THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 324

292

PA R T I I I

FYI

Financial Institutions

The AIG Blowup

American International Group, better known
as AIG, was a trillion-dollar insurance giant
and before 2008 was one of the twenty
largest companies in the world. A small separate unit, AIG s Financial Products division,
went into the credit default swap business in
a big way, insuring over US$400 billion of
securities, of which US$57 billion were debt
securities backed by subprime mortgages.
Lehman Brothers troubles and eventual
bankruptcy on September 15, 2008, revealed
that subprime securities were worth much
less than they were being valued at and
investors came to the realization that AIG s
losses, which had already been substantial in
the first half of the year, could bankrupt the
company. Lenders to AIG then pulled back
with a vengeance, and AIG could not raise
enough capital to stay afloat.
On September 16, the Federal Reserve
and the U.S. Treasury decided to rescue AIG
because its failure was deemed potentially

catastrophic for the financial system. Banks

and mutual funds were large holders of AIG s
debt, plus the bankruptcy of AIG would have
rendered all the credit default swaps it had
sold worthless, thereby imposing huge losses
on financial institutions that had bought
them. The Federal Reserve set up an
US$85 billion credit facility (with the total
loan from the Fed and the government
increased to US$173 billion) to provide liquidity to AIG. The rescue did not come
cheap, however: AIG was charged a very
high interest rate on the loans from the Fed
and the government was given the rights to
an 80% stake in the company if it survived.
Maurice Greenberg, the former CEO of the
company, described the government s
actions as a nationalization of AIG.
Insurance companies have never been
viewed as posing a risk to the financial system as a whole. Because the problems at AIG
nearly brought down the U.S. financial system, this view is no longer tenable. The
insurance industry will never be the same.

alone, are therefore the only insurance companies that are allowed to provide
insurance that guarantees the timely repayment of bond principal and interest
when a debt issuer defaults. These insurance companies have become particularly
important in the municipal bond market, where they insure a large percentage of
these securities. When a municipal security with a lower credit rating, say an A rating, has an insurance policy from a monoline insurer, it takes on the credit rating
of the monoline insurer, say AAA. This lowers the interest cost for the municipality and so makes it worthwhile for the municipality to pay premiums for this insurance policy. Of course, to do this, the monoline insurers need to have a very high
credit rating.

The New
Legislative
Framework

As noted in Chapter 11, in 2001 the government passed legislation reforming the
regulatory framework governing Canada s financial services sector. The new legislation allows demutualized life and health insurance companies to restructure
under a holding company structure, to enter into joint ventures and strategic
alliances, and to access the Canadian payments and clearance systems, in an
attempt to bring the sector in line with the banking sector. However, the new legislation does not allow mergers involving large banks and large demutualized life
and health insurance companies. Moreover, the new legislation requires that large
life and health insurance companies (those with equity over $5 billion) be widely