Cote,
And finally, before I finish cooking dinner, just one more link to help in your continued education of 2008 and all that. Tis all about the CDOs (that is 'collateralised debt obligations'). Note the highlight about how the epicentre was in London.
www.investopedia.com/articles/economics/09/american-investment-group-aig-bailout.asp
What was once the unthinkable occurred on September 16, 2008. On that date, the federal government gave the American International Group - better known as AIG (NYSE:AIG) - a bailout of $85 billion. In exchange, the U.S. government received nearly 80% of the firm's equity. For decades, AIG was the world's biggest insurer, a company known around the world for providing protection for individuals, companies and others. But in September, the company would have gone under if it were not for government assistance.
Read on to learn what caused AIG to begin a downward spiral and how and why the federal government pulled it back from the brink of bankruptcy.
High Flying
The epicenter of the near-collapse of AIG was an office in London. A division of the company, entitled AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of American capitalism. For years, the AIGFP division sold insurance against investments gone awry, such as protection against interest rate changes or other unforeseen economic problems. But in the late 1990s, the AIGFP discovered a new way to make money.
A new financial tool known as a collateralized debt obligation (CDO) became prevalent among large investment banks and other large institutions. CDOs lump various types of debt - from the very safe to the very risky - into one bundle. The various types of debt are known as tranches. Many large investors holding mortgage-backed securities created CDOs, which included tranches filled with subprime loans. (For more on this concept, check out our Subprime Mortgage Meltdown special feature.)
The AIGFP was presented with an option. Why not insure CDOs against default through a financial product known as a credit default swap? The chances of having to pay out on this insurance were highly unlikely, and for a while, the CDO insurance plan was highly successful. In about five years, the division's revenues rose from $737 million to over $3 billion, about 17.5% of the entire company's total. (Read Credit Default Swaps: An Introduction to learn more about the derivative that took AIG down.)
One large chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that what it insured would never have to be covered. Or, if it did, it would be in insignificant amounts. But when foreclosures rose to incredibly high levels, AIG had to pay out on what it promised to cover. This, naturally, caused a huge hit to AIG's revenue streams. The AIGFP division ended up incurring about $25 billion in losses, causing a drastic hit to the parent company's stock price. (Read more about the lead-up to the credit crunch in The Fuel That Fed The Subprime Meltdown.)
Accounting problems within the division also caused losses. This, in turn, lowered AIG's credit rating, which caused the firm to post collateral for its bondholders, causing even more worries about the company's financial situation.
It was clear that AIG was in danger of insolvency. In order to prevent that, the federal government stepped in. But why was AIG saved by the government while other companies affected by the credit crunch weren't? (Read about one company that didn't survive financial crisis in The Rise And Demise Of New Century Financial.)