To the Teacher
AIG is among a host of American enterprises that succumbed to the irresistible opportunity to make easy money through arcane financial instruments that even the company's former CEO, Maurice Greenberg, said "bewildered" him. American taxpayers are now paying the price. Following a brief introductory overview, the student reading below focuses on the housing boom and bust, then why AIG foundered and why taxpayers are propping it up. Discussion questions and a suggested fish bowl discussion follow.
The rise and fall of AIG
In 1919, Cornelius Vander Starr, a Californian, opened an insurance agency in Shanghai. Joined by a partner, the pair expanded their business in China and to the Philippines and Indonesia by hiring local people as agents and managers.
Using that strategy, the company became the American International Group (AIG) with offices worldwide and 116,000 employees. It added a diversity of other enterprises to its insurance business over the years—real estate development, aircraft leasing, shipping terminal operation, a ski resort in Stowe, Vermont, a soccer team in England.
Yet suddenly, in September 2008, AIG was on the verge of collapse. To prevent it, the U.S. government came to its aid with an $85 billion line of credit. But three times since then, the US has added billions more, most recently on March 2, 2009, as the company, sinking under the weight of countless billions in "toxic assets," announced the biggest quarterly loss in any company's history, $61.7 billion.
American taxpayers now own about 80% of a once hugely profitable private enterprise, into which cash disappears down a black hole. Why? What are these "toxic assets"? Should the US use taxpayer money to bail out a private company?
An "irresponsible" company
Lending money for mortgages was once a conservative business. Potential homebuyers had to reveal their credit history and make a substantial down payment before receiving loans for mortgages.
The Federal Reserve slashed interest rates. Buyers could more easily finance an expensive purchase like a car or even a house. For little or no money down, a homebuyer could get an adjustable rate mortgage that might require only payment of interest for two years. Sharply rising payments followed. But as the flood of new homeowners drove prices up steadily, the home buyer could borrow more on it, or even sell for a profit.
Banks, mortgage broker agencies, and Wall Street investment firms took advantage of the boom to sell mortgage-backed securities. These were bundles of mortgages they transformed into stock securities and sold to individuals and institutions worldwide. The business of lending money to people became a reckless, unregulated gold rush. In 2004, for example, the Securities and Exchange Commission, whose job is to oversee and regulate Wall Street, exempted big investment banks from a debt limit regulation. This allowed them to invest billions held in reserve against losses and invest the money in mortgage-backed securities and other newly-created, complex financial instruments.
Joe Nocera writes in the New York Times that an AIG unit in London "was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street's insatiable appetite for mortgage-backed securities,"and sold credit-default swaps, a kind of insurance for the securities.
"In effect," writes Nocera, "AIG was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses." But because the company had a AAA credit rating, the mortgage-backed securities they insured with credit-default swaps got AAA ratings, too.
"Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to AIG, and the AAA rating made the securities much easier to market." AIG got substantial fees, but it saw them "as risk-free money" and "surely would never have to actually pay up. Like everyone else on Wall Street, AIG operated on the belief that the underlying assets—housing—could only go up in price."
They were wrong. Unlike other forms of insurance, say for a fire, that require the insuring company to set aside enough money if it has to compensate an owner for one, AIG didn't have to set aside anything. It didn't. Credit-default swaps were not regulated.
In 2006, new housing construction and prices faltered. By 2007, in an overstuffed housing market, both declined. By 2008 it was clear that the boom had become a deflating bubble. AIG, or, rather, the American taxpayer, was eventually stuck with hundreds of billions in credit default swaps.
The company had also taken on other mysterious risks, like "collateral triggers." They guaranteed that "if certain events took place, like a ratings downgrade for either AIG or the securities it was insuring, it would have to put up collateral against those securities, Again, the reason it agreed to the collateral triggers was pure greed: it could get higher fees by including them. And again, it assumed that the triggers would never actually kick in...Those collateral riggers have since cost AIG many, many billions of dollars. Or, rather, they've cost American taxpayers billions." (Joe Nocera, "Propping Up A House of Cards," New York Times, 2/28/09)
US government leaders decided that AIG was "too big to fail," that the consequences of failure were too damaging to permit.
