March 5, 2009

Why is AIG so important?

Watching the news I've wondered why AIG is getting so much attention and government funding. I don't know much about AIG personally. I knew they are an insurance company but not much past that. I've had a hard time understanding why people felt that saving AIG was so important and why it was worth so much government aid. This has puzzled me personally for a while. Why *IS* AIG so important?!?

I decided to try and figure this out and did a bit of research. I found a number of press articles on the topic of why AIG matters or why an AIG failure would really hurt the economy.

They are huge.
Why AIG matters at MSN said that "the company [AIG] is the world's biggest insurer and does business in nearly every country". The Star Ledger of New Jersey elaborated: "AIG has assets worth more than $1 trillion and 74 million customers around the world. Its stock is held by many mutual funds. Indeed, AIG is responsible for dragging the Dow Jones industrial average down more than 400 points so far this year, according to CNNMoney.com." A Seattle Times article said that they have 30 million customers in the US alone.

But being big alone isn't the real problem. What is the key reason that AIG is important? We fear that their failure could cripple financial markets worldwide.

They sold insurance against the subprime crisis
AIG sells a lot of different kinds of insurance. Its not just life, home and auto. AIG insures other companies investments. In a Reuters article "How AIG Fell Apart" they explain AIG sold something called a Credit Default Swap (CDS) which is basically insurance on financial investments like bonds. One of the big things they sold CDS on was mortgage backed securities. The MSN article said "AIG has been selling insurance against the very calamity that is now engulfing the markets". When the subprime mortgage crisis started those bonds started to fail and AIG had to pay out on their CDS's. Now we're faced with the situation where all sorts of banks and financial companies are dependent on the insurance of CDS sold by AIG to guard them against further failures in the world economy. If AIG were to go bankrupt then everyone would lose their insurance. That would cause all the banks to get more expensive insurance and or withdraw their activities even further. The upshot is that if all the sudden AIG went under then it would remove a layer of protection in the already shaky economy and it would send a ripple through the financial sector that would shut down the economy even more.

At a personal level that all might be hard to relate to. But think of it this way: What if you had a pre-existing medical condition and all the sudden you lost your health insurance cause the insurance company went bankrupt? Thats a similar situation for if AIG went under. The world economy has a crisis right now that is like a pre-existing condition. If banks had to get other insurance it would be hard to come by and very expensive. Then if they were in that situation they'd either be in serious jeopardy of losing everything if they didn't have insurance or spending much more money to pay for expensive insurance.

Is AIG to blame?

Honestly I don't know how irresponsible AIG was in their financial dealings. But for the most part if they were insuring bonds then thats a pretty safe thing to insure. High rating bonds very rarely fail. In general I would think that writing insurance to cover bond failures is a fairly safe financial move. Many of the mortgage backed securities had much higher credit ratings than were really warranted. AIG may have been a bit irresponsible in getting over exposed to CDS failures. But I don't think I'd consider selling the CDS's to be irresponsible in general. Theres plenty of blame go around and it doesn't all fall on AIG for their problems.

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