The AIG Incident: WHY??

Given the crisis on Wall Street and the focus on American International Group Inc., one of the world's largest insurers, everybody is suddenly talking about counterparty risk.

What is counterparty risk, and why is it now an issue?

In the simplest terms, counterparty risk is the chance that the person on the other side of a deal - the counterparty - won't be there when it's time to pay up. Take an example most people can relate to: Selling a home. There's always the chance that when it comes time to close the deal a month or so down the road, the buyer won't show up or won't have the money.

In financial markets, traders and banks are constantly thinking about counterparty risk. When they make a deal to buy or sell, they often look at the credit rating of the party on the other side of the transaction. If the credit rating is high, they will go ahead with the deal. If the credit rating isn't so hot, they might ask for additional guarantees or collateral. Or maybe they won't do business with the counterparty at all, which is what happened to Lehman Brothers and Bear Stearns in their last days.

How does that relate to what's happening at AIG?

As an insurer, AIG expanded into the business of selling insurance against bond defaults, probably figuring it wasn't that much different than underwriting life or home insurance. AIG provided the insurance through derivative contracts known as credit default swaps. The problem for AIG is that it looks as if there could be a lot of claims at once because of a wave of defaults on mortgages and also by companies such as Lehman Brothers, Fannie Mae and Freddie Mac. By some estimates, the firm could face losses of $25-billion (U.S.) on the swaps.

How does a credit default swap work?

Credit default swap is like an insurance policy. In fact, it is an insurance policy. Suppose you own bonds issued by XYZ Corporation and you want to hedge against the possibility of a default. The credit default swap market has developed over the years to allow you to do that. You would enter into a contract with say an insurance company that would sell you a "policy" that would make you whole if XYZ defaulted. The contracts usually run for five years and you pay an annual premium for the coverage. AIG is a big insurance company and they issued a lot of these contracts. They allowed their customers to "swap" to them the risk of XYZ defaulting.

If XYZ's situation worsened, be it real or imagined, a new credit default swap would cost more to enter into and the value of the existing one would change. The issuing company has to mark the value of the existing contract to the current market and that is one of the reasons why AIG has taken such huge markdowns the past few quarters.

And these markdowns are just that, markdowns. If XYZ doesn't default during the life of the insurance policy, then the markdown will be marked back up. AIG has said that the economic risk they see is much smaller than the markdowns they have taken. That may be but I don't know they have any more insight into the fortunes of a GM, Lehman, Merrill or Washington Mutual than the rest of us ( I don't know if AIG has written contracts on these companies. Using them as examples only.) This was probably a poor business decision to enter this business. There really isn't a bad risk in the insurance business. There is bad pricing of that risk.

How did AIG end up in this situation?

The company worked through the weekend to raise capital by selling subsidiaries, but ended up rejecting bids from private equity firms and instead appealed to the U.S. government for a loan. The government said no and told AIG and the rest of Wall Street to seek a private sector solution. Banks such as Goldman Sachs Group Inc. have been asked by the U.S. Treasury to try to come up with as much as $75-billion to lend to AIG, but there are questions about the feasibility of that plan. That pushed the ball back into the U.S. government's court and it was seeking a solution last night.

Why would a failure at AIG potentially be more trouble than at Lehman?

For the world financial system, AIG is a powder keg because of its CDS contracts. Lehman was a big player in the market, but it was both a buyer and a seller, so its net exposure is relatively small as many contracts cancel one another out. AIG is primarily a seller of credit default swaps, meaning there are many players who are depending on AIG's ability to pay up on insurance policies

Contributed By:

Arjun Pal

(Knowledge Cell - Globsyn Business School)