Saturday, October 10, 2009
Do you want to know why AIG went broke, threatening to bring down the whole US economy? It’s easy to find out: just wade through the 500+ pages in the Form 10-K that AIG filed two weeks ago [around the first of March, 2009]. It’s all in there. I read it.
Derivatives certainly contributed to the problem. That’s why the “stress test” on page 178 says that AIG has an “exposure” of $500,000,000,000 (yup, $500 billion) to long-term interest rates. (As opposed to $5 billion, according to page 183, if San Francisco is destroyed in an earthquake.) So now we know why the Federal Reserve has been buying long term bonds just as fast as the Chinese dump them – to keep its ward AIG from being liable for $500 billion. $500 bil is a lot of money, even to the Fed.
And to whom would AIG owe that money? The answer is on page 176. AIG’s “largest credit exposure” – 160% of its shareholders’ equity -- is to “Money Center/Global Bank Groups”. In other words, Wall Street. And almost half of that amount is owed to only five banks.
The real AIG losses have not come not from derivatives, though, but from AIG’s basic business model. In a news release last Monday, AIG said that it has had to make payouts of $43.7 billion to “securities lending counterparties.” The news release doesn’t explain why, but the 10-K does.
The standard insurance business model is as follows: you make your money from minimizing claims payments, and you make more money on your investments. Warren Buffett has explained this countless times in Berkshire Hathaway’s 10-Ks. It’s a stable, steady business. And, indeed, AIG’s insurance subsidiaries took in premiums, invested them, and paid out on claims.
That’s when things went horribly wrong. According to AIG’s 10-K, AIG’s parent company sucked the investment assets out of its insurance subsidiaries, and lent them out to Wall Street and foreign banks in return for cash. AIG then took this borrowed cash and invested it in – wait for it – mortgage-backed securities.
It’s not in AIG’s 10-K, but the counterparties undoubtedly took the stocks and bonds borrowed from AIG, and sold them short. That’s why institutions borrow securities: to sell them, buy them back at a lower price later, return them, and claim the profit. So as the markets dropped, AIG’s counterparties laughed all the way to the bank. Except they are banks.
And AIG? According to the first few pages of AIG’s 10-K, when the counterparties returned the securities to AIG, AIG had trouble coming up with the cash, because: (i) the mortgage-backed securities market had blown up, and (ii) the securities that AIG had lent out were worth far less. Hence the federal bailout, at $150+ billion and counting. (Which money, by the way, AIG implausibly lists as “shareholders’ equity,” not loans, on its balance sheet, per page 153.)
So why would AIG do something as convoluted and nutty as this? To goose its profit by a few points, by counting both the returns on the lent securities and the returns on the mortgage-backed securities as “profit.” In other words, greed.
Obviously, AIG shouldn’t have done this, and no insurance company ever should be able to do it in the future. This kind of financial “innovation” brings into focus why we need to regulate. The choice is not between regulation and “freedom.” The choice is between regulation and chaos.