AIG bailout – Necessary, unfortunately

September 17, 2008 at 7:53 am | Posted in credit, Housing | 1 Comment
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So the US government is deeper into the business of being in business. This NYTimes article
http://www.nytimes.com/2008/09/17/business/17insure.html
talks about the Fed’s $85 billion loan to AIG.

Fearing a financial crisis worldwide, the Federal Reserve reversed course on Tuesday and agreed to an $85 billion bailout that would give the government control of the troubled insurance giant American International Group.

The decision, only two weeks after the Treasury took over the federally chartered mortgage finance companies Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank’s history.

Financial institutions need a certain amount of capital to remain solvent – basically, when they borrow money, they need to be able to pay it back, or go bankrupt. So they need enough of their own money -equity – to cover any losses they make, so that they are still able to pay off the debt.

Here’s an example of this works – Say I borrowed $80, and put in $20 from my pocket. I then lent the $100 out to borrowers – some borrowers want to borrow to buy a house, others, to buy products for sale in their store, others, to build a plant or buy a shop – whatever. The people I borrowed from don’t really care where I lend the money – they only care that they can get back their money. So let’s say that a storekeeper went bankrupt and couldn’t return the $10 he borrowed from me. I still have the other $90 lent to other people – I owe my lenders $80, and have basically lost $10 of the $20 I put in. Now, if a homeowner went bankrupt and I lost $20 more, I’m in trouble, because my assets (the stuff I own) are now just $70, but I owe my lenders $80. Either I put in another $10 from my pocket (this won’t be enough, because then I have $80, and owe $80, and if another of my borrowers goes under, I will again need to add more from my pocket), or I go bankrupt too. But like I could go bankrupt because somebody who borrowed from me went bankrupt, so could somebody who lent me the money go bankrupt if I cannot pay them back. And this could cascade through the system. That’s why the government had to step in – They don’t really want to save any one company – but if each bankruptcy or other, less serious event were to trigger another such event, the entire system can get into a lot of trouble.

That’s why the government had to step in as the last resort, to prevent the system from collapsing. I think better regulation can help protect the taxpayers from some of the consequences. I don’t think regulation has all the answers – we can’t anticipate everything that can go wrong, or how things can go wrong, but we can certainly assume that something will go wrong, and regulate risk norms accordingly. That wouldn’t fix everything, and we must be careful not to over-regulate, but what we did have is not enough.

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1 Comment »

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  1. I still get the feeling we are being duped, being robbed, and being played as pawns.
    $700 BILLION!

    I think Obama would be better at sorting out this mess.
    McCain’s chief financial adviser is Phil Gramm, the architect of the bill that deregulated the financial industry.

    Look up the Gramm-Leach-Bliley Act.
    http://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act


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