An explanation of why we had to bail out AIG

Market Movers over on Portfolio.com explains the original rationale behind bailing out AIG. AIG sold insurance to other financial institutions that protected them when particular assets (like mortgage-backed bonds) dropped in value. When the bottom fell out of the housing market and foreclosures shot up, AIG was unable to make good on its insurance contracts... and it wasn't clear what the fallout would be:

Here's the fear: AIG goes bust, and can no longer make good on the promises it made when it said that it would pay out on a CDS [credit default swap] contract in the event that a certain credit defaults. Default protection sold by AIG, in other words, becomes worthless. Now let's say you're a CDS desk at, say, JP Morgan. You're buying and selling default protection all the time, and so long as the amount you've bought, on any given credit, is equal to the amount you've sold, you reckon that you have no net exposure.

The minute that AIG fails, everybody else's net position alters substantially, and in a very unpredictable way. The protection that JP Morgan bought from AIG is worthless, while the offsetting protection that JP Morgan sold to some hedge fund remains outstanding. So JP Morgan now has a large position it never wanted.

Now there's a good chance that JP Morgan will have hedged its counterparty risk to AIG -- but that doesn't make the risk go away, it just shunts it elsewhere in the financial system. And the web of connections between the thousands of counterparties in the CDS market is so complex that no one really has a clue who would have ended up holding the multi-billion-dollar bag. All those AIG losses which are currently being borne by the government wouldn't have disappeared if AIG had failed: they would simply have turned up somewhere else in the financial system.

And since bank regulators were trying to prop up the entire financial system (not only in the U.S. but with all of our financial partners), saving AIG was the best solution:

What's more, bailing out AIG had the pleasant side-effect of putting the entire global CDS market on a much stronger footing. Remember that CDS, like all derivatives, are a zero-sum game: for every loser, there's an equal and opposite winner. Very few institutions were net sellers of protection; AIG was by far the largest. So what that means is that the rest of the CDS market, ex AIG, is now a net winner to the exact extent that AIG is a loser: a hundred billion dollars or more. Given worries about the fragility of the CDS market and the systemic risks that it posed, bailing out the single largest net seller of protection essentially meant injecting a large amount of government cash into the part of the market that regulators were most worried about. It was quite an elegant solution, in its way: rather than trying to unpick the CDS knot institution by institution, you could just bail them all out at once by backstopping AIG.

IF NOTHING ELSE, hopefully this disaster will bring an end to the absurd concept of "too big to fail" with new regulations that prevent institutions from becoming that big in the first place. Once upon a time (i.e. the 1990s) we still had laws that limited the ability of banks to work across state lines. While I'm not sure what the original logic behind the rule was, it did have the useful effect of keeping banks from growing so large that... they were too big to fail.

Here are some thoughts on the subject that were offered last fall by Robert Reich and Matthew Yglesias.