Thursday, March 19, 2009

Why AIG Was Rescued

Felix Salmon argues that AIG was rescued because if it had failed, no one would have known who was ultimately bearing the losses, which would have caused financial markets to freeze virtually overnight:

[T]he web of connections between the thousands of counterparties in the CDS market is so complex that no one really has a clue who would have ended up holding the multi-billion-dollar bag. ... But no one would have had a clue where in the financial system, exactly, those losses would have ultimately come to rest. And given the magnitude of the losses, you can be sure that no one would have wanted to have any kind of dealings with the poor schmucks who ended up on the hook for all those billions of dollars. And since those pooor schumcks could be pretty much anybody, no one would do any kind of business with anybody else: you'd get settlement risk run amok. The entire global financial system could grind to a halt overnight, due to the inability of any given institution to persuade any other institution that it was actually solvent.
I tend to disagree. Incidentally, I think this is more or less the explanation for why Bear Stearns was rescued, but not for why AIG was rescued. The reason AIG was rescued was much simpler: regulatory capital relief. AIG's massive CDS portfolio was providing an enormous amount of regulatory capital relief at the time, primarily to the major U.S. and European banks. Had AIG failed, all the major banks—which were already engaged in mass deleveraging due to Lehman—would have suddenly lost most, if not all, of the regulatory capital relief that AIG's CDS contracts had been providing. This would have put the banks well under their regulatory capital requirements, and thus would have sparked a fresh wave of forced liquidations, depressed asset prices, writedowns, and yet more forced liquidations, as the banks scrambled to raise capital to meet their minimum capital requirements. With the markets already convulsing wildly due to Lehman's failure, this would have been a devastating body blow, and I don't think the markets could have taken it. From what I understand, this is the doomsday scenario that ultimately led Geithner to rescue AIG.


Andrew Hofer said...

Bingo. And there is still a few hundred billion of that stuff out there. It runs off quickly, though.

Donald Pretari said...

I think you're both correct. There was a literal Calling Run that would have directly followed from AIG, but there was also a larger Flight To Safety that began in which investors only tangentially involved or uncertain whether or not they were involved starting moving into cash. It is this larger Calling Run which led to a real fear of Debt-Deflation coming out of this crisis.

Don the libertarian Democrat

Anonymous said...

Interesting point about regulatory capital relief. I would just add that had AIG collapsed, the dealers would have been left with open CDO positions (much like post-Lehman) that they would have had to hedge in the market all at once in large size. This would have caused spreads to blow up leading to MTM losses for the banks. Flesh this out somewhat here:

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