Bank Regulation Helped Destroy American International Group (AIG)

I was wondering that at this moment should I invest in the U.S. share market? How about invest in one of the giant insurance company in the world? American International Group. At the price of USD 0.45 cents, I was wondering whether to invest in AIG or KNM Group Berhad (RM 0.35)? Or we might be looking for Genting International P.L.C (SGD 0.43)? Which one will move faster when the share market recover?

Previously AIG share prices was about USD 40.00 to USD 60.00 level before the financial crisis strike but now at USD 0.45 per share, it is way too cheap to ignore. Basically I will wait further before any decision can be make.

On March 2, 2009, AIG reported a fourth quarter loss of USD 61.7 billion (£43bn) for the final three months of 2008. This was the largest quarterly loss in all corporate history. The news of the loss came the day after the U.S. Tresury Department had confirmed that AIG was to get an additional USD 30 billion of aid, on top of the USD 150 billion it has already received.

The Treasury Department suggested that the potential losses to the US and global economy would be 'extremely high' if it were to collapse and has suggested that if in future there is no improvement, it will invest more money into the company, as it is unwilling to allow it to fail.

The firm's position as not just a domestic insurer, but also one for small businesses and many listed firms, has prompted US officials to suggest its demise could be 'disastrous' and the Federal Reserve said that AIG posed a 'system risk' to the global economy. The fourth quarter result meant the company made a USD 99.29 billion loss for the whole of 2008, with five consecutive quarters of losses costing the company well over USD 100 billion.

How Bank Regulation Helped Destroy AIG

What ever changes we make to our financial regulations, hopefully we'll ensure that we can never have another AIG putting the entire global financial system at risk. Unfortunately, our track record of building regulations is terrible. In fact, in many ways the last round of regulatory reform helped cause the disaster in AIG.

How could AIG's destruction have been caused by banking regulation? Most people wil probably be surprised by the very idea. After all, they've been told that what really happened to AIG involved unregulated credit default swaps, insurance contracts on bonds that AIG sold across the world. They suspect AIG might have been caused by too little regulation.

In fact, much of AIG's problem was caused by credit default swaps and regulation. After Hank Greenberg was ousted from AIG, the company began to get heavily involved in the credit default swap market. That market was growing in large part because of banking regulation. How the regulations created a demand for CDS. Banks around the world operate under rules that determine how much capital they must hold in reserve.

The rules say that a riskier the assets held by a bank, the larger the reserve they have to maintain. One way to reduce the riskiness of your assets was to buy insurance on them. This created a huge demand for credit default swaps as a kind of regulatory arbitrage, banks trying to comply with regulations while maximizing their own profits. Let's use an example. Say you are running a bank in Europe.

You have a bunch of deposits you want to invest, and you want to invest those in assets that will give you the highest return with the lowest risk. If you buy a bunch of high-yield loans, that is counter-productive. Even if you earn more for each dollar you invest, the reserve requirements will tell you that you can't invest as much.

Now if you throw a credit default swap on, which you can buy cheaply from AIG, you can invest more of your depositors money in highly rated securities. In effect, you get extra-credit for the swap when calculating your reserve requirements. But isn't it insane for banks to keep buying insurance policies from a company that obviously couldn't pay them back? After all, AIG sold USD 527 billion of these.

There's no way it could make good on even a tiny fraction of them. But bankers didn't see it that way. They didn't expect to ever collect on the insurance policies. The main reason they bought them was because the regulations rewarded them for buying them, allowing them to hold less money in reserve and invest more.

In a sense, the credit default swaps were more like 'regulatory compliance policies' than 'insurance policies.' This wasn't some nefarious secret. AIG sold hundreds of billions of credit default swaps to European banks for precisely this regulatory reason. And it wasn't shy about it. It revealed in its annual statement that about USD 379 billion of the USD 527 billion in AIG's default swap portfolio "represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation."

This story, about how banking regulations helped create the demand for a financial product that now has crippled the world's largest insurance company, is another reason to be cautious about building a new regulatory framework. You never quite know what monsters you could be creating.

Article from BusinessInsider.com