Tuesday, March 3, 2009

AIG's Bottomless Pit

Since the majority of the general public, and all of the Financial Media, seem to be constantly asking in bewilderment as to reason AIG keeps requiring additional bail-outs, I decided to try my hands at a simple answer. AIG has exposure to the highest tranches of credit risk. In other words, AIG has insured the highest quality credit in the world. But it did that with gusto. I reckon AIG has risk exposure roughly equal to $1 billion/basis point of investment grade risk*. In other words, every time investment grade credit risk rises by 0.01% AIG books a mark-to-market loss of $1 billion. Why mark-to-market then? The mark-to-market is required by AIG's counterparties and the rating agencies to properly protect against an AIG default. When an adverse mark-to-market takes place, one has to post additional collateral with counterparties or convince rating agencies of reserve adequacy. The inability to do so, causes a total collapse in credit quality and ultimately insolvency. That is why the bail-outs keep coming.

Two years ago investment grade credit spreads where around 30bps. Today they are over 200bps*. This blow-up in credit spreads has happened without any considerable defaults in the investment grade world. What would happen when default start taking place. How much of a bail-out would AIG then need. Go figure!

* A March 3, 2009 article at CNNMoney.com states that the total AIG bailout so far stands at $163 billion. This almost exactly confirms the analysis presented above.