Bailout Billions And Managing Risk

by Sachin Balagopalan on September 17, 2008 · 1 comment

Seems like the Lehman Brothers bankruptcy story that broke only last Monday is now a distant past as we awake to the latest debacle on Wall Street. The Federal Reserve announced on Tuesday night that it will be bailing out insurance giant American International Group (AIG) to the tune of $85 billion which will essentially give the government about a 80% stake in the troubled insurance company. The New York Times has an interesting piece describing the chain of events that led to the decision to make the so called “bridge loan” to AIG by the Fed.

Apparently the main reason to “rescue” AIG (and not Lehman) is because of the potential impact to the global economy

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s role as an enormous provider of esoteric financial insurance contracts to investors who bought complex debt securities.

I’m not a financial guru by any stretch of the imagination - far from it - but something does not seem right when the Fed and the Treasury are at a point where they have to be concerned that one single company going bankrupt will have a negative impact worldwide. After all AIG is an American company and the last time I checked …

The Fed is the gatekeeper of the U.S. economy. It is the bank of the U.S. government and, as such, it regulates the nation’s financial institutions

Given the above definition how could this happen where one company has such an impact where its liquidation could potentially cause a global economic meltdown ?

If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, and that in turn would have reduced their own capital and the value of their own debt. Small investors, including anyone who owned money market funds with A.I.G. securities, could have been hurt, too. And some insurance policy holders were worried, even though they have some protections.

“It would have been a chain reaction,” said Uwe Reinhardt, a professor of economics at Princeton University. “The spillover effects could have been incredible.”

The irony here is insurance companies and financial institutions like AIG and Lehman are in the business of managing risk and the fact that they can’t “manage” themselves is troubling. A large portion of this mess IMO has to be attributed to the policy makers and regulators i.e the Fed ,Treasury, SEC and the insurance regulators. For the last several years loose monetary policy ultimately led to an explosion of mostly unregulated complex financial instruments like credit default swaps which ultimately led to the collapse of AIG.

Looks like this crisis isn’t over yet.

{ 1 comment… read it below or add one }

Commercial mortgage rate 01.16.12 at 12:55 am

Very good post!
With best regards

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