How Credit Default Swaps Became a Timebomb

A Credit Default Swap is a credit derivative or agreement between two counterparties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer." The second party gives credit protection and is called the "seller". The third party, the one that might go bankrupt or default, is known as the "reference entity."

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against a default on a debt. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes.

Such exotic financial products are extremely profitable in times of easy credit, but when markets reverse, as has been the case since August 2007, they amplify risk considerably.

Read about the role Of Credit Default Swaps (CDS's) in the Financial Crisis in a great 3 part article
Link to Part 1

Link to Part 2
Link to Part 3

A.I.G: A Financial Blackhole

On Monday the American International Group(A.I.G) reported a loss of $61.7 billion, the largest quarterly loss in history. Most of it is due to write-downs on the value of the company’s assets. The American Government on Sunday agreed to provide an additional $30 billion in taxpayer money to A.I.G. This is the fourth time the American taxpayer has had to step in to stave off a collapse. So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat. A.I.G is becoming a financial black-hole swallowing billions upon billions of dollars.

Background Information
A.I.G. had to be propped up because its business and trading activities were intricately woven through the world’s banking system. After the calamity that followed the fall of Lehman Brothers, which was far less enmeshed in the global financial system than A.I.G., who would dare allow the world’s biggest insurer to fail? Who would want to take that risk?

The previous rescues were intended to stabilize A.I.G. and buy it time to restructure its business. The idea was that A.I.G Would gradually sell its various assets and repay the Government. Basically a controlled breakup of the company without leading to upheaveals in the financial markets.

Previous Bailouts For A.I.G.

In September 2008 after Lehman Brothers went bust, the Federal Reserve lent A.I.G. $85 billion when the company suddenly found itself unable to meet a round of margin calls. In return A.I.G. issued warrants for slightly less than 80 percent of the company’s shares.

But in just weeks it became clear that A.I.G.’s problems were so grave the $85 billion would not be enough. It was using up that money alarmingly fast. In October another $38 billion was lent to the company.

But that was not enough either. In mid-November A.I.G was back for more. The conditions of the previous loans were relaxed and $40 billion was injected into A.I.G. in exchange for preferred shares.

In all, A.I.G has received $160bn of government help: $85bn in exchange for an effective 79.9% equity stake, loans worth $38bn and around $40bn to capitalize two vehicles holding AIG’s dodgy assets. Add the latest $30 Billion and the bill reaches almost $200bn.

The Bottom Line
The American taxpayer is going to lose billions of dollars sorting out A.I.G's mess. At best $100-120bn will be realized by selling A.I.G's various pieces. Expected loss to the American taxpayer: $50 bn(minimum)

Ben Bernanke, the chairman of the Federal Reserve, is pretty peeved at the company as well. “This was a hedge fund, basically, that was attached to a large and stable insurance company,” Mr. Bernanke told lawmakers on Tuesday, later adding, “There was no regulatory oversight because there was a gap in the system.”

Read Mr. Bernanke’s Testimony here