Why AIG is in Trouble . . .and Why its Failure Would Be a Big Deal

Why is AIG in trouble and why are people saying its failure would be a big deal?

You know the answer . . . derivatives.

Specifically, a February 2008 article in the International Herald Tribune states:

[AIG revealed that] auditors had questioned whether it properly valued its derivatives portfolio, raising new questions about accounting practices at one of the world's largest insurance companies.

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The disclosure sent AIG shares down 11.33 percent and cast doubt on the company's previous contention that it did not face major problems stemming from the credit crisis that has slammed other financial institutions.

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We "believe AIG management will have an extremely difficult time regaining investor confidence," Standard & Poor's wrote Monday in a note.

[AIG's auditor] concluded that AIG had a material weakness in its internal controls over financial reporting relating to the fair valuation of credit default swap portfolio obligations of AIG Financial Products.

S&P cut its price target on AIG shares by 38 percent to $43 and downgraded the shares to "sell" from "buy." It said the company's problems with valuing the derivatives portfolio were "very troubling" and that the lower price target - a discount to AIG's peers - was "warranted in light of these disclosures."

What's happening with AIG now? And what would its failure mean? A money manger explains in a New York Times op-ed:

Late Monday, A.I.G. was downgraded by the major credit rating agencies . . . . This credit downgrade could require A.I.G. to post billions of dollars of additional collateral for its mortgage derivative contracts.

Fat chance. That’s collateral A.I.G. does not have. There is therefore a substantial possibility that A.I.G. will be unable to meet its obligations and be forced into liquidation. A side effect: Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression.

A.I.G. does business with virtually every financial institution in the world. Most important, it is a central player in the unregulated . . . credit default swap market that is reported to be at least $60 trillion in size.

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If A.I.G. collapsed, its hundreds of billions of dollars of mortgage-related assets would be added to those being sold by other financial institutions. This would just depress values further. The counterparties around the world to A.I.G.’s credit default swaps may be unable to collect on their trades. As a large hedge-fund investor, A.I.G. would suddenly become a large redeemer from hedge funds, forcing fund managers to sell positions and probably driving down prices in the world’s financial markets. More failures, particularly of hedge funds, could follow.

Note: this explanation is admittedly somewhat of an oversimplification. However, it does accurately reflect the centrality of derivatives to the economic crisis.