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What did the Federal Reserve Bank fear about a collapse of American International Group that it did not fear about a collapse of Lehman Brothers? The Fed feared a financial catastrophe because of a special line of business of AIG.

Today, September 16, 2008, the Federal Reserve Bank “loaned” American International Group approximately $85 billion dollars and giving the government a 79.9% stake in the company. However, earlier in the day, Lehman Brothers filed for Chapter 11 bankruptcy protection after reportedly asking if the Fed would loan to Lehman. What was it about American International Group that inclined the Fed to make such an unprecedented loan to a private company?

American International Group is one of the world’s largest insurance companies, insuring risks across a wide spectrum of activities, from property and casualty, to director and officer insurance, to one of the most arcane areas of insurance – credit default swaps. Although “credit default swaps” does not sound like insurance, it is a type of insurance in which AIG played a large role. A credit default swap is a contract by which one party agrees for a certain payment to accept the risk that another party’s bonds will not default. For example, assume a company has a low credit rating from the major rating agencies – a company like General Motors for instance. If General Motors wants to sell bonds with a low rating (commonly called “junk bonds” or “high yield” debt), the party that buys the bonds may want to purchase some insurance on the bonds’ full payment if General Motors cannot ultimately pay the principal or interest on the bond when it comes due. The buyer may purchase such insurance from an insurance company like AIG. These types of insured arrangements are called credit default swaps – in short, they relate to bonds, thus the “credit” term, they relate to a default, thus the “default” term, and they relate to an exchange of risk, thus the “swap” term. These arrangements are also called counterparty risk transactions, where the risk of a default is traded to the insurance company (the counterparty) in exchange for a payment.

During the great bull market of 1982-2000, and during the relatively strong economy from 2002-2007, credit default swaps were a good business for insurance companies. They received premium payments, and in turn the bond defaults ran very predictably very low. That party ended when the mortgage-backed security market collapsed due to demonstrably over-rated collateral; that is, the homes backing up the mortgages were decreasing in value making the collateral for those securities less valuable; thus, making those securities less valuable. That reality is what pushed Bear Stearns close to bankruptcy before the Fed convinced JP Morgan to purchase the spent husk of what was once Bear Stearns.

That is all a long-winded explanation of a type of insurance, but that does not explain why the Fed opted to bailout AIG and not Lehman Brothers. The reason for the bailout is that the entire credit default system is a large unknown to the Fed, and the Fed fears that if a large credit default player like AIG cannot make good on its swaps, then a lot of bonds will not in reality be insured, and the balance sheets of many large banks holding low-rated bonds will be severely impaired causing any number of large institutions (banks and otherwise) to suddenly become insolvent. The Fed feared that a credit default meltdown could meltdown the entire financial system and cost the Fed many multiples of $85 billion.

The credit default market is not organized on any exchange. Each arrangement is unique and structured privately. Often the counterparty risk assumed in a credit default swap is swapped again to another party or broken up and swapped out to multiple players, kind of like reinsurance. The only problem is that no one has a handle on exactly how much exposure exists in the credit default market. The risk is that as one follows the trail of swaps, the last man standing will not have the capital to honor the swap agreement, and that will put the swap holder and the swap maker both into default. The Fed really does not know how close we are to some major financial catastrophe that could arise from credit default swaps so the Fed is taking a very conservative approach with the AIG bailout.

Hence, the Fed is content to see some major investment banks collapse, but allowing the credit default swap arrangements to default in a monumental way is even too risky for the Fed. Thus, the Fed opted for the bailout, and is working with Treasury Secretary Paulson to find a way to shine some light on the credit default swap markets.