Image by Mike Licht, via Flickr

As the AIG bailout goes north of $160 billion dollars, I have been trying to figure out who this money is really supporting.  The latest round of money illuminated that a major thrust was on maintaining AIG’s AAA rating.  A number of people are starting to dig out the answer.  The following is my interpretation.

European banks were creating sub-prime debt (a lot with Eastern Europe).  Because competition was fierce, margins were razor thin, so banks wanted to increase their leverage to increase their profits.  Under the regulatory scheme these banks work under, a AAA asset requires MUCH small reserves than a sub-prime asset.  So the banks went to AIG and bought credit default swaps on some of their sub-prime debt (insuring themselves against loss).  Since AIG has a AAA rating this greatly reduced their reserve requirements and allowed the bank to levered  up even further.

Now if AIG were to lose its AAA rating, every European bank that was using this trick (and most of the big banks were), would instantly find a huge increase in their reserves requirements and would be out of compliance.  This would grind Europe to a halt as almost every major bank would need to be recapitilized.  The fact that many of these banks levered themselves beyond their host country’s ability to recapitalize them makes it even more problematic.

So in my mind, a good portion of the $163 billion, is to keep Europe out of an instant meltdown.  For reference, the original Marshall plan is estimated to have cost around $115 billion in today’s dollars.  The rest is probably going to support large counterparties like Goldman.


Reblog this post [with Zemanta]