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.

In a nutshell, here’s what I understand to be happening with American International Group (AIG):

1. AIG is a major player in the market for “Credit Default Swaps” (CDS’s).

a. A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties.

b. A CDS provides its buyer with protection against default, a credit rating downgrade, or some other negative “credit event” (e.g., being put on a credit watch list by a rating agency).

c. The CDS seller (in this case, AIG) assumes the credit risk that the buyer does not wish to bear in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. Essentially, AIG’s CDS business is a form of financial insurance.

2. What’s AIG’s “problem”?

a. As the “credit crunch” has continued to worsen, AIG’s CDS’s are declining in value and becoming increasingly less liquid. Consequently, regulatory and rating agency capital standards are essentially forcing AIG to collateralize these assets by raising more capital. However, it is very difficult (particularly for an already credit-impaired firm like AIG competing in an adverse financial market environment) to raise the capital needed on a timely basis in order to be able to comply with these standards.

b. To make matter even worse, a substantial share of AIG’s business involves exposure to commercial insurance products, whose buyers (primarily private and public sector risk managers) expect to place their business with high credit quality insurers. As AIG’s credit rating continues to decline, this substantially puts at risk AIG’s valuable commercial insurance franchise, which in turn makes it all the more difficult for AIG to raise capital.

It can be very tempting to criticize someone else’s actions when you have the benefit of hindsight. Having said that, the credit crisis does expose a fundamental flaw with AIG business model; specifically, it probably doesn’t make much sense to expose a business which has tremendous franchise value (i.e., AIG’s commercial insurance business) to an inordinate amount of credit risk. It is interesting to note that by and large, most firms in the financial guarantee business (e.g., companies like MBIA and AMBAC) are monoline companies; i.e., they market and distribute financial insurance products only.