A Simplified Explanation of the AIG Bailout

I was asked by Mr. Dawn Treader why the failure of AIG would have lead to a market meltdown. He seemed to find the following explanation helpful.

Suppose you start a bank by selling $10 worth of stock and taking $100 of deposits. It invests $100 in a bond issued by XYZ corporation. Your bank's balance sheet would look like this:

ASSETS		LIABILITIES
Cash	$ 10	Liability to depositors	$ 100
XYZ Corp. bond	$ 100	EQUITY
		Shareholder Equity	$ 10

The capital ratio for the bank is 9.1% (Shareholder’s equity divided by total assets). All banks are required to maintain a certain capital ratio.



Now suppose that the bond declines in value to $95 due to financial difficulties at XYZ Corp. Now the balance sheet looks like this.

ASSETS		LIABILITIES
Cash	$ 10	Liability to depositors	$ 100
XYZ Corp. bond	$ 95	EQUITY
		Shareholder Equity	$ 5

Now the capital ratio is 4.8%. If the relevant capital requirement for your bank is 5%, you must either sell some assets or raise more equity by selling more stock.

Financial institutions all over the world hold bonds that are insured by AIG. If AIG fails, the bonds are no longer be insured and the banks must mark down the value of the bonds on their balance sheets. When this happens, the banks no longer have satisfactory capital ratios and they must either sell assets or raise more capital by selling stock. Eighteen months ago, this would not have been a problem, but the market for bonds and for new stock has dried up completely.

I suspect that everyone remembers the run on the bank in It’s a Wonderful Life. Uncle Billy told George that he had turned over all their cash to the bank because the bank had called their loan. Companies all over the world depend on short term financing from banks to meet fluctuating cash needs. Even more importantly, banks depend on such financing from other banks.

If AIG had failed, there would have been a mad scramble for cash by banks all over the world. Being unable to sell the bonds they own, they would reduce the amount of loans they have outstanding. Businesses would see credit lines pulled and individuals would see the rates on their credit cards jump.