Friday, March 20, 2009

Will AIG Debacle Result in Criminal Prosecutions?

Tell me the difference between the Madoff scheme and AIG. I don't think there is one.

According to the allegations, Madoff took money from investors in exchange for an obligation to invest that money and pay them a return. He met that obligation, part of the time, by using money from new investors to pay his obligations to older clients. This process, apparently, was repeated many times over until the plunging stock market of 2008-2009 drove up demands for liquidity beyond what he could meet and brought the scheme to an end.

AIG, according to reports, sold credit default swaps guaranteeing the liquidity of mortgages that had been bundled and sold as securities to investment funds, banks, and other financial institutions. Apparently this worked in much the same way as insuring a municipal bond offering increases the marketability of an issue. If news reports are true, AIG sold far more in credit default obligations than the company held in assets available to cover the total risk. This practice created income for AIG but amounted to a gamble, betting the company against the income "float" that the risk would never imperil the life of the corporation. This position posed no problem until the collapsing real estate market caught up with the scheme. As mortgage default rates rose, AIG's obligations on the default guarantees rose as well, pushing the company to the brink of disaster.

Just as Madoff's alleged practices threatened his investors equity, so also AIG's practices impinged upon the financial condition of both their investors and those who purchased the mortgage-backed securities for which AIG guaranteed against default losses. Madoff's scheme fell apart when falling asset values brought greater demand for liquidation from clients. AIG's scheme fell apart when rising defaults drove up claims for redemption on the default guarantees. Both were extended on obligations far beyond their ability to pay. Both were meeting former obligations with later arriving capital - Madoff before the situation was discovered, AIG after.

Madoff is going to jail for what he did. If his conduct deserves punishment, why isn't he sharing a cell with someone from AIG?

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