The AIG Bailout and the Tea Party, Part 1

The bailout of American International Group (AIG) during the financial crisis illustrates the conflicts inherent in the Tea Party and why it’s having problems translating support into tangible change.

In the late 1990s AIG, a very large and very old insurer, began selling a form of insurance on bundles of mortgage-backed bonds. By the mid 2000s AIG had issued almost a half a trillion dollars of this insurance, called credit default swaps. Traditionally our government has regulated insurers to guarantee that they maintained sufficient financial reserves to cover potential insurance claims. AIG and other financial industry participants worked aggressively to exempt credit default swaps from any kind of government regulatory oversight.

Much of this insurance was bought by large investment banks, for a number of reasons. If they actually owned the bundle of bonds, the insurance protected against a drop in the bond price. But unlike regular insurance, investment banks didn’t have to actually own the bonds – they didn’t have to have what English Common Law referred to as “insurable interest”. So many of these banks bought the insurance just as a general protection against a slowdown in the economy or because they thought the bonds would drop in price – they used the insurance to speculate against the value of the bonds.

When the financial crisis hit, caused in part by years of real estate speculation, the value of these insured bonds plummeted. As a result AIG was faced with tens of billions of dollars in obligations to investment banks that it couldn’t cover. One of the early casualties of the financial crisis was an investment bank called Lehman Brothers. The banks and financial institutions that lent money to Lehman lost confidence in the value of the assets that Lehman had pledged in support of its loans and began demanding repayment or additional collateral. When Lehman couldn’t come up with the tens of billions in additional cash it collapsed, generating tens of billions in losses for investors and financial institutions.

The federal government worried that if AIG defaulted on its obligations to the remaining large investment banks then the market would lose confidence in them and they would eventually be forced out of business just like Lehman. The economy withstood the collapse of one big investment bank; several big banks failing would very likely undermine confidence in the overall economy and could potentially lead to a collapse of our financial system. Potentially, financial collapse could lead to a broader economic collapse, a new Great Depression. Not willing to take the risk, the Federal Government injected $182 billion into AIG, much of which was then paid it out to a Who’s Who of investment banks such as Merrill Lynch, Goldman Sachs and Deutsche Bank.

Of the different efforts by the government to respond to the financial crisis, the bailout is particularly galling to Tea Partiers and indeed to a very broad cross section of our population. The large investment banks had generated billions in profits during the mortgage bubble by creating, buying and selling mortgage backed bonds. Now taxpayers were being asked to protect those banks from the collapse in value of mortgage backed bonds even while the taxpayers themselves were suffering the impact of falling home values. And after preaching the virtues of the free market the investment banks now wanted to be protected from the free market doing exactly what it was supposed to, penalize companies that made bad decisions. In this case the investment banks’ bad decisions to buy unregulated insurance while greatly misjudging the counter party risk that AIG wouldn’t be able to make good on its obligations. The government had to do what it thought best to stabilize the economy, but as the Tea Party continually points out the bailout was objectionable on many different levels.

NEXT INSTALLMENT: But how to keep this from happening again?

This entry was posted in Commentary. Bookmark the permalink.