The US Government’s AIG Bailout is Good Insurance

AIG has been a huge topic on Twitter this week.  Armchair economists, like myself, have very strong opinions about the recent bonuses paid to people in AIGs financial services division.  This is the same division responsible for creating and marketing the very same hyper-complex financial instruments that made sense only in the magical world of Wall Street where home mortgagees are all properly vetted for their ability to repay the loan and/or home prices were pegged to the growth rate of China’s economy.

In all the discussion and bitching about AIG there is a strong undertone of “we need to get revenge on these guys”.  I can understand that desire but I think there are many people who are not really clear on why the US government felt that propping up AIG was money well spent.

The blog post excepted below by Felix Salmon explains in clear and simple terms exactly why in this case, the best solution to a problem is to throw money at it.

Why AIG Wasn’t Allowed to Fail

Felix Salmon

Justin Fox wonders whether we should have just let AIG fail — or at least the holdco and the AIGFP subsidiary. They certainly deserved to fail. So why did we bail them out?

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Here’s the fear: AIG goes bust, and can no longer make good on the promises it made when it said that it would pay out on a CDS contract in the event that a certain credit defaults. Default protection sold by AIG, in other words, becomes worthless. Now let’s say you’re a CDS desk at, say, JP Morgan. You’re buying and selling default protection all the time, and so long as the amount you’ve bought, on any given credit, is equal to the amount you’ve sold, you reckon that you have no net exposure.

The minute that AIG fails, everybody else’s net position alters substantially, and in a very unpredictable way. The protection that JP Morgan bought from AIG is worthless, while the offsetting protection that JP Morgan sold to some hedge fund remains outstanding. So JP Morgan now has a large position it never wanted.

Now there’s a good chance that JP Morgan will have hedged its counterparty risk to AIG — but that doesn’t make the risk go away, it just shunts it elsewhere in the financial system. And the 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. All those AIG losses which are currently being borne by the government wouldn’t have disappeared if AIG had failed: they would simply have turned up somewhere else in the financial system.

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Remember that what regulators were most worried about at the time was systemic risk. Whether or not AIG deserved the money was pretty much beside the point: the key thing was that if it didn’t get the money, the entire global financial system would be put at risk of collapse. In which light, the cost of the AIG bailout looks positively modest, compared to its benefit.

via Why AIG Wasn’t Allowed to Fail – Finance Blog – Felix Salmon – Market Movers – Portfolio.com.