AIG Autopsy: It's Not About Insurance

(MoneyWatch)  New York Insurance Superintendent Eric Dinallo is one of the few regulators who understands the chaos that has befallen American International Group (AIG). So his testimony before the U.S. Senate Banking Committee today (March 5) should give comfort to investors in other insurance companies, but might worry those who feel we've already sunk enough tax dollars into this failing giant.

Dinallo told the senators that AIG's far-reaching insurance operations, which include auto insurance that competes with GEICO, home and life coverage units in Japan and China, and even insurance for other insurers who were doing just fine, thank you.
According to Dinallo, the problem is the small Financial Products unit within AIG, the world's largest insurer. This unit wrote credit default swaps worth $2.7 trillion, "equal to the gross national product of France." These swaps, which were totally unregulated due to federal legislation, "made huge numbers of irresponsible bets, and took huge losses."

The other piece of the equation is AIG's securities lending program. Virtually every insurer has large amounts of securities, and lends them out to other institutions in return for cash. Once again AIG acted "aggressively rather than prudently."

When the credit defaults market collapsed and the other institutions wanted to return these securities to AIG, it didn't have the money to pay them back. And to top it off, AIG's investments, like mortgage securities, had lost their value.

The very public problems with AIG Financial Products caused what was essentially "a run on the bank" at its securities lending unit. From mid to late September, borrowers demanded about $24 billion, but AIG couldn't pay. That's when the Federal Reserve stepped in, Dinallo said.

And Dinallo should know. He helped engineer the AIG federal bailout that has now reached $180 billion. He also gave no indication that, if needed, he and the Feds wouldn't pump more money into AIG. "Our primary principle ... has been to protect insurance company policyholders and to stabilize the marketplace," he told the Committee.

What's the positive takeaway? Dinallo said that he and his staff have scrutinized the securities lending program at all other New York life insurance companies, such as MetLife, and are sure they can handle any redemptions, even in times like these.