What are these "toxic assets?
As the housing market collapsed, mortgage-backed securities became toxic, credit-default swaps became toxic, collateral triggers became toxic. Investment banking firms—Bear Stearns, Lehman Brothers, Merrill Lynch—were left holding mortgage-backed securities whose worth kept sinking. AIG was stuck with hundreds of billions in debts for credit default swaps and collateral triggers and nothing in reserve to pay them.
Should taxpayers bail out a private company?
Holders of the insurance represented by credit-default swaps and collateral triggers are American and European banks. If AIG failed to honor these debts, the collapse of many of those banks could follow. "AIG has more than 375 million [insurance] policies with a face value of $19 trillion. If policyholders lost faith in AIG and rushed to cash in their policies all at once, the entire insurance industry could falter." (Andrew Ross Sorkin, New York Times, 3/3/09)
The New York Times editorialized (3/3/09): "The AIG bailouts fail the basic test of transparency. Who ends up with the money? Major financial institutions are not innocent victims...They are sophisticated investors, and they should have known the risks being taken-and who profited mightily from the relationship before it all came crashing down.. Whomever the recipients are, they should be investigated for their roles in the crash and, to the extent possible, be made to pay for the bailouts."
"Who ends up with the money?' is a question the Senate Banking Committee failed to get an answer to at its hearing on March 5, 2009. But lawmakers and the public were so angry about the $165 million AIG paid its executives in bonuses that they forced the company to release the names of dozens of institutions that have benefited from federal bailout money. They included some well-known names—Goldman Sachs, Deutsche Bank, Merrill Lynch, Bank of America, and JPMorgan.
"The institutions that received the Fed payments were owed money by AIG because they had bought its credit derivatives," the New York Times report. These derivatives included credit-default swaps intended to protect buyers of mortgage backed securities and other shaky loans."But AIG was suddenly unable to honor its promises last fall, leaving its trading partners exposed to potentially sizable losses." ("AIG Lists Firms To Which It Paid Taxpayer Money," New York Times, 3/16/09)
"AIG exploited a huge gap in the regulatory system" and was "irresponsible," said Federal Reserve Chairman Ben Bernanke in testimony before the Senate Budget Committee on March 3, 2009. He expressed his anger again on "60 Minutes" on March 15: "Here was a company that made all kinds of unconscionable bets. Then, when those bets went wrong...we had a situation where the failure of that company would have brought down the financial system."
1. What questions do students have about the reading? How might they be answered?
2. Are students clear about certain key terms? For instance: mortgage, interest rate, mortgage-backed securities, debt limits for financial institutions, credit-default swaps, credit rating, collateral, collateral triggers?
For a fish bowl discussion
A fish bowl discussion provides an opportunity for everyone in a class to examine an important issue. It promotes listening, invites participation, and focuses attention. For details, see "Engaging Your Class Through Groupwork."
Suggested questions for fish bowl or for a conventional classroom session:
1. Why did America experience a housing boom?
2. Why did the boom seem to produce a win-win situation for homebuyers and home sellers?
3. What happened to the housing boom and why?
4. What happened to AIG and why?
5. Who's paying the bill and why?
6. How would you assign blame for the housing market collapse and the economic and financial crises that followed? Why?
7. Should there be a federal investigation of AIG as the Times editorializes? Why or why not?
8. Who or what was responsible for "a huge gap in the regulatory system," the system that was supposed to prevent disasters like the one Americans are suffering today? If you don't know, how might you find out?
This lesson was written for TeachableMoment.Org, a project of Morningside Center for Teaching Social Responsibility. We welcome your comments. Please email them to: firstname.lastname@example.org