The epicenter of the near-collapse of AIG was an office in London. A division of the company, entitled AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of American capitalism. For years, the AIGFP division sold insurance against investments gone awry, such as protection against interest rate changes or other unforeseen economic problems. But in the late 1990s, the AIGFP discovered a new way to make money.
A new financial tool known as a collateralized debt obligation (CDO) became prevalent among large investment banks and other large institutions. CDOs lump various types of debt - from the very safe to the very risky - into one bundle. The various types of debt are known as tranches. Many large investors holding mortgage-backed securities created CDOs, which included tranches filled with subprime loans. (For more on this concept, check out our Subprime Mortgage Meltdown special feature.)
The AIGFP was presented with an option. Why not insure CDOs against default through a financial product known as a credit default swap? The chances of having to pay out on this insurance were highly unlikely, and for a while, the CDO insurance plan was highly successful. In about five years, the...
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... And The Federal Reserve_.)
AIG's bailout has not come without controversy. Some have criticized whether or not it is appropriate for the government to use taxpayer money to purchase a struggling insurance company. In addition, the use of the public funds to pay out bonuses to AIG's officials has only caused its own uproar. However, others have said that, if successful, the bailout will actually benefit taxpayers due to returns on the government's shares of the company's equity.
No matter the issue, one thing is clear. AIG's involvement in the financial crisis was important to the world's economy. Whether the government's actions will completely heal the wounds or will merely act as a bandage remedy remains to be seen.
To learn more about bailouts such as this one, be sure to read our related article, Top 6 U.S. Government Financial Bailouts.
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