Underlying cause of AIG's financial woes


The popular fury at the executive bonuses paid out by American International Group is well placed. Despite the fact that these bonuses represent only one tenth of one percent of the total bailout money received by AIG, the symbolism of these bonuses enrages the average taxpayer. However, rather than bonuses, I would like to examine the underlying cause of AIG's financial woes.

At the very center of the issue is a little known financial derivative known as a credit default swap. Let me lay some basic groundwork in explaining what these are. A financial derivative is an asset whose intrinsic value is tied to another fundamental asset. A classic example of a derivative would be a stock option; the value of the option is dependent upon the value of the stock. If the stock rises or falls, the option can become either valuable or worthless. In the case of a credit default swap, the underlying asset is some form of debt.

An individual investor who owns debt, a creditor, has in effect loaned money to an institution. The creditor expects to receive the principal back at a given maturity date and perhaps receive periodic interest payments. The debtor is contractually obligated to repay the creditors. This legal obligation ensures that creditors are the first people to be paid by a company; preferred and common stockholders must divide any remaining equity. However, debtors sometimes default as they are unable to repay their creditors. This is known as a credit default. Enter credit default swaps.

A credit default swap was designed to be a form of protection for the creditor. The creditor would be able to purchase a credit default swap from a financial institution, like AIG, against the debtor, often a company, municipality, or even government. If the debtor pays back the creditor, then the credit default swap becomes null and void. However, if the debtor defaults on their debt, then the buyer of the credit default swap is entitled to a payout from the seller of the credit default swap. Thus, a creditor can hedge the risk of lending by purchasing a credit default swap against the debtor. Because of this, credit default swaps have been likened to insurance; you pay a premium and if things go wrong you receive a payoff.

So how many credit default swaps were actually used for insurance purposes? It is difficult to get exact numbers, but it is useful to look at some rough estimates. The International Swaps and Derivatives Association claims that the volume of outstanding credit default swaps at the end of 2007 was roughly $62 trillion; it went down to $55 trillion by the end of 2008. According to the International Monetary Fund, in the third quarter of 2007, the total volume of outstanding international debt securities was $20.7 trillion. To obtain a conservative lower bound on the ratio of speculation to insurance, let us assume that every dollar of outstanding debt was covered by a credit default swap. In 2007, the estimated ratio of speculation to insurance then becomes approximately 2:1. This implies that for every individual who was actually seeking to protect their debt, there were two people who were simply making bets — gambling.

These gamblers bought credit default swaps even though they did not own debt in the company they were betting against. A credit default swap became an alternative way of selling short, but without the need to own or borrow any actual asset related to the company. The buyer of a credit default swap does not need to suffer any loss in the event of credit default. This is like purchasing fire insurance on your neighbor's home in the hope that it will burn down and you will receive a payout!

Although credit default swaps were presented as insurance and a way to hedge your bets, sellers of these derivatives were not regulated as normal insurers are. There were no limits set on the amount of swaps an institution could sell relative to the amount of capital it owned. Similarly, there were no provisions to ensure that anyone who purchased a credit default swap actually owned bonds or debt of the reference company.

Why does this all matter? It matters because we, the taxpayers, are expected to blindly hand money over to institutions that gambled big time and lost. Credit default swap sellers sold more than they could afford and buyers failed to understand the risk that the credit default swap sellers could themselves default on their debts. We do not bail out stockholders or casino-gamblers when they fail to understand the systemic risk associated with their gambles. We also do not bail out casinos when they do not have enough cash reserves to cover their bets. It is preposterous that we should be bailing out companies like AIG who are suffering the consequences of their own foolish actions.

The government and taxpayer should never be expected to subsidize gambling in any form. If you gamble, that should be your risk, not ours.

Alexander Draine is a Rutgers College senior majoring in economics. His column, "Draine on Society," runs on alternate Tuesdays. He is a contributing writer to the Johnsonville Press.

 


Alexander Draine

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