safety net has allowed banks to account for their assets more accurately and completely, because they are not faced with the uncertainty that is associated with lending out money and instead transfer that burden onto AIG.
The added security for lending institutions historically led to an increase in the number of loans and a decrease in collateral required to secure the loan. This development fueled the occurrence of subprime mortgages that is now often being referred to as a crisis (subprime refers to the fact that the “loanee” is viewed as under-qualified for the loan based on traditional standards). Subprime mortgages truly proved detrimental to AIG in two ways: as the housing market began to deflate they saw an increase in people defaulting on their loans that were insured through a CDS, which held them accountable for covering more bad debt. On top of this, credit reporting agencies were keen to the fact that this was lowering the firm’s financial resources and began to place serious doubt on their ability to summon up large amounts of cash if the need should arise.
In realizing this, the credit reporting agencies lowered the credit score they had assigned to AIG as a corporation, and this is where the one-two punch from the subprime mortgages really put AIG “down for the count” if you will. With the lower credit score, as with individuals, AIG as a company was seen as less capable of repaying their financial obligations to other firms. This lead to firms who had lent money to AIG to fear for their own investments, and AIG saw an increase in the collateral requested by approximately $14.5 billion. Their already-strained supply of cash at hand was pushed past the breaking point by these requirements, and to further the metaphor, AIG was up against the ropes. They were in desperate need of large amounts of cash to meet their immediate financial obligations or they were going to have to declare bankruptcy.
Let them go bankrupt; they’re just another insurance company one might argue at this point. However, the depth of their involvement with other corporations and the sheer number of CDS-backed investments that existed through AIG would have pushed our economy further downward, possibly into a full-fledged depression. Had AIG been allowed to declare bankruptcy and therefore defaulted on all of their CDS accounts, the value of every piece of credit that was previously backed by a CDS would drop by a significant portion as the risk of individuals defaulting on their obligations would then have to be subtracted from the face value. To exemplify this, if I have a loan for $10,000 from a bank that is backed by a CDS through AIG, that bank knows they will receive their money either from me or from AIG, and they can therefore extend this credit to me with little or no consideration for my current financial status or credit history. If the CDS backing is withdrawn, the bank will then have to rely entirely on my ability to repay the loan back if they wish to get their money. Essentially, it shifts the emphasis back onto my personal financial history, and if my credit score is less than stellar, the bank will be required to account for the likelihood of me defaulting on my loan when reporting their assets. With this drop in value, many financial institutions would face similar problems as AIG had faced as their credit ratings would plummet with the loss of these fiscally-secure investments. The collateral damage of this happening would amount to banks struggling to be able to secure lines of credit necessary for their operation, which would in turn ripple through the business sector and eventually decrease the availability for loans to private citizens as well. Essentially, every level of the population would experience what is referred to as a cash freeze, where in there is a halt on the ability for cash to flow from the top tiers of financial institutions, down through corporations, and to the general public. Without liquid assets necessary to perform day-to-day operations businesses and people would suffer immensely and our country would face dire consequences: our economy would slow to a standstill.
With apocalyptic-level circumstances such as these facing our country it is no mystery as to why the AIG “bailout” was swiftly approved. The government was convinced that the company was simply too deeply rooted in our economy to be considered expendable: AIG was too big to fail. The terms of the bailout revolved around a maximum amount of $89 billion to be loaned out by the Federal Reserve, to be repayed within a 24-month term at libor plus 8.5% (a technical way of calculating the interest, equates to around 11%, but fluctuates daily). In addition, the credit is secured by a 79.9% stake in the assets of AIG.
What kind of effects does this legislation carry for us as a nation? First and foremost, the government is now the principle owner of a private insurer, which has never been seen in the history of the United States. Secondly, the government (and taxpayers by association) actually stand benefit monetarily as this is in fact an interest-bearing credit extension backed by a significant portion of a multi-billion dollar corporation. Although it is definitely worth noting; remember those subprime mortgages that were at the bottom of this entire ruckus? Well, those guys are still around, except for now the government owns a stake in the ordeal. This is something to think about, although if a lower percentage of people default on their mortgages than the entire credit industry is predicting, the government does stand to benefit.
So, what makes a business more important than another? If the failure of that business breeds a flash-freeze of all liquid assets within the United States and has a significant chance of bringing about the downfall of our entire economy, it is most likely worth lending $89 billion. With circumstances as menacing as those faced in the AIG bailout, it is most imperative that government officials shed their partisan affiliations and roll up their sleeves for the sake of the preserving our economy, and our country.
[Published in Content Magazine, Fall 2008]