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AIG on the Brink: Was a Bailout Necessary to Save the Financial System?

This is 1 of 3 in our AIG Series. Check out "AIG: The Center of a Financial Apocalypse" for the second article and "The Government Bails Out AIG: Was It Worth It?" for the third article.

AIG was running out of liquid assets in the latter half of 2008 to cover its liabilities tied to its selling of credit default swaps on mortgage backed securities. Most of AIG’s cash was tied up in its regulated subsidiaries, and regulators did not allow cash to be transferred freely from its subsidiaries to AIG as the holding company. Adding to its liquidity shortfall, AIG had $4.6 billion in commercial paper coming due with the prospects of rolling over the paper being minuscule due to AIG’s faltering business and diminishing liquidity.

The growing number of counterparties requiring that AIG make due on its credit default swaps further added to investors’, counterparties’, and all related parties’ concerns about the viability of the company. Collateral calls amounted to over $20 billion in early September and were growing. The ratings agencies were warning that they may downgrade AIG’s debt, which would further harm the company’s liquidity and ability to raise capital as it would cause investors to sell AIG debt and AIG shareholders to sell their shares. Moreover, AIG’s security lending business was facing a shortfall and could not raise equal amounts of cash for the securities. AIG estimated that it had only five to ten days to survive in September 2008 before its liquidity dried up.



A financial rescue package was needed in order to avoid the cascading effects of AIG defaulting on its obligations and the resulting chaos that would have ensued in its counterparties and the greater financial system. The financial system could have come to a complete halt and led to not only a U.S. depression but a worldwide one as well. The complexity of AIG’s derivatives and the opacity of its off-balance sheet liabilities made valuing the company or understanding its obligations concretely, especially in a short timeframe, virtually impossible. However, more government supervision is not the sure answer for saving the financial system.

AIG was on fire in September 2008 threatening to take down the whole financial system with it.

The market itself is the greatest regulatory mechanism as it would have made AIG and its leaders realize that the business could indeed fail. Instead, AIG and institutions like it were under the impression that they were too big to fail and had implicit backing from the U.S. government. If businesses are allowed to fail, then risk management becomes paramount. It is always in the government’s best interest to blame financial crises and depressions on the failures of markets because it necessitates more power in government. Milton Friedman had shifted the understanding of the causes of the Depression to the Federal Reserve and the government; previously and very much today, surprisingly, many students learn that the Depression was the result of excesses in private markets and a failure of capitalism.

You either have free markets or you do not. AIG and other financial institutions were already regulated bodies and subject to laws, which steer their behavior for better or worse in different directions. Regulations and laws too often concentrate on benefits and intentions rather than costs and consequences. The increased regulation of banking, for example, has led to the growth of a relatively unregulated shadow banking system. It's likely that Dodd-Frank and other regulatory measures will in some way or form exacerbate the next crisis either directly or indirectly. Hints of this can already be seen with a possible bond bubble combined with the diminished liquidity manifested by the Volcker rule. Only time will tell if we can avoid financial collapse as we have done so many times in the past.

> Part 1: "AIG on the Brink: Was a Bailout Necessary to Save the Financial System?"
> Part 2: "AIG: The Center of a Financial Apocalypse"
> Part 3: "The Government Bails Out AIG: Was It Worth It?"

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