Size matters

EVEN by the recent standards of Wall Street bailouts, that of American International Group is colossal. At its peak the insurance firm was the world's largest with a market value of $239 billion. Its assets are bigger than those of either Lehman Brothers or Fannie Mae. Yet size alone does not explain the rescue. Nor do the images of customers queuing to cancel their policies as far away as Singapore. AIG posed a systemic risk because of its investment bank, tucked away behind the dull business of writing insurance contracts, which has lost it both a fortune—and now its independence (see chart).

At one stage, this unit contributed over a quarter of profits. It has played the role of schmuck in one of finance's most dangerous games by writing credit-default swaps (CDSs), a type of guarantee against default, with a giant notional exposure of $441 billion as of June. Of this, $58 billion is exposed to subprime securities which have already generated huge mark-to-market losses. For regulators, the real horror story may be the $307 billion of contracts written on instruments owned by banks in America and Europe and designed to guarantee the banks' asset quality, thereby helping their regulatory capital levels.

How much pain taxpayers will ultimately bear is an open question. The official line is that AIG only suffered a liquidity crisis. As subprime losses mounted, it had to put up more collateral with its counterparties, in turn prompting credit-rating downgrades, which in turn triggered more margin calls. It is probable that operating cashflow was drying up too as big risk-sensitive commercial customers stopped doing business with the insurer. On September 16th the Federal Reserve extended a two-year, $85 billion credit facility at a penal rate. The government will get a 79.9% stake in the company in return. The idea is that this buys time for AIG to improve its liquidity in an orderly way. The bail-out's structure should also avoid a technical bankruptcy, which could force the unwinding of many of those CDS contracts.

Yet might the government be taking over a company that is insolvent as well as illiquid? Extrapolating from AIG's own test, but adjusting fully for mark-to-market losses and stripping out goodwill and hybrid capital, even at the end of June AIG might have had about $24 billion less book equity than it needed to be safely capitalised. And some of its equity may be “trapped” within its insurance subsidiaries, whose capital positions are ringfenced by insurance regulators. That might leave the holding company that taxpayers have backed in a far worse state. On September 17th Eric Dinallo, New York's insurance regulator, vouched for the solvency of AIG's insurance subsidiaries but was more circumspect on the company overall.

Ultimately, though, AIG may turn out be worth something after all: in June it had $67 billion of tangible equity, a much bigger buffer relative to assets than existed at Lehman or Bear Stearns. And, says Andrew Rear of Oliver Wyman, a consultancy, AIG's insurance assets will attract a lot of interest. That raises the chances of their being sold at a premium, raising cash for the holding company. If the government holds on long enough, perhaps even AIG's CDS contracts might make money.