Why AIG Must Be Bailed Out

Suppose somebody wants to make a bet with me that the San Francisco 49ers will win the next two Super Bowls.  He gives me $100 today, and I have to give him $100 million in case he’s right. The chances of this happening are very small, but just in case the impossible happens I want some backup. I buy insurance from my next-door neighbor.  I offer to give him a nickel every week in return for his promise to cover my bet.

My neighbor sees that he has a good thing going — getting money for nothing.  After a while he takes on more and more bets until others follow in his footsteps.  Soon, a market develops.  In effect, people can bet on bets. Eventually, the total potential amount of money builds up into the billions and trillions of dollars.

Unexpectedly, the San Francisco 49ers win two Super Bowls in a row.  My neighbor does not have $100 million on hand to cover my loss.  The nickels I have been giving him have been wasted. I don’t have $100 million either.

Suddenly everybody in the market is worried about people’s ability to back up their bets. The Federal Reserve steps in and takes over the market.  The free world is saved.

7 comments so far

  1. Kevin on

    So who backs up the fed? Oh $85B is pocket change…free world will love it.

  2. mperelman on

    The faith & credit of the US government backs up the Fed. See you next week? If not, enjoy Brazil & Australia.

  3. Kevin on

    So what happens when the faith and credit of the US gov. starts deteriorating? i.e. no one wants to buy our debt anymore? I will be in town this Friday and some of Sat. Would love to catch up before I depart.

  4. Mark Hansen on

    the “full faith and credit of the united states of america” means that those who pay taxes in the u.s. are on the hook for the bill.
    this of course includes those who will be paying taxes in the u.s. for the next many generations.

  5. mperelman on

    If it came to a full out crisis, the US could stiff the foreign holders of $2 trillion worth of US debt, which could have big consequences.

  6. Burton Leed on

    Both the bet and it’s insurer are examples of the greater fool theory. Who insures the bet of a fool? An even greater fool.

    You can fix AIG with a trustee in a bankruptcy court cheaper than $85 Billion. But if we need to stop doing this nonsense just stop the FASB rules regarding marking securities to market, at least for a while. FDR did this in 1933. No write downs of the worthless bonds and mortgages and it worked for almost 70 years.

  7. mperelman on

    Burton, the system became increasingly deregulated & more complex. Putting toothpaste back in the tube will be difficult, especially because regulation will face powerful resistance.

    Instead, the increasingly concentrated financial system will be more difficult to regulate.

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