A Few Important Clarifications About AIG

We’ve been watching the President of the United States hyperventilate in shock over the fact that publicly-owned financial companies pay bonuses even when they lose money. It’s really hard not to get the impression that Obama is playing to the galleries here. He and David Axelrod were probably blindsided by the public furor that this news kicked up, even though the Administration was well aware that the bonuses would be paid, so they decided to jump in front of the parade.

Let’s leave aside the critically important question of whether the government should force AIG to break the contracts it freely made with its employees, and acknowledge that the public wants a pound of flesh. Even though there is a principled case to be made in favor of the bonuses, principle is something Obama has never known or cared anything about.

It makes more sense, rather, that he decided he’d better turn AIG into the bete noir, or else he’d see the people’s righteous anger turned on himself, heaven forfend. As always with this President, politics trumps policy.

But I need to clarify an important point that is getting thrown around by a lot of people this morning: the idea that a lot of the money that taxpayers gave AIG was actually paid out by AIG to other, perfectly healthy banks and investment firms, and also to some banks that themselves received government assistance.

Perfectly true, and perfectly misleading.

AIG got into trouble because it wrote credit-default swaps, which function like insurance policies on debt securities. When the market moves against a CDS writer, he will always be required by his counterparties to deposit additional collateral with them, in order to ensure performance in case a protected security does default.

That’s what happened to AIG, to the tune of about $75 billion in mid-September alone. Of course this money got paid out to a lot of other companies. Who do you think bought the CDS insurance from AIG in the first place? The whole point of marking collateral positions to market is to make the overall system more stable by ensuring payment on the swaps.

If some of the people commenting on this story got their way, and AIG had not paid on its collateral calls, you’d see suddenly-undercapitalized banks and technical defaults happening all over the world. This is precisely why we have a TARP program: it was proposed three days after the AIG takeover to deal with the fallout from that event. If AIG had failed outright, we would indeed have had a total financial meltdown, instead of the far milder disruptions we actually got.

You may think a global depression and a stock market collapse are pretty bad, but they’re practically nothing, compared to how things might have gone last September. I’m getting very annoyed at the people who are saying AIG should have been left to fail. I’m sure those same people would be mightily exercised if their paychecks were to bounce and their money-market accounts had been frozen.

Yes, indeed, let’s punish AIG good and hard. Let’s even take away their trader’s bonuses. But let’s not misunderstand the gravity of the situation they caused.