Aig Finance

AIG Financial Products (AIGFP), a subsidiary of American International Group (AIG), played a central and highly controversial role in the 2008 financial crisis. While AIG itself was a global insurance giant, AIGFP’s activities, particularly its involvement in credit default swaps (CDS), ultimately brought the entire company to the brink of collapse, requiring a massive government bailout.

AIGFP’s primary business involved selling credit default swaps, essentially insurance contracts against the default of various debt instruments, most notably mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). These were complex financial instruments derived from bundled mortgages. AIGFP promised to pay out if these securities defaulted, collecting premiums in return. The appeal for AIGFP was the lucrative premiums they received without initially setting aside sufficient reserves to cover potential losses. This was, in part, due to a flawed risk assessment model that underestimated the systemic risks associated with the housing market.

As the housing bubble began to burst and mortgage defaults surged, the value of MBS and CDOs plummeted. Consequently, the creditworthiness of these instruments deteriorated rapidly. AIGFP was suddenly on the hook for billions of dollars in payouts as the underlying assets it had insured began to default. Because AIGFP had not adequately hedged its exposure, it faced enormous financial strain.

The interconnectedness of the financial system further exacerbated the problem. AIGFP’s CDS were widely held by major financial institutions around the world. A default by AIGFP would have triggered a domino effect, potentially causing a catastrophic collapse of the entire financial system. This systemic risk was a key reason why the U.S. government intervened with a massive bailout package exceeding $180 billion.

The bailout of AIG was highly controversial. Critics argued that it rewarded irresponsible risk-taking and created a moral hazard. However, proponents maintained that the bailout was necessary to prevent a broader financial meltdown that would have devastated the global economy. The government eventually recovered its investment, plus a profit, but the crisis severely damaged AIG’s reputation and led to significant regulatory reforms in the financial industry.

The AIGFP debacle highlighted the dangers of complex financial instruments, inadequate risk management, and the interconnectedness of the global financial system. It served as a stark reminder of the potential for seemingly low-risk investments to generate catastrophic losses and the critical importance of robust regulatory oversight.