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The AIG Blowup
American International Group, better known as AIG,
was a trillion-dollar insurance giant and before 2008
was one of the 20 largest companies in the world. A
small separate unit, AIG’s Financial Products division,
went into the credit default swap business in a big
way, insuring over $400 billion of securities, of which
$57 billion was debt securities backed by subprime
mortgages. Lehman Brother’s troubles and eventual
bankruptcy on September 15, 2008, revealed that
subprime securities were worth much less than they
were being valued on the books, and investors came
to the realization that AIG’s losses, which had already
been substantial in the first half of the year, could
bankrupt the company. Lenders to AIG then pulled
back with a vengeance, and AIG could not raise
enough capital to stay afloat.
On September 16, the Federal Reserve and the
U.S. Treasury decided to rescue AIG because its fail-
ure was deemed as potentially catastrophic for the
financial system. Not only were banks and mutual
funds large holders of AIG’s debt, but the bankruptcy
of AIG would have rendered all the credit default
swaps it had sold worthless, thereby imposing huge
losses on financial institutions which had bought
them. The Federal Reserve set up an $85 billion
credit facility (later raised to $182 billion) to provide
liquidity to AIG. The rescue did not come cheap how-
ever. AIG was charged a very high interest rate on
the loans from the Fed, and the government was
given the rights to an 80% stake in the company if it
survived. Maurice Greenberg, the former CEO of the
company, described the government’s actions as a
“nationalization” of AIG.
Insurance companies have never been viewed as
posing a risk to the financial system as a whole and
this is why their regulation has been left to insurance
commissions in each state. Since the problems at AIG
nearly brought down the U.S. financial system, this
view is no longer tenable. The insurance industry will
never be the same.
Chapter 21 Insurance Companies and Pension Funds
531
Monoline Insurance
Instead of providing credit insurance with CDSs, an insur-
ance company may supply it directly, just as with any insurance policy. However,
insurance regulations do not allow property/casualty insurance companies, life insur-
ance companies, or insurance companies with multiple lines of business to under-
write credit insurance. Monoline insurance companies, which specialize in credit
insurance alone, are therefore the only insurance companies that are allowed to
provide insurance that guarantees the timely repayment of bond principal and inter-
est when a debt issuer defaults. These insurance companies, such as Ambac Financial
Group and MBIA, have become particularly important in the municipal bond mar-
ket, where they insure a large percentage of these securities. When a municipal secu-
rity with a lower credit rating, say an A rating, has an insurance policy from a
monoline insurer, it takes on the credit rating of the monoline insurer, say AAA.
This lowers the interest cost for the municipality and so makes it worthwhile for
the municipality to pay premiums for this insurance policy. Of course, to do this,
the monoline insurers need to have a very high credit rating. When the monoline
insurers experienced credit downgrades during the subprime financial crisis, not only
did they suffer, but so did the municipal bond market (see the Conflicts of Interest
box, “The Subprime Financial Crisis and the Monoline Insurers”)
Pensions
A pension plan is an asset pool that accumulates over an individual’s working years
and is paid out during the nonworking years. Pension plans represent the fastest-
growing financial intermediary. There are a number of reasons for this rapid growth.
As the United States became more urban, people realized that they could not rely
on their children to care for them in their retirement. In a rural culture, families
tend to stay together on the farm. The property passes from generation to genera-
tion with an implicit understanding that the younger generations will care for the
older ones. When families became more dispersed and moved off farms, both the
opportunity for and the expectation of extensive financial support of the older gen-
erations declined.
C O N F L I C T S O F I N T E R E S T
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