THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 324

292 PA R T I I I FYI Financial Institutions The AIG Blowup American International Group, better known as AIG, was a trillion-dollar insurance giant and before 2008 was one of the twenty largest companies in the world A small separate unit, AIG s Financial Products division, went into the credit default swap business in a big way, insuring over US$400 billion of securities, of which US$57 billion were debt securities backed by subprime mortgages Lehman Brothers troubles and eventual bankruptcy on September 15, 2008, revealed that subprime securities were worth much less than they were being valued at and investors came to the realization that AIG s losses, which had already been substantial in the first half of the year, could bankrupt the company Lenders to AIG then pulled back with a vengeance, and AIG could not raise enough capital to stay afloat On September 16, the Federal Reserve and the U.S Treasury decided to rescue AIG because its failure was deemed potentially catastrophic for the financial system Banks and mutual funds were large holders of AIG s debt, plus the bankruptcy of AIG would have rendered all the credit default swaps it had sold worthless, thereby imposing huge losses on financial institutions that had bought them The Federal Reserve set up an US$85 billion credit facility (with the total loan from the Fed and the government increased to US$173 billion) to provide liquidity to AIG The rescue did not come cheap, however: AIG was charged a very high interest rate on the loans from the Fed and the government was given the rights to an 80% stake in the company if it survived Maurice Greenberg, the former CEO of the company, described the government s actions as a nationalization of AIG Insurance companies have never been viewed as posing a risk to the financial system as a whole Because the problems at AIG nearly brought down the U.S financial system, this view is no longer tenable The insurance industry will never be the same alone, are therefore the only insurance companies that are allowed to provide insurance that guarantees the timely repayment of bond principal and interest when a debt issuer defaults These insurance companies have become particularly important in the municipal bond market, where they insure a large percentage of these securities When a municipal security with a lower credit rating, say an A rating, has an insurance policy from a monoline insurer, it takes on the credit rating of the monoline insurer, say AAA This lowers the interest cost for the municipality and so makes it worthwhile for the municipality to pay premiums for this insurance policy Of course, to this, the monoline insurers need to have a very high credit rating The New Legislative Framework As noted in Chapter 11, in 2001 the government passed legislation reforming the regulatory framework governing Canada s financial services sector The new legislation allows demutualized life and health insurance companies to restructure under a holding company structure, to enter into joint ventures and strategic alliances, and to access the Canadian payments and clearance systems, in an attempt to bring the sector in line with the banking sector However, the new legislation does not allow mergers involving large banks and large demutualized life and health insurance companies Moreover, the new legislation requires that large life and health insurance companies (those with equity over $5 billion) be widely