If you don't want to click through to his post, he explains that AIG is in fact two different companies.
The first. the old firm, is the largest life insurance company in the world. It is AAA rated because it is state regulated. State regulation means that a company that sells life insurance, where they sell a policy that is basically a promise to pay a certain amount when the insured dies. Because an insurance company collects premiums for years, even decades, before it comes time to pay what it promised, a lot of companies used to keep too little in reserves and simply gamble that they can keep collecting money and not have to pay "until later." So the states inspect life insurance companies and guarantee that they have sufficient reserves to be able to pay the claims and are not wasting those already committed reserve funds elsewhere. AIG not only was regulated, it did everything possible to guarantee that the funds were on hand. It was, and remains, a very conservative AAA rated insurance company and made (and continues to make) good money based on its reputation.
The second company has grown out of the first, and is an unregulated hedge fund that sold CDS and other derivatives into the shadow banking system. Trading on the reputation and AAA rating of the insurance company, they became one of the biggest gamblers on Wall Street. This is the bankrupt company (created because of the disastrous Commodities Futures Modernization Act pushed through the Senate by Sen. Phil Gramm and signed by Bill Clinton. It is this second nest of gamblers, operating under the shadow of the first companies' AAA rating (a scam if there ever was one) that is now bankrupt and has caused the government to nationalize both companies.
Henry Paulson, Secretary of Treasury under Bush and previously Chairman of Goldman Sachs, made the decision that in order to protect the counterparties to the disastrous CDS sold by the AIG hedge fund company the taxpayers were going to have to bail out the unregulated, uninsured gamblers at the AIG hedge Fund side and pay off all those bad CDS even though they were uninsured and had no guarantee of government backing. Ritholtz offfers his suggestion.
I agree that this is the decision that should have been made. Why did Paulson not make it? Here are three facts to consider:
What should have been done?
Simple: When we nationalized AIG, we should have immediately spun out the good, solvent life insurance company. It is a highly viable standalone entity.
The hedge fund should have been wound down in an orderly fashion. Match up the offsetting trades, the rest go to zero. End of story.
You as a credit default swap gambler have no reasonable expectation that anyone other than the incompetent firm you placed your bet with is going to make good. You had as your counter party another hedge fund. That was the risk YOU — not the taxpayer — assumed. That is was under the roof of a legitimate insurance company is irrelevant.
Right now, we are into this clusterfuck for $166 billion — every last penny of which is a needless waste.
Taxpayers should not be bailing out hedge fund trades. This insanity must cease immediately .
- From what I have read, no one knows who the counterparties out there who will be damaged are. Bank secrecy, you know.
- But I have also read that Goldman Sachs was AIG's biggest customer for derivatives and CDS.
- The disastrous decision to pay off the uninsured debts for AIG was made by Hank Paulson, ex-Chairman of Goldman Sachs.
Whatever you decide about Paulson's decision, one thing is completely clear. Any so-called bank that is too big to fail is also too big to operate without close, intensive government regulation. Such regulation does not imply insuring their product, though. That needs to be made absolutely and publicly clear.