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AIG Explained

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AIG Explained

Everybody is screaming about AIG and the nerve that they were giving out bonuses while accepting taxpayer's money. Most of the people who are screaming the loudest never heard of AIG before last Summer. I would like to try to explain what happened at AIG by using an easily understood analogy to what AIG did and who the people getting the bonuses at AIG are. For the sake of this discussion, I will write in the first person pretending that the events actually happened in the past.

I have an insurance license, so in the Summer of 2004, I approached a storefront insurance office and asked if they needed a salesman. The owner of the small operation said he did. I signed a contract to work for the agency and for the insurance company the agency represented. He told me that he would give me 20% of the first year's premiums for each policy I sold. He also told me that the salesman who takes in the highest dollar amount in premiums each month in the state gets a $1,000 bonus and whoever has the best month for premiums received during the year gets a $10,000 bonus paid in the next calendar year. The owner/agent gave me a briefcase full of blank home owner's contracts. I looked up a listing of who needed insurance and set out to become rich. Just prior to going out to sell home owner's insurance I checked my computer and found out that hurricane Francis was headed directly at my sales area and was scheduled to hit in 6 days. When I got to the first address on my list, I explained to the home owner how important insurance was. We read the contract and it said that fire and theft coverage started on the day the first premium installment was paid, but that the hurricane protection went into effect 30 days after the first installment was paid, and the first installment must be a minimum of 10% of the total yearly premium. For this address, the premium would be $1,000 for everything except hurricane damage or $2,000 for everything including hurricane damage. The owner said that he was very worried about hurricane Francis, but since hurricane protection would not start for 30 days, he was not interested. That's when my brain went into overdrive. I said, "Let me make 3 quick modifications to this standard contract and then I'll ask you again if you would like to buy insurance." I changed the hurricane coverage from going "into effect 30 days after the first installment was paid" to "into effect 30 minutes after the first installment was paid" and I changed "the first installment must be a minimum of 10% of the total yearly premium" to "the first installment must be a minimum of 100% of the total yearly premium" and I changed "the premium would be $1,000 for everything except hurricane damage or $2,000 for everything including hurricane damage" to "the premium would be $1000 for everything except hurricane damage or $2,500 for everything including hurricane damage". The home owner said, "Sold" and wrote out a check for $2,500.

I did this about 200 times in the next 6 days and showed up at my boss' Insurance Agency with over $500,000 and a pile of contracts. I showed my boss the contracts and while he was skeptical of my idea, he also worked on commission, so he countersigned each contract. The insurance company who's name the contracts were drawn under loved hearing about the large influx of cash. However, after hurricanes Francis and Jeanne both hit within the next 30 days, they received $25,000,000 worth of claims on these newly insured houses and went bankrupt. The state's backup insurance company had to step in to pay all the company's contractual obligations using tax-payer's funds. I got my bonus before the insurance company paid on the claims and I got fired a month later. But in February of 2005, I got my $10,000 check for having the best income for any month of the year from the state backup insurance company.

That is about what has happened with AIG. A bunch of salesmen rigged up a scheme to insure banks who were selling AAA rated bonds that were actually junk. The AIG salesmen brought in billions in commissions but left AIG exposed to over a trillion dollars in possible claims. Now the salesmen want their bonuses for the great job they did bringing in premiums even though they never evaluated the bonds they were insuring or AIG's possible exposure.

Any salesman who would do what I did with the home owner's contracts should be fired. Any salesmen who did what the AIG salesmen did should also have been fired and maybe brought up on charges of fraud.

Another item that people are complaining about is that AIG is giving money to foreign banks and also to American banks who have been bailed out by the Federal Reserve Bank (FED) and/or the US Treasury. There is no news here. AIG is an insurance company. The banks that packaged toxic mortgages into bonds wanted insurance for those bonds and bought it from AIG. The banks knew that the bonds were junk so they induced the ratings companies like Dun & Bradstreet, Moody's, Fitch, etc. to rate their junk bonds as AAA, but the banks were smart enough to know they needed insurance. Regular insurance is regulated, so they made bets with AIG that are called Credit Default Swaps. Under these contractual wagers, the banks made periodic payments to AIG, and in return AIG would have to payoff the banks if a bond defaulted. It was Las Vegas on steroids.

So of course, AIG is using the bailout money to payoff banks. AIG lost the bets which were basically insurance without regulation. What reason did the Federal Government and the FED think that AIG was in debt? The FED knew that AIG owed banks money. That is why the FED loaned AIG 85 Billion Dollars in September of 2008. It is rather disingenuous for anyone to act surprised that AIG is giving money to the same banks as Congress bailed out with the 2008 TARP bailout bill or with the FED's bailouts that started with the May, 2008 bailout of Bear Stearns.

If we stop AIG from paying off on the Credit Default Swaps, then the banks will be deeper in debt and need more bailouts. If we stop AIG from paying the foreign banks, it will put more stress on the economies of those countries where the banks are located and it will curtail the willingness of those countries to cooperate with the US to solve the International Financial Crisis. So the choices are (1) restrict AIG and give more bailout money to the banks or (2) let AIG meet its contractual obligations and then the Federal government can give less in bailouts to the banks. If I owed $200 on my credit card and my son owed me $300, does it matter if he gives me a $300 check and then I write a $200 check to the bank or if he gives the bank a $200 check and gives me $100?

And yes there is a third choice, (3) let the banks and/or AIG fail and let the World Wide Economy go into another Great Depression.

 

I was born in Brooklyn, NY in 1945, worked as aircraft mechanic for 35 years and moved to Florida from Brooklyn in 2003. My wife and I will celebrate our 42nd wedding anniversary this year. Our only son is 41, married and has one daughter, plus his (more...)
 
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Excellent writeup and essentially accurate. In sim... by TomK on Monday, Apr 6, 2009 at 1:10:03 PM
Insurance has always been a racket that should be ... by John Hanks on Monday, Apr 6, 2009 at 7:25:13 PM
A very readable way of explaining the AIG fiasco. ... by Jeff Sweet on Wednesday, Apr 8, 2009 at 2:28:49 PM