The AIG backdoor bailout: but a bailout of whom?

• Author: Kos, Dino
• Position: American International Group - Statistical data

Why did the U.S. government bail out American International Group? The commonly accepted version of events has the Federal Reserve and U.S. Treasury engineering a "backdoor bailout" of Wall Street as money injected into AIG was quickly paid out to Goldman Sachs and other banks then under duress.

No doubt Wall Street banks--including Goldman, despite its protestations--were huge beneficiaries. However, they were not the only ones. Who else was exposed to AIG? A review of its 2008 SEC filings shows that another group--European banks--was even more exposed. Confronted with the risk of falling dominos on the continent immediately after Lehman's bankruptcy, it's easy to see why allowing AIG to tail was never a serious option.

European banks were exposed to AIG in at least three ways. First, they were large purchasers of credit default swaps on pools of assets to reduce regulatory capital requirements. Second, they purchased credit default swaps against subprime mortgage and other so-called "multi-sector" collateralized debt obligations. Finally, they were exposed to AIG's substantial--and very poorly managed--securities lending operation. We look at each in turn.

REGULATORY CAPITAL REDUCTIONS FOR BANKS

Why would AIG be involved with regulatory capital requirements for European banks? This calls for a quick explanation of Basel I. Each country implements the basic Basel framework, with some adjustment for each country's unique circumstances. In theory the Basel Accord, negotiated by the Basel Committee on Banking Supervision, sets the "minimum" standard for everyone, though countries can always be tougher. In practice countries do not always abide by that principle.

A case in point is the implementation of credit risk standards in Europe. Under Basel I, banks were required to hold varying degrees of capital depending on the riskiness of the asset: typically 8 percent for private-sector claims, 4 percent against mortgages, and so on until reaching claims on governments which did not require capital (though later an interest rate risk charge was added). Capital charges for structured products were viewed to be especially high. Somehow European banks convinced regulators to reduce capital charges for pools of assets that were insured with financially sound third parties such as highly rated insurers.

The goal was to shift credit risk from bank balance sheets to insurers and others willing to take on the risk. Banks moved quickly and purchased...