Did we need to bail out AIG?
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WE'LL never know what would have happened if we did not bail out AIG. The prospect of letting such a large and interconnected institution fail was not a gamble the government was willing to take (especially while caught in the riptide of Lehman). The justification has been that if AIG defaulted on its CDS contracts it would cause a ripple effect, bringing everyone who bought them into serious peril. That is why the AIG bail-out is considered by some a back-door bail-out of other financial firms (including twelve foreign banks).
The biggest recipient, Goldman Sachs, has maintained it had no exposure to AIG. Between the collateral AIG posted and other assets on their books, Goldman claims to have fully hedged any counterparty risk. But assuming Goldman actually had the foresight to insure against what seemed an improbable AIG default, surely some of the holders of CDS contracts that Goldman bought (to insure the counterparty risk) did not.
Goldman's Lucas van Praag, in a letter to the Wall Street Journal. says this wouldn't have affected his firm's
In order to collect under a credit default swap, there has to be an event of default. No event of default means no payout. By supporting AIG, the government prevented the company from defaulting. Some have questioned whether, if AIG had defaulted, we would have received the money owed to us under the credit default swap arrangements. Because these swaps were written by large financial institutions which mark to market their obligations to each other and net their positions at the close of business every day, we exchanged collateral with the CDS providers on a daily basis. This protected us from the risk of any knock-on defaults.
If that's true does it mean the AIG bail-out was unnecessary? I doubt it. First, dealing with the other products AIG offered—life insurance, annuities, etc—would have been messy. Also the panic of letting AIG fail right after Lehman could have made things even worse.
Just because Goldman allegedly managed to hedge itself does not mean the others did. The AIG bail-out has been unpleasant, expensive, and politically costly. But we’ll never know if the alternative would have been worse.
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