AIG and Credit Default Swaps- Here’s the Scoop

Have you heard the term “credit default swap” and had no idea what it meant?  How about why AIG is making front page headlines so often?  Let’s take a look at my childhood for an explanation.

 

Have you ever asked your mother, father, friend, pastor, or some other trusted person to hold some money for you?  I remember a time when I was saving up for a new bike and I didn’t trust myself to hold on to the money.  I knew that as a preteen I was prone to get a little haphazard with my things.  The life of a preteen is busy, you know.

 

So sure enough, they held the money and when it came time to buy my bike, they wrote a check or some other complicated payment instrument was used.  (To a preteen, anything involving something other than cash is complicated)  It took me a while to save up enough money so it was months before I asked them to write the check.  What they did with my money while they were holding it wasn’t something I knew.  Rather they put it in a drawer, invested it, or whatever else was something I didn’t know nor did I care.  I just wanted my money back when it was time and you know what, I got it.

 

If you understand my childhood example, you understand how insurance works.  It’s simple really.  You give an insurance company some portion of your money and in exchange, they invest it and should you need the money for some big expense, they will pay it for you.  Obviously insurance is a little bit different than my story but essentially the same.

 

Let’s change the story a little bit.  What if my parents would have taken my money and invested it in something risky and ended up losing it?  I went back to them when it was time to buy the bike and they gave me the bad news.  “Son, we invested your money and lost it and now it’s gone.  I’m sorry, you can’t have the bike.”  That would be really disappointing wouldn’t it?  Now you know the story of AIG.

 

A Credit Default Swap is simply insurance on a loan.  In this case we’re talking about mortgages.  AIG was contracted to supply insurance to numerous large banks in case the mortgage loans they were making ended up defaulting.  (Kind of makes you think that these banks knew these risky mortgage loans were a bad idea, doesn’t it?)  What should have happened is this:  When AIG supplied this insurance, they should have been building up reserves in case they had to pay out on these claims just as my parents made sure they had the money to buy my bike.  Because of some loopholes in the law, AIG wasn’t being asked to show proof that they were doing this and guess what?  They weren’t.  Instead, they were taking the insurance premiums and investing it themselves.

 

Then the market had a meltdown and the high price of homes came crashing down.  This spelled disaster for AIG.  Not only had AIG lost major bucks investing the insurance premiums, they had no reserve to pay the claims and all of these banks were losing money right and left on their high risk mortgages so they were filing claims with AIG.  AIG had no money to pay it and the ripple effect began.

 

AIG melted down and the government stepped in with a massive bailout.  Where do you think the bailout money went?  It went to all of these big banks to pay their insurance claims.  If these banks wouldn’t have received money on these claims, they would have melted down as well and we would have had a financial disaster!

 

There is more to the story than this but now you have an idea of what a credit default swap is and how it works and why the big bailout of AIG took place.

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