Global Markets Fear Disaster If AIG Is Allowed to Fail

A revised bailout of American International Group Inc. may be just another “band-aid” solution, but more than five months after it was first rescued by the government the option of letting the insurer fail would still be considered too big a shock to already fragile global markets.

AIG’s board Sunday approved a broad revision of the U.S. government’s $150 billion rescue. It was the third time the government has reached out to the struggling insurer and the latest rescue is expected to put greater funds at AIG’s disposal to keep it afloat as it readies to report a roughly $60 billion loss early on Monday.

While putting more taxpayer money at risk is unlikely to be palatable in the current economic environment, analysts said the U.S. government had little choice. Without government intervention, AIG’s expected losses would prompt credit ratings downgrades — triggering even more debilitating losses for the insurer, and its trading partners.

“The government really does not have the option of letting AIG totally blow up,” said Robert Haines, senior insurance analyst at CreditSights.

AIG’s foray into the roughly $28.5 trillion credit default swap market left it heavily exposed to losses on toxic mortgage assets that it had guaranteed against default.

AIG, through a financial products unit, sold more than $450 billion of protection on securities to U.S. and European banks. With government support, some of those derivatives have been unwound, but the company still has about $300 billion of this exposure, according to Credit Sights.

Haines said that European banks in particular, counterparties on many of AIG’s outstanding derivative contracts, “would be hammered if the U.S. walked away.”

Donn Vickrey, an analyst with Gradient Analytics, who has closely followed the financial deterioration at AIG said while “European banks are about two-third of the problem … it would be a domino effect across the globe.

“The ensuing panic would be disastrous,” he said.

AIG was saved from bankruptcy last September, just days after the collapse of investment bank Lehman Brothers, with $85 billion in taxpayer funds that later swelled to $150 billion. The company has tried to plug its deepening financial problems by raising funds through asset sales but has found few buyers in the current environment.

Lehman’s collapse caused significant losses for banks worldwide. Many more could suffer if AIG failed, as it would leave trading partners — banks around the world — to absorb giant losses, something their already weakened balance sheets can ill afford.

“It would surely have had a bigger impact if AIG had failed at the same time as Lehman” last September, said Suki Mann, credit strategist at Societe Generale in London.

But even now, in AIG’s weakened state, “they simply can’t be allowed to fail. There would be more unwinds on trades and obviously markets are very fragile,” Mann added.

Moody’s Investors Service and Standard & Poor’s both have AIG on review for downgrade from the seventh highest investment grade, and have said that only government support was keeping ratings from being cut to “junk” status.

“If AIG is allowed to fail — many banks holding CDS paper from AIG could also fail,” said Mark Keenan, insurance partner at law firm Anderson Kill & Olick. “In other words, I don’t think the U.S. government can afford to allow AIG to fail — no matter how many bandaids may be needed,” he added.

Over time, however, some analysts say the U.S. government may find that an orderly failure of AIG is the only way to stop the financial bleeding.

“The whole thing is ridiculous. How much longer are we going to do this? This is another bandaid, and we’ll be having this discussion again,” said Christopher Whalen, co-founder of Institutional Risk Analytics, a provider of analysis and ratings for banks.

“The government can not fund AIG’s operating losses, the numbers are too big,” he added. “We should have simply restructured AIG. Between their real estate exposure and structured exposure on CDS, I don’t think this company is viable.”

(Reporting by Lilla Zuill and Kristina Cooke, additional reporting by Walden Siew; Editing by Bernard Orr)