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How AIG Took Your Money and Ruined the Stock Market

The Dow fell below 7,000 this morning, for the first time in more than a decade. This was mostly based on news that insurance giant AIG had posted a $61.7 billion dollar loss this quarter, the largest ever quarterly loss in the history of quarterly losses. We've been inundated with news about the financial crisis, but how did things get so bad, and what does AIG have to do with it?Luckily for us, The New York Times ran a great article this weekend that you may have missed while you were trying to not think about the stock market that really got to the bottom of the credit crisis and AIG's enormous part in it, and why they can't be allowed to go out of business (it's because that would make hundreds of other companies go out of business).Let's start at the beginning: What was AIG doing during the heady days of the early aughts, when money flowed like water? When you start asking around about how A.I.G. made money during the housing bubble, you hear the same two phrases again and again: "regulatory arbitrage" and "ratings arbitrage." The word "arbitrage" usually means taking advantage of a price differential between two securities - a bond and stock of the same company, for instance - that are related in some way. When the word is used to describe A.I.G.'s actions, however, it means something entirely different. It means taking advantage of a loophole in the rules. A less polite but perhaps more accurate term would be "scam."So, by manipulating regulations loopholes, AIG was finding a way to make what it turns out were really unsafe investments seem totally safe. It did this by allowing banks and investors to put the entire risk of the investment on AIG, by using its AAA credit rating and other sundry methods. The problem is that all of AIG's actions were predicated on the idea that housing prices would never go down. Oops. It did most of this through credit-default swaps, a term that has been thrown around, but which I still have a hard time understanding. The Times piece does a nice breakdown:These exotic instruments acted as a form of insurance ... In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too. That was the ratings arbitrage. "It was a way to exploit the triple A rating," said Robert J. Arvanitis, a former A.I.G. executive who has since become a leading A.I.G. critic.Even worse, with the money in fees AIG was taking in from making these deals, it was buying its own mortgage-backed securities, instead of holding enough cash to guarantee the deals. So, as the market crashed and AIG was on the hook for the losses, all the company's assets had already declined in value, making it impossible. So, they don't sound so smart, and yet the government is bailing them out; in effect, we are paying them to keep their business going. Why?If the company defaulted, hundreds of billions of dollars' worth of credit-default swaps would "blow up," and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren't so awful. There isn't really much more to add. Your tax dollars at work, folks, thanks to the friendly folks at AIG.

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