Today, I learned an interesting fact about the AIG CDS situation. Apparently AIG has in excess of $400 billion in exposure to credit derivatives, much of which were sold to foreign as well as U.S. banks. The reason why banks like to purchase CDS’s is that this enables them to satisfy risk-based capital requirements associated with holding risky bonds (e.g., instruments like mortgage backed securities (MBS’s) and collateralized debt obligations (CDO’s)) in their asset portfolios. Therefore, AIG may in fact be big to fail because if it does, then this would likely unleash a financial contagion throughout the banking system which would substantially limit the availability of credit throughout the US economy.
Here’s a simple explanation of how financial contagion could occur if AIG were to fail. If AIG failed, then banks who relied up AIG’s contingent capital (in the form of CDS’s) would be required to raise cash in order to comply with risk-based regulatory capital requirements. Probably quite a few banks would not be successful in doing this on a timely basis, and would be forced to file for bankruptcy. In this scenario, surviving banks who managed to comply with regulatory capital requirements would naturally become quite reticent about lending. The net result would be a substantial credit shock for the overall real economy.
One final point; apparently the U.S. penchant for bailing out “too big to fail” financial institutions is going global. For example, lately the Bank of England is beginning to act much more “Fed-like” in terms of establishing contingent credit facilities for troubled financial institutions in the UK. Anyway, the real world is providing us with lots of risk management data and it will be interesting to see how this all plays out.