How AIG Destroyed the World

(updated below with thoughts on the bonus situation)

Okay, that's a little hyperbolic, but it really is hard to overstate what a key role AIG played in bringing the financial system to the brink of collapse. I've tried before to explain, in simple terms, just how we got into this mess, and I'm going to try again, this time with a focus on AIG's role.

Imagine, for a moment, that there was a company that offered stock market insurance. For a small premium--pennies on the dollar--you could buy an insurance policy that compensated you in the event your stock investments lost money. If there were such a company, what would you do? You'd buy a whole lot of stock, of course, and a corresponding insurance policy to hedge your bets. It would be a no-brainer, a low-risk, high-reward investment strategy.

In fact, because you were exposed to so little apparent risk, you'd probably leverage up big time. You'd borrow as much money as you could and you'd buy stock with it (along with corresponding insurance policies). Why not? Your investment gains would be more than enough to cover the interest on your loan. You'd be making money off other people's money.

And everyone else would be too. The ability to cheaply hedge against loss would encourage everyone to buy massive amounts of stock, with borrowed money. With everyone's money pouring into the stock market, stock prices would rise at a brisk and steady pace, seemingly validating everyone's investment strategy. A massive stock market bubble would soon form, but for a while, everyone would make lots of money. The investors would make money. The folks loaning them money would make money. And the insurance company would make lots of money from the premiums it was collecting.

But at some point, people would realize that stocks were greatly overvalued. The bubble would burst and the market would come crashing down. And the insurance company would suddenly owe unfathomable sums of money (much more than it could possibly pay) to everyone who had purchased its stock market insurance policies.

That, in a nutshell, is the story of AIG, except of course that AIG was insuring a different type of investment. AIG was in the business of issuing credit default swaps, which are essentially insurance policies that protect lenders from defaults by borrowers. The availability of cheap credit default swaps turned mortgages into a seemingly risk free investment. Mortgages and mortgage-backed securities paid steady, consistent returns and any downside risk could be effectively hedged by buying AIG's credit default swaps. So demand for mortgage-backed securities shot through the roof. Investment banks couldn't get enough of them. In order to fill the demand, banks and mortgage companies started issuing mortgages to anyone and everyone one who wanted one, even if they had terrible credit. New fly-by-night lenders and new kinds of mortgages suddenly appeared on the scene. They offered no-down payment loans and teaser rates. Anything to get people to sign on the dotted line. The mortgage issuers would then turn around and immediately sell them to investors, thereby insulating themselves from any default risk. As the market flooded with easy credit, housing prices rose at a brisk pace. The steady rise in value encouraged people to take out even bigger loans and to borrow against their apparent equity. The lenders were happy to oblige because the market for mortgages was so strong. The investors kept buying because they were getting steady returns and were insured against loss. The returns were so steady, in fact, that they saw an opportunity to leverage and began buying mortgage securities with borrowed money.

A huge asset bubble was created. Eventually it became so obvious that a bubble existed that savvy investors started buying credit default swaps not as a hedge, but simply because they knew everything was about to come crashing down. And AIG was happy to issue them.

Then the bubble burst. Now AIG is on the hook for all of the ridiculous policies it underwrote. And there's no way it can possibly pay them all off.

I don't mean to imply that this is all AIG's fault. There's a lot of blame to go around, and there were other companies that were in the credit default swap business. But AIG was the worst offender and it played a critical role in creating this fiasco. Without a big company willing to write these insane insurance policies, the situation never would have gotten as out of control as it eventually did. Investors made horrible bets on mortgages and mortgage-backed securities, but they were encouraged to do so by the availability of an easy hedging mechanism, i.e., cheap credit default swaps that AIG issued by the billions without ever considering what would actually happen if home owners began defaulting on their mortgages in large numbers. AIG was as reckless as a company can possibly be.

And our leaders were inexcusably negligent in not regulating the credit default swap market (as we do with every other kind of insurance, for exactly this reason).

We're going to be paying for this recklessness for generations to come.

UPDATE: I've gotten several emails asking me what I think about the AIG bonus situation. The short answer is that I'm angry and frustrated just like everyone else, but at the same time, I think much of the anger being expressed in the blogosphere is somewhat misdirected.

While we all talk about AIG as some sort of monolithic entity, the reality is that it is unlikely that any of the people who received these bonuses bear any personal culpability for AIG's bad decisions. Decisions about high-level business strategy at big companies like AIG are made by a very small group of people. The fateful decision to go heavy into the credit default swap market was most likely made by no more than a few people, and from what I understand, they are no longer with the company. Everyone else, even within the financial products division, either worked on other stuff or acted at the direction of their bosses. Their jobs weren't to formulate investment strategy for the company, but to execute transactions. And at companies like this, it is true that a good portion of your yearly salary is expected to come in the form of a lump sum payment (called a "bonus"), regardless of the companiy's performance.

So it's likely that the people who received or are slated to receive these bonuses are not any more "undeserving" of them than anyone else in the financial industry. It's unfair to suggest that they are personally responsible for AIG's sins.

That said, the financial industry as a whole has gotten used to compensation levels that are just not sustainable in non-bubble conditions. A new, post-bubble, equilibrium needs to be reached and these folks are going to have to come to grips with the fact that their services just aren't worth anything close to what they thought they were worth. And that's why this is so frustrating.

I'm actually willing to believe the argument that it is in our best interest for AIG to retain some of the people in the financial products division whose experience and knowledge will facilitate the unwinding of AIG's derivative obligations. Now that we all own AIG, the orderly liquidation and unwinding of the company's investments is in all of our interests. But my strong suspicion is that these folks were paid far more than was actually necessary to keep them from bolting. The financial industry is in ruins right now, and there is a massive oversupply of qualified labor (i.e., unemployed financial services workers). It is unlikely that any of these folks could have secured jobs at anything close to their current level of compensation. And apparently some of the bonus money went to people who left anyway, which makes no sense.

The damage may already be done, though. While I haven't seen the contracts, my understanding is that failing to pay promised compensation can, among other things, expose a company and its employees to liability for double the amount of the compensation, plus attorneys fees. Anyone who thinks these employees wouldn't sue is being unrealistic. Given the amounts of money involved, they would sue, and, barring some sort of legislative intervention (of questionable constitutionality), they'd probably win, meaning that we could end up having to pay them twice as much down the road (not to mention the legal costs to both sides, all of which the government would bear).

It's certainly true that all of the company's contracts could be adjusted if it were to file for bankruptcy, but the government has made the calculated decision (right or wrong) that the costs of an AIG bankruptcy outweigh the benefits. And as long as AIG remains out of bankruptcy, it's very hard to see how abrogating contracts is a viable option. The fact that Andrew Cuomo and others are throwing around phrases like "fraudulent conveyance" indicates to me that they don't really have any strong legal grounds for clawing back these bonuses.

New facts could emerge that would change my opinion, but for now, I'm doubtful that anything short of legislation (which would immediately be challenged) is an option.