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Saturday, August 15, 2009

The Collapse of AIG and Its Impact on the Mortgage and Banking System

Most people have no real understanding of the impact of the American Insurance Group or AIG on the mortgage market and the global banking system and how close we came to Financial Armageddon. All of a sudden the dominoes started to fall and the Federal Reserve Bank of America started to pick and choose who they would save. Lehman Brothers, the investment company posted losses of $3.9billion before they filed for Chapter 11 bankruptcy protection and then collapsed. Merrill Lynch was bought by the Bank of America for $50billion.

The Federal Reserve Bank of America stepped in and agreed to lend AIG $85 billion in order to facilitate the sale of its global assets estimated at over $1 trillion in exchange for essentially all the company's equity. The Federal Reserve Bank is currently lending AIG the money while they sell off their assets to pay their liabilities for all the Credit Default Swaps that they insured. AIG are paying the Federal Reserve Bank 8.5% above the 3-month Libor rate, currently 11.5% and they currently own 79.9% of AIG.

An AIG bankruptcy would have been the worst financial collapse in history if it had been allowed. So what had happened and why did the Federal Reserve Bank stepped in? Most of us thought it was saved by the Federal Reserve Bank because AIG was the largest Insurance Company in the world with 74 million clients in over 130 countries and its demise would have left us all uninsured if it had gone bust. Wrong! Few of us actually understood the significance of this take over by the Federal Reserve Bank and its impact if the Federal Reserve Bank had not intervened.

The Past Decade
What had happened over the past decade was that the banks and investment banks had been bundling up risky sub-prime mortgages that they had sold and then selling these to investors or banks in Europe. To make these mortgage investments more saleable they would purchase an AIG Credit Default Swaps or also known as debt insurance contracts. AIG's credit default swaps were insurance contracts which were not regulated. Typically these insurance policies were for three to five years. AIG did not have the capital reserves required to back up these policies should they ever have to pay any claims out. This would prove to be their downfall or their nemesis when their day of reckoning arrived.

AIG was not required to hold any capital in reserve as collateral on its credit default swaps as long as they maintained a triple-A credit rating. AIG made hundreds of millions of dollars in 'profit' each year, without any collateral reserves. All the banks that purchased these credit default swaps were able to assure their national regulators that they were holding only triple-A credits mortgage products instead of the sub-prime mortgages that they were really holding which were high risk and toxic.

AIG's Day of Reckoning arrived
On the 15th September AIG's day of reckoning arrived when the major credit-rating agencies Standard & Poor's, Moody's and Fitch downgraded AIG's triple-A credit status. The credit rating agencies had discovered the soaring claims being paid out by AIG for their credit default swaps insurance policies. AIG was able to raise capital $11billion only once from the market to repair the damage, but the claims kept growing. The Largest Insurance Company in the world was effectively bankrupt.

The domino effect had started, the first to fall was Lehman Brothers they were reported to be the biggest bankruptcy in history. Merrill Lynch was bought by the Bank of America. The Federal Reserve Bank stepped into help AIG. AIG's problems could still cause further turmoil in the market for the debt insurance contracts. That market was considered to be worth $58 trillion worldwide at the end of 2007. The biggest problem is that nobody really knows how much of the $58 trillion AIG is responsible for? Frightening!

There is still more to emerge and this is possible only the tip of the iceberg. We have had Freddie Mac, Fannie Mae, the American car manufacturers, I-Save the Icelandic bank, Royal Bank of Scotland, Lloyds TSB, HBOS and others. These are the big and the great, what about all the smaller banks and companies around that are now trying to struggle on in the current circumstances

The consequences of AIG's
The mortgage bubble would never have grown so large had it not been for AIG's involvement. The banks would never have made such huge profits and the supply of money would not have been so easy to obtain by everyone and the growth in the mortgage market would have been controlled. Today the investment banks are now struggling as they have no way of borrowing money as no one will insure their obligations any more since the collapse of Credit Default Swaps or debt insurance contracts.

The Impact of AIG
The collapse of AIG has had a major impact on the mortgage market and the banking system worldwide. It has added to the dire situation we all find ourselves in today with:

A worldwide recession
Unemployment rising
Home repossessions rising
Homeowners falling in to arrears with mortgage payments
Falling house prices
Negative equity
Mortgages that are hard to obtain
Lack of confidence between banks when lending money to each other
Falling stock markets
Falling interest rates
Government intervention to prop up the banking systems
Deflation on the horizon
Uncertainty in the financial markets.

The future for the next two to three years is gloomy at present. We need to hope that a consequence of all this spending by governments to ease this recession does not lead to high inflation in the future in order to down value the overall debt that all the governments will have in the future.


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