Closing the Gaps

The cautionary tale of AIG's downfall

THE TALE of insurance giant AIG's rise and fall, which Post reporters Robert O'Harrow Jr., Brady Dennis and Bob Woodward laid out in gripping detail this week, is a cautionary one. AIG, once the largest and most profitable insurance company in the world, failed last year, prompting a federal intervention that has cost $152 billion so far.

The company landed in the taxpayers' lap because of its exposure to credit-default swaps, or CDSs, which are essentially contracts to pay customers if their investments in other securities go sour. Like other financial derivatives, CDSs can help investors hedge their bets, thus improving the liquidity and efficiency of financial markets. But, when sold as insurance for shaky underlying assets, such as securities backed by subprime mortgages, CDSs can increase rather than reduce systemic risk. AIG sold $80 billion worth of subprime-related credit-default swaps on Wall Street between 1998 and 2005 -- when it concluded that the business was too dicey and got out.

By then, however, it was too late. The company thought it would be protected against potential losses in the CDS business because of its AAA rating from Wall Street credit agencies. But it lost that seal of approval, thanks in part to market concerns about the 2005 resignation of chairman and chief executive Maurice R. "Hank" Greenberg amid a New York state investigation of other company practices. As a result, AIG had to post collateral to back up its CDSs, and, in September, when the company could not come up with enough cash, the Federal Reserve and the Treasury had to step in, lest its giant web of credit-default swaps collapse and bring the world economy down with it.

In hindsight, it is clear that government regulation was lacking in the early stages of AIG's CDS boom. As they were building it, AIG executives regarded their CDS business as virtually risk-free -- "like catastrophe insurance for events that would never happen," according to the Post series. This something-for-nothing aspect of the business should have been a red flag for the government -- and for the ratings agencies, too. Yet another lesson of the AIG saga is the sheer difficulty of comprehending the myriad pathways of modern finance. The trick in regulating financial derivatives will be to preserve their efficiency-enhancing attributes while eliminating those factors that tend to concentrate systemic risk where it cannot be easily detected. AIG built up its CDS business in the interstices of governmental authority; those gaps can and should be closed without choking the arteries of capitalism.