Toxic Securities Insurance

Last September, AIG approached the Fed for a $75B loan. Instead, they were given $85B. By November they had received $40B of TARP money, and with another $25B infusion they were up to $150B in bailout money all told. Yesterday, they received another $30B from the Fed, and for the first time ever we see Bernanke showing an edge of emotion about the mess. AIG gained additional notoriety for a nearly half-million dollar spa retreat right after its first bailout, and then a hunting trip in England because its executives were still under a lot of stress.

More and more, it appears an insurance company—AIG—is central to this credit bubble. Make no mistake; there still would have been a major bubble in real estate and probably stocks without AIG, merely with the Fed lowering interest rates to 1%. But it would not have lasted as long and not have gone as crazy as it did without the ability to insure debt. By securitizing loans and then insuring unrated tranches, banks had the opportunity to go ballistic.

By securitizing loans, banks can avoid most, but not all of the risk of the loan. I’ve argued recently that securitized loans remove credit from the money supply. A loan from a bank increases money supply by that which is not part of the fractional reserve—in other words, a $1000 loan must be backed by $100 in a 10% fractional reserve system, and the remaining $900 is pure monetary expansion. It is monetary expansion because that $900 exists in two places: both as a deposit for the depositor, and as a loan. Selling the loan as a security undoes this process, such that securitized debt is no different than any credit between two private, non-banking entities.

As long as banks can sell loans as securities, they can make the craziest loans they want to, and securities buyers bear the risk of loan defaults. As long as loans are removed from the balance sheets through sales of securities, banks are not limited by fractional reserves; as long as securities are a hot market, fractional reserves remain available for further lending. In selling securities, banks forego profit by interest (which goes to the investor) but still profit by fees, both in packaging the securities and handling the loans. Once a loan is securitized it is risk-free to the bank.

But there is a catch, and here is where AIG comes in. When securities are chopped up and sold, banks have to keep the riskiest tranches. Those tranches that go belly-up first, banks have to hold on to them, per regulations. That means they are holding on to a lot of toxic material waiting to go bad as lending standards completely collapsed around 2005 and 2006. So what they do is insure toxic debt with credit default obligations (CDOs). AIG was happy to sell this toxic debt insurance. If and when the debt goes bad, banks get the insurance money. There is no way to go wrong, right?

Then AIG can even sell those CDOs to private investors, as it did to Lehman Brothers and Bear Stearns hedge funds, removing AIG from the risk of a systemic collapse.

Okay, so bad loans went belly-up. Bear Stearns and Lehman ran out of money from paying of loan insurance to banks (and anyone else who wanted to insure the debt). Paying off what CDOs AIG couldn’t sell, now they’ve run out of money too, and with AIG in trouble, banks are under the pressure of a big pile of unrated tranches.

This is where the taxpayer comes in. And now you know the rest of the story.

The big boys have to fall. It’s the only solution. Keeping this kind of corporate malfeasance alive is wholly counterproductive. Contrary to fear mongering we hear lately, new banks will rise to replace the old.