Understanding AIG

American International Group has been dominating the news for a good week, and I really didn't want to write about it because it's more politics than economics, but reporters have truly lost perspective over these bonuses. Well, everyone except for Rex Murphy of the CBC. It's impossible not to get outraged about those bonuses, but as Rex points out, this is only one of several politically related distractions with the AIG bailout.

I didn't have time to watch the hearings myself, but my friend Paul did - and he gave me his account of what unfolded. Most of the hearings consisted of congressmen grandstanding, which is to be expected. Paul did mention one particular congressman who brought up the issue of credit default swaps. Just one.

Why are credit default swaps important?

Fact: the total notional amount of credit default swaps that exist in the world is larger than the world’s economy.

Credit Default Swap: It's like buying insurance on your neighbour's house and then setting it on fire.

The sole reason AIG needs billions upon billions of financial relief is because of credit default swaps. If they didn't have these swap obligations to pay, there would be no problem. If Congressmen want to hold AIG accountable for anything, it should be how they are using federal funds to pay these liabilities down. I'm not oversimplifying this - the magnitude of these swap obligations is so large that nothing else should matter.

I've always found it ironic that an insurance company got themselves into so much trouble with these swaps, simply because the swap itself is a surrogate for insurance. It's not actual insurance. Real insurance involves the burden of abiding by regulations, keeping a reserve for potential payouts, and someone involved actually needs ownership of the very thing being insured. The way these swaps have been structured, they are more like bets than insurance. When you hear about how Wall Street lost "bets," they literally mean bets.

How could AIG’s exposure to swaps grow so ridiculously large? Obviously, none of the executives had sufficient oversight of the process. It's an understatement to say they took an optimistic view of the American credit market.

But for an insurance company, managing its exposure to the risk generated by swaps should have been intuitive. This is what AIG does for its core business, except it uses real insurance products and not swaps. Not bothering to assess the true risk these swaps brought the company is like loading up the shopping cart even after you realize you’ve forgotten your wallet at home.

But how did credit default swaps get so out of control?

Recall:

1. Financially, a CDS works like insurance: AIG was providing “protection” on a wide variety of credit products. So in return for monthly “premiums”, AIG made a promise to guarantee the principal if the underlying creditor(s) went into default;
2. Structurally, this was like betting: There were no regulations surrounding these swaps, no limit to how many bets you can make, and no requirement for you to set aside some just-in-case reserve money should you need to pay a large number of obligations at once.

Here’s an important footnote – in order to participate in the swap arrangement, neither party involved needs to own the credit product being insured. It's like buying insurance on your neighbour's house and then setting it on fire (I know I already said that one, but I've heard it floating around and I'm falling in love with it). With normal insurance, the insurance company will verify the existence and value of the asset being insured. But with credit default swaps, AIG got involved without performing such due diligence. Even if the analysis was performed, they ignored it. Overall, they thought, bad credit will not be an issue.

I happen to have an intimate relationship with the credit default swap. Since 2003 I’ve watched the CDS transform from a clever way to hedge credit-heavy investment strategies into a misunderstood “hot” commodity that led to quick cash for those who were willing to provide "protection" or guarantees (like AIG).

It’s clear now AIG was willing to multiply these swap arrangements without actually asking themselves why others were so eager to get into business with them. When two people shake hands on a credit default swap – one of them has to lose. AIG repeatedly took the wrong side of the bet. It’s fair to conclude that they are a bunch of losers.