AIG Rescue

Since the first infusion of cash from the federal government into AIG it has been stated that AIG was 'too big to fail' and that its failure could have led to the collapse of the entire US Financial System. The release of data on AIG Counterparties who have received cash and collateral drove this point home as no government argument could.

Virtually every firm listed by AIG has received significant capital infusions from a government and/or private investors. Solomon Brothers received around $12 billion alone, if AIG had been allowed to collapse the entire investment by Warren Buffett plus a few extra billion would have been wiped out. Could Solomon Brothers have withstood such a dramatic hit? This would likely have been even worse as open hedge contracts for which they have not been fully paid or for which they are offsetting other risks they hold would have instantly lapsed and additional write downs would have been required. I am only naming Solomon as they topped the list of receipients this story plays out again and again down AIG's list.

What is highlighted by this fiasco is that a particular industry participant could insure/hedge away their risk and work to contain the exposure to a particular counterparty but they can't control other market participants. It is very likely that Solomon maintained hedges with other firms then AIG on the same products and in the same direction to limit their counterparty exposure. These other firms may have then gone to AIG independently and hedged their exposure so that Solomon's true exposure to AIG was much greater then their internal systems could track due to a lack of information.

Regulatory reform that requires market participants to publish their exposure to Swap contracts is welcome as a means to minimize this market risk. Sure lots of hedge funds will be upset as they try to hard their investment strategies from competitors but the greater good must be considered.

One needs to remember that hedging doesn't reduce absolute risk, it simply shifts it to another party. Amazingly AIG seems to have taken on a significant portion of the risk that existed within the mortgage market and no one was aware or they ignored it and hoped for the best.