This is what I read this morning on FT.com: “The US Federal Reserve announced that it will lend AIG up to $85bn in emergency funds in return for a government stake of 79.9 per cent and effective control of the company - an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system. Under the plan, the existing management of the company will be replaced and new executives will be appointed. It also gives the US government veto power over major decisions at the company.”
I almost decided to go back to bed, convinced I must be dreaming.The proximate cause of the demise of AIG as a private firm were its ‘monoline' activities, its exposure to massive amounts of credit risk derivatives like CDS, many of them linked to the US real estate sector. The largest insurance supermarket in the world, with a balance sheet in excess of $1 trillion nationalised because it was deemed too big and too globally interconnected to fail! The fear that drove this extraordinary decision is that AIG's failure would increase counterparty risk, actual and perceived, throughout the financial system of the US and the rest of the world, to such an extent that no financial institution would have been willing to extend credit to any other financial institution.Credit to households and non-financial enterprises would have been the next domino to fall, and voilà! , financial Armageddon.
I cannot judge the likelihood of the disaster scenario, but if there ever was a case for applying the precautionary principle in economic analysis, then this is it. It was also done in the right way, by insisting on controlling public ownership, i.e. nationalisation, of the company.The existing management is gone - again as it should. We will find out whether they left with golden parachutes or with just a carton box packed with their personal belongings.