A well written piece on AIG. The exposes the core of a nuclear economy whose meltdown we observe.
AIG wrote unhedged Credit Default Swaps, insurance against credit defaults of packaged debt obligations like mortgages, in a notional value of $450 billion. That stack is now down to $300 billion. The U.S. people have so far pumped $150 billion into AIG. That this is exactly the amount AIG has now less in CDS exposure is certainly not pure coincidence.
We can expect that all CDS's AIG has written will be called on as all classes of debt will have very high default rates over the next years. There were several other fields of faulty financial engineering AIG 'invested' in that will result in additional tens of billions of losses.
Tomorrow AIG will post a new quarterly loss of $60 billion ($460,000 per minute). Also tomorrow the U.S. government will put another $30 billion of fresh capital into AIG. We can be sure that more will follow each quarter for many years to come.
Why does the U.S. government do this?
If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.
There is certainly no lack of people who think it would be a good idea to let the entire 'western' banking system fail.
But unfortunately we do need banks to 1. aggregate savings, 2. allocate the aggregated savings as credit to productive investments and 3. administrate the general public payment systems.
So either the U.S. bails out AIG or the sky falls down.
But there may be a way out. Why not instantiate a new banking system?
Set up clean New Banks in all countries under very strict regulatory rules and give them some basic capital. Then declare all credit default swaps null and void and let the dice fall where they may. When the old banks default, the new banks will pick up their good assets and business.
The advantage of such a 'shock and awe' solution is that the drag on the real economy will be over much faster than in any other solution. The current slow pace of backing up the system again and again does not generated trust. It is devastating for real production, trade and the livelihood of billions of people.