The New York Times has an article explaining the business model of the failed insurer AIG that is giving me a new perspective on why I walked out of a bank in New Mexico wondering whether it was worth it to put my kids college funds at risk to get a loan. As I understand it, AIG got into the business of selling insurance on mortgage backed assets to banks that wanted to be able to put more of their depositors money into crazy bets.
In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too. That was the ratings arbitrage.
AIG put away reserves of precisely $0 for this insurance on the incredible assumption that housing prices would go up forever – or more likely, until the AIG managers had moved on to something else. I’ve been in business for a long time now, and I’ve seen some deals that made me edge away to the door fast, but this is mind-blowing – and the bank side of the deal was worse.
A huge part of the company’s credit-default swap business was devised, quite simply, to allow banks to make their balance sheets look safer than they really were. Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements. The less risky the assets, obviously, the lower the regulatory capital requirement.
How did banks get their risk measures low? It certainly wasn’t by owning less risky assets. Instead, they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free†assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began.
Bernie Madoff was a small-timer compared to this scheme. Imagine all the people who had money in pension plans that went into buying bank stocks – without knowing that the banks were betting everything that housing prices would never, ever, go down! And that’s where I come in. While the banks were buying CDOs and fueling the run-up in real-estate prices, they were not buying municipal bonds to pay for infrastructure and schools or lending money money to Wind and Solar power projects, biotech, computer systems, and small business.
I tried to borrow $250K for FSM to expand the business in 2005 and the banks refused to make the loan unless they got the rights to take all of my personal assets. I wanted the loan also as a form of insurance. The idea was to expand sales and engineering (using our own funds) and the 1/4 million would have been there to cushion the landing if sales did not take off as hoped. That is, if we spent $1M expanding and money failed to come in, the loan would have meant we could give employees severance and keep operating as we cut back. This was a loan qualifying for government insurance – so the banks were covered 90%. We had a great credit record, some nice patents, and had been profitable every year of operation. But I was supposed to sign over my house and my kids college fund in order to make sure that there would be plenty to cover the last 10% and whatever expenses the bank would have collecting. So at the very moment they were happily throwing hundreds of billions of dollars into bets that would have made Los Vegas croupier wince, the banks would not consider risking $25K on a loan to a profitable small business. We ended up doing very well – but I can’t believe that our situation was in any way unique. And it’s hard not to think of what might have been and how much of my taxes are now going to AIG and its banking partners.