AIG bailout question: Why rescue banks but not me?

McClatchy NewspapersSeptember 17, 2008 

AIG logo in New York City.

MARK LENNIHAN / AP

WASHINGTON — The dramatic late-night rescue of insurance and finance giant American International Group raised as many questions as it answered. The company was saved from bankruptcy, but the move effectively put the nation's largest insurer under government control, which flies in the face of America's free-market values.

Coming Tuesday night after four days of government signals that it wasn't likely to step in, the action left investors worried Wednesday that financial conditions might be even worse than they appear.

Here are some answers to questions about this week's complex developments in financial markets:

Q. Why did the Federal Reserve lend AIG $85 billion, after Treasury Secretary Henry Paulson seemed to frown on it days earlier and the government let investment bank Lehman Brothers fail Monday? Aren't free markets supposed to be free from government intervention?

A. The Fed thought that AIG posed a risk to the global financial order, and if that fell into chaos, the U.S. economy and the lifestyles of average Americans would be endangered. Lehman was considered less of a risk, and was allowed to fail. Lehman's problems were known for six months, which gave many investors time to untangle themselves from their deals with Lehman.

In contrast, AIG's stock lost more than 60 percent of its value Monday. It came under the equivalent of a bank run very quickly, much like the circumstances that prompted the Fed's intervention with investment bank Bear Stearns in March. The Fed took $29 billion of Bear's shakiest assets onto its books as collateral to persuade JP Morgan Chase to acquire it. Bear Stearns' financial interrelationships around the world also posed a potential global meltdown if left to collapse.

Q. Are taxpayers footing the bill for the Fed's loan to AIG?

A. Yes. The Treasury Department announced Wednesday morning that it will issue $40 billion in new short-term Treasury bonds, separate from its usual bond issuance. Proceeds from this bond sale are going to the Federal Reserve for use as AIG draws down the 24-month $85 billion loan.

The potential saving grace is that the Fed, over time, can sell off assets from Bear Stearns and AIG and recover much of its upfront loans. That's what happened after the savings and loan crisis of the late 1980s, when the Resolution Trust Corp. took possession of many bad S&L assets at a huge upfront cost, then gradually sold them. After the financial markets settled down, the asset prices stabilized and the RTC regained much of what it had put out upfront.

Q. Food, gasoline and health-care costs have soared for the little guy, so why is Washington spending such large sums on bank bailouts instead of helping me? And isn't a government takeover of AIG, or Fannie Mae and Freddie Mac, the same as socialism? What happened to the free market?

A. Fair questions. The unprecedented moves by the Federal Reserve since March all have one aim in mind: preventing a total meltdown in global finance. If you think the Main Street economy is bad now, imagine a world in which many of the globe's biggest banks all collapse at once. That was the Great Depression of the 1930s. One in four American workers couldn't find a job; today, in contrast, the unemployment rate is 6.1 percent.

Fed Chairman Ben Bernanke is arguably the world's leading expert on the Great Depression. He's thought and written extensively about the mistakes that allowed the global financial system to collapse, and he may the best qualified in trying to prevent it from happening again.

If he fails in avoiding such a calamity, it won't be for lack of trying, even if some of the Fed's actions must look like the very socialistic nationalization of banks and lenders that U.S. policymakers long have decried.

Q. But AIG isn't a bank, so why does the Fed care?

A. AIG is a giant insurance company that provided a form of investment insurance called credit default swaps to many global financial institutions. These swaps amount to insurance against a default on bonds. AIG had written a huge amount of these to insure the mortgage bonds that are at the heart of the financial meltdown.

Hundreds of banks were on the other ends of swaps deals with AIG. Had AIG gone bankrupt it could have caused a global domino effect.

Q. Insurance usually involves an underwriter and a policyholder. Are these swaps different?

A. The big difference is the swaps market often involves investing by players who don't have underlying assets that they're insuring. In these circumstances, a swap is like taking out a life insurance policy on someone you don't know and betting that he'll die.

"The real concern is a lot of these credit default swaps, the parties in them don't have an underlying bond or credit risk that they're protecting. They're just betting, to an extent, on nonperformance," said Bert Ely, an expert on bank regulation.

The last estimate by the Bank of International Settlements on the size of the global swaps market was in June 2007, and it was valued at $42 trillion. That's about three times the size of the entire U.S. economy's annual production. That's why the Fed and Treasury worry when an issuer of swaps can't pay its partners in swaps, called the counterparty.

"The potential dollar amount here is so great that there is concern about pulling out of the mix any one of the counterparties," for fear of a domino effect, Ely said.

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