AIG Is Paying Out Its Bailout Money to Investment Banks?!?!??1!?!! Uh...That Was the Point.

In all the populist fervor surrounