AIG May Pay Back Much of What We Lent It

I've listened to a couple of radio interviews lately with the author of The Big Short. Michael Levin wrote Liar's Poker a few years ago about the peccadilloes of investment bankers. He has a real talent for breaking down arcane (and sometimes deliberately obscure) financial operations into language normal people can understand. In The Big Short he goes at the myth that no one saw the financial crises of 2007 and 2008 coming. There were people who saw that the emperor had no clothes, and they made a lot of money betting against the boom.

The bottom line was that banks and insurers radically underestimated the risk inherent in certain securitized mortgage instruments and their derivatives. The premiums paid by purchasers of credit default swaps were absurdly low; when they went bust, the insurers didn't have the cash to cover the claims. That's the AIG story in a nutshell. They didn't charge enough in premiums to make up for the risk of the financial instruments they were insuring.

One could note that, by charging more for premiums, AIG would have protected itself in two ways: 1) It would have taken in enough money to cover the likely claims, and 2) it would have diminished the number of claims it would have had to cover. The latter effect would have come about because either investors would have chosen not to buy the expensive insurance, or they would have had second thoughts about buying securities that were so obviously risky. Premiums are a signal to the market of the degree of risk.

In this column, Daniel Gross estimates that the government bailout of AIG may wind up costing us only $12 or $15 billion. If we get some effective financial regulation out of the deal, that may be a small price to pay.