Thursday, September 18, 2008

AIG and CDS

For those of you trying to sort out what's behind the AIG implosion, the answer is a derivative contract called a collateralized Debt Swap (CDS). These contracts are used to transfer the risk of default on debt (bonds and other debt-based securities) to other parties. There's a good graphic explaining how they work here, courtesy of The New York Times.

The problem for AIG is their exposure to these instruments. As an insurer, they were involved in a lot of these contracts to help other firms hedge against loss. But the value of the underlying contracts (mortgages in many cases) was uncertain. This is leaving AIG exposed to a lot of claims as contracts go into default. When that happens, AIG makes a payment. Consequently, with the number of default payments they've had to make, AIG is short capital.

There's more to come on this, but in the interim, I will point you to two other resources that may help you as the smoke clears. The first is a YouTube video that features an interview with Princeton economics professor and former Federal Reserve vice-chairman, Alan Blinder. (HT to Greg Mankiw.)

The other is the blog by Professor William Polley at Western Illinois University. I met Dr. Polley when I was in Chicago and he writes one of the best Fed watching blogs for educators. I always appreciate his insights.

I look forward to your insights, as well.

4 comments:

Stiles said...

It seems AIG is so important to our Economy, that the Government is doing everything in can to help it.

Alex Strickland said...

I feel like this can only lead to a worse situation. With the government having an 80% stake in one of the world's largest privately owned insurance agencies, one can only think that this newfound government control will only produce more and more corruption. I wonder how this will affect other private firms.

Alex Strickland said...

This may be a little random but i wanted to post a link to my favorite stock site. Even though economics is not all about the stock market, i think its still interesting because it gives a lot of insight into the US economy and also has an international flare as well. Its actually another blog-like website,

http://www.bloggingstocks.com/

Julia said...

Tim, thank you for the link to the NYTimes explanation. As you might imagine the questions were coming as fast and furious as "sell" orders. The financial system crisis has rewritten the order of my curriculum---particularly when the fed funds and LIBOR rates spiked. I've spent alot of time explaining to colleagues here WHY the Fed made a bridge loan to AIG. As you might guess, knowledge of the Fed is lacking and I've spent time explaning their purpose and functions this week. Keep us up to date on the good and clear explanations as you read.