AIG WHAT PEOPLE DON'T KNOW

AIG is getting more loans and lines of credit from the government. You really want to know why?

AIG is one of the world’s largest insurance companies. AIG like many insurance companies was very involved in the mortgage meltdown but not in a capacity that many actually understand. This really has nothing to do with insurance as you and I know it to be. This is largely about RE Insurance.

I mentioned this would be a catastrophe as big or bigger than the banking bailout and it will turn out to be and is certainly the fact just with AIG. I will paint a simple picture.

Preamble

You and I get mortgages at $100 each with a 10% interest rate. The bank lends us $100 each. The bank has depleted its coffers by $200. The bank then lends several thousand others the same amount, more or less, at say 10% interest as well. The bank then takes all those loans and bundles them into a Collateralized Mortgage Obligation and sells this instrument into what was a massive bond market to get their money back. In other words if the bank put out $1 billion in loans it sells a $1 billion CMO so it can borrow its money back from the bond market.

Now here it is. The bank should sell this bundle of mortgages with an interest rate for investors at least 10%. The problem is the banks can’t borrow the money back to lend again at that rate because they can’t borrow and lend and make money if the interest rate is the same or higher on the bonds. So here comes the insurance industry.

BELOW IS THE REASON WHY!

Companies like AIG RE Insure or “credit enhance” the CMO. What is a 10% bundle of loans becomes insured and the underlying assets, the loans, are guaranteed by insurance and RE insurance companies assuring the loan portfolio will at least repay the $1 billion at a minimum. The CMO is now principal protected so investors or those buying the bonds are holding an instrument that was very safe. Why not right its insured? Now the bank can sell its bundle of 10% loans to the bond market at an interest rate of let’s say 3 or 4 percent because of the safety of this investments and the RE insurance companies get a fee and a taste of the deal.

Now the bank can recoup its money at a low interest rate and turn around and lend it at a higher interest rate and therefore make money on the difference. In this case 7% on the loans. This is how the mortgage industry worked for years.

Well then it is obvious what is happening. The insurance companies are all on the hook with guarantees for all these toxic products. When the confidence in the CMO eroded essentially because of the US housing market and its decline everyone stopped buying CMOs. Well everyone had them in their portfolio, pensions, unions, endowments, the banks and yes the insurance companies bought them too. It was like buying Treasuries. Well when those CMOs go bad and they have been devastated the insurance companies have to come up with the money to pay back investors.

It is very complicated because the insurance companies all work together, no one single insurance company takes on the whole risk of any individual bond, and back each other up as well as spread the risk of insurance among themselves. This is called retrocessioning. Where insurance companies insure other insurance companies and participate together in insuring the risk of the CMOs.

It’s like Alice in Wonderland and the Rabbit Hole for most people to even think about. But the bottom line is the RE Insurance lines of business inside large insurance companies have infected the main lines of insurance by being on the hook. Worse as this all happening the rating agencies are down grading the investment worthiness of these institutions further halting their ability to borrow huge sums of money at decent interest rates to cover their losses.

A vicious cycle I described in July 08 that is and will be as big as the banking meltdown just that its now showing its ugly head.