By John W. Schoen Senior producer
msnbc.com
updated 3/22/2009 4:28:24 PM ET 2009-03-22T20:28:24

Last week’s outrage over big bonuses paid to executives at AIG has more than a few readers wondering: Why can’t we just let these big companies go out of business?

I read everywhere that the economy and taxpayers would be worse off with these large corporations failing. What would happen if the government let (AIG) company fail, and instead of pumping money into the failing company, direct the bailout money directly to those AIG insured?
Mike G., West Chester, Pa.

Roughly half of the $180 billion the government has given AIG has already flowed, indirectly, to the “counterparties” that bought what amounts to financial insurance policies. The list includes big banks, other financial institutions and governments.

The state of California, for example, collected $1 billion it invested in what’s called a Guaranteed Investment Agreement. That’s a kind of interest-bearing savings account where states and cities stash money they’ve raised from a bond offering until they need the money. More than $12 billion in federal bailout funds paid to AIG went to more than 20 states that invested money with the company.

Some $80 billion in AIG bailout money also went straight to banks and investment firms around the world that did business with AIG. It’s possible some of those banks might be able to absorb those losses. But given the current fragile state of the global banking system, it’s entirely possible that AIG’s failure could bring down one or more big banks.

Why not let those banks fail, too? The problem is that the world’s banks are interconnected in a kind of global river of money that we all rely on to keep the economy moving. If too many banks fail, that river starts to dry up. With the economy in a steep decline, we need money flowing through the system faster — not slower.

But AIG isn't a bank. Most of it is a giant collection of heavily regulated, fairly traditional insurance companies that sold policies to millions of governments, companies and individuals. So if AIG is allowed to collapse, anyone who bought one of those insurance policies could have  harder time collecting on a claim.

AIG's regulated insurance operations were doing just fine until a tiny piece of the company called the Financial Products division started making big bets guaranteeing investments — many of them backed by subprime mortgages.

When a regulated insurance company makes a promise to pay you for a loss, it has to show regulators it can handle all potential claims.

AIG’s Financial Products division wasn’t regulated. After Congress passed a law in 2000 deregulating the kind of paper bets AIG was making, the company was free to write as much this “insurance” as it wanted without demonstrating it could cover any and all bets that went bad. By some estimates, the company made about $500 billion in paper bets with little or nothing to back them up.

What the government is hoping to do now is keep AIG afloat long enough to sell it off in pieces. But time is running out. As AIG’s financial problems continue, its customers will likely look elsewhere for insurance as their policies expire.

Some have argued that the government needs to move more quickly — and get more directly involved in managing the unwinding — before the bleeding gets worse. Though the government now owns 80 percent of AIG, the company is being run by Edward Liddy, the CEO who came out of retirement to take over after the government stepped in last year.

Congress was happy to give Mr. Liddy a lengthy public grilling last week, but it has been surprisingly slow to take real action. Taking back bonuses paid to the people who made the mess does little to fix the underlying problem. Some of the members of Congress now expressing the loudest outrage were among those who approved the rules that let AIG get into the casino business in the first place.

Then again, maybe the failure of Congress to act sooner isn’t all that surprising. AIG was one of the biggest contributors to key members of Congress in charge of making the rules. The company, like the rest of the financial services industry, got some of the best laws money can buy.

Why do banks lend money to each other?
— Ray, Bronx, N.Y.

The simple answer is that, on a given day, more of their customers want to borrow money than keep it in a savings account.

When you borrow money, banks get it from a variety of sources, but deposits make up the bulk of the funds used for lending. To make sure banks can make good on those deposits, regulators set minimum requirements for how much they have to hold in reserve. Every day, after the bank closes, it adds up all its outstanding loans and deposits on hand to make sure it has enough reserves.

If it doesn’t, it borrows from what’s called the interbank loan market: a network of banks that shuffle funds overnight. Banks with excess reserves get to lend — and collect interest — to a bank whose reserves came up short that day.

Interest on a loan that just runs overnight may not seem like much, but when you’re moving billions of dollars through the system, it adds up. And bankers don’t like to let money sitting around not earning interest. The rates on the interbank loans are less than the bank charges its customers to borrow, so it still makes a profit. (This is where the LIBOR, or London Interbank Offer Rate, comes from; it’s the rate set every day by a private group of British banks.)

Banks have other reasons to borrow from each other, especially when they’re making a large loan to a single party. Lending too much to any one customer is risky; if that customer can’t pay back the loan, you could get wiped out. So a bank may decide to “syndicate” a big loan — chopping it up, along with the risk, and spreading it among other banks.

It wasn’t much of a leap from syndicating loans to “securitizing” them. Instead of dividing up a loan among banks, you sell pieces of it to anyone who wants to invest in it. Or you can take a lot of smaller loans — like mortgages, car loans and credit card debt —bundle them into a big package, and then sell pieces of that package to investors. As each borrower pays back their loan — plus interest — payments are divided up among investors. This practice vastly increased the pool of money banks now draw from in what’s known as the “shadow” lending market.

All went well until someone decided to do this with subprime mortgages — without first bothering to check if the people getting the mortgages could pay them back. When those borrowers defaulted faster than expected, and house prices fell, investors didn't want to buy mortgage-backed securities any more. Big banks churning them out were stuck with hundreds of billions of dollars worth of these “toxic assets.”

Not all of these investments are worthless; some 90 percent of homeowners are paying their mortgages. The problem is that no one knows which securities are going to get hit with the next mortgage default.

It’s a little like someone offering you 10 glasses of water with a warning that one of them is poison — but they’re not sure which one. No matter how thirsty you are, you’re probably not going to take a drink.

Until banks can figure out a way to unload these things, they’re stuck trying to figure out just how much money they have to lend. Until that riddle is solved, it will be hard to get enough credit flowing again to get the economy moving. In the meantime, the government has become the "lender of last resort."

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