17 September 2008

AIG: the bagholder is broke

”Ken Lewis, the chief executive of Bank of America, said yesterday that "I don't know of a major bank that doesn't have some significant exposure to AIG"

How exactly are banks "exposed" to AIG?

What this shows is the fearful complexity of AIG's corporate structure, which just adds to the difficulty in negotiating a rescue

Sandy Chen of Panmure Gordon found the following paragraph in AIG's US regulatory filing:

"Approximately $307bn (consisting of corporate loans and prime residential mortgages) of the $441bn in notional exposure of AIGFP's super senior credit default swap portfolio as of June 30, 2008 represented derivatives written for financial institutions, principally in Europe, for the purpose of providing regulatory capital relief rather than risk mitigation. In exchange for a minimum guaranteed fee, the counterparties receive credit protection with respect to diversified loan portfolios they own, thus improving their regulatory capital position."

AIG is saying here that it has insured $307bn of corporate loans and prime residential mortgages that are on the balance sheets of banks, mostly European banks.

The banks have bought this insurance to protect themselves against the risk that these loans would go bad, that borrowers would default. Their motive for doing so was to reassure their respective regulators that these loans are of minimal risk. And the benefit of doing that was that they could lend considerably more relative to their capital resources.

But if AIG is in trouble, then doubts arise about whether it would be able to honour the financial commitments it has made through these insurance contracts (which are called super senior credit default swaps).

In fact, in a wholly mechanistic way, the downgrades of AIG's credit rating that we saw last night automatically increased the perceived riskiness of loans made by banks that have insured credit with AIG. Which means those banks' balance sheets become weaker - and that could mean that they'll be forced by their regulators to raise additional capital.

If AIG went down, a number of banks' balance sheets would be a dangerous risk to the stability of the global financial system. Or to put it another way, AIG is so pivotal in the global financial system, it can't be consigned to the dustbin of history in a precipitous way.

Update: Suspect that Sandy Chen has found only a part of AIG's credit protection business, since I am told that US banks are more exposed to AIG than are European banks (which is not what the regulatory filing spotted by Chen shows).

And here's a compelling wrinkle

AIG writes its credit default swaps contracts (its loan insurance business) through a French banking subsidiary. Even so, the possible collapse of AIG isn't a French problem. What AIG needs to obtain is financial support from the American taxpayer at the top holding company level in the US - and it would then use these funds to recapitalise the French bank it owns.

Europe's ETF Securities Rattled By AIG

AIG insured ETF company ETF markets in the UK. due to the problems trading in many etf's were suspended today, affecting thousands of retail investors in ETF's. It is doubtful if their investments are now worth anything or whether they can get their money back through their brokers. This is an early indicator of the type of harm a failure of AIG could cause to the man in the street so to speak.

Summary - based on comments to article

AIG provided insurance on loans made by banks to cover the banks in the event of default on the loans, and this totals $371 billion dollars. Their motive for doing so was to reassure their respective regulators that these loans were of minimal risk. The benefit of doing that was that allowed them to lend considerably more relative to their capital resources. It means the banks have been extending credit left, right and center with absolutely nothing to cover themselves if any of these loans turn out to be bad. If the loans are bad, the last thing the banks would want to do is collect on the insurance from AIG as this exposes AIG to the danger of collapse, which would be bad for all the banks concerned.

The credit crunch has shown that the whole banking system is insolvent. Regulators were responsible by allowing loans made by the banks to be considered as an asset instead of a liability if insurance was obtained. The very size of the insurances obtained should have rung alarm bells everywhere! Now, it's actually in the interests of AIG and their creditors to maintain the myth that AIG will pay out if a claim is made. That would keep AIG in business and maintain the ability of the banks to lend more money on the basis of valueless securites!

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