The saga or AIG and the taxpayer continues, but with some surprising good news for the taxpayer. The Treasury reports here that AIG may actually be able to pay back the NY Fed and the Treasury for all the money poured into the firm to keep it afloat during the crisis. This surprises me to no end, given how bleak things looked for the firm in the summer and fall of 2009.
One could make the case that the foolish AIG insurance in the mid-2000’s caused the subprime crisis in that AIG nearly singlehandedly supported the price of the bonds by writing this insurance. It supported the mortgage machine despite some smart investors who were aware of the low expected payout of many of these assets.
The background . . . early in the 2000’s, the giant insurance company decided that it was a good idea to use its triple AAA rating to write insurance on aggregate house prices through insuring securitized mortgage-backed bonds, including billions upon billions of subprime mortgages. And when the house prices started to decline, AIG lost hundreds of billions, much of which was promises to US financial institutions, but also banks and investors worldwide. And the government stepped in to take over the firm (or at least 80%) and pay off its debts and insurance contracts.
Who is to blame? Well, the guys who were at AIG financial products. As long as the crisis did not hit, AIG (meaning shareholders and the people who worked there) made lots of money. But its unclear, as always, the relative importance of greed and stupidity.
Second, the regulators. In the 2000’s up to 2008, regulation failed grossly. Insurers are supposed to be regulated so that they have enough collateral to pay off insurance contracts in any future state of the world (which of course means almost any future state of the world). In insurance, insuring against burglaries is straightforward. Because only a small number of houses are burglarized, the insurer collects premiums, pays out to those who were robbed, and, if it set prices right, makes some profits. Insurers are not supposed to collect insurance premia and then not be able to pay when looses occur – they are not supposed to do the robbing. But AIG, through its financial products division, insured mortgage backed securities in amounts far more than it could ever pay off. This was because bond failures were not like robberies and more like flood insurance. Unlike burglaries, if there is a flood, flood insurance pays off to all homeowners. As a result, regulators are either supposed to prohibit insurers from insuring property against damage from floods or wars or natural disasters which can hit everyone at once or at least require high enough collateral backing the insurance that the insurer can cover the losses.
Finally, the market is to blame. The market foolishly thought that a triple A rated, regulated insurance company wouldn’t be so foolish as to write insurance it could not cover. So banks and investors bought the insurance, exposed themselves to the risk that AIG would go under, and left the financial system exposed to an AIG bankruptcy. Ultimately so exposed that we the people stepped in and bailed them out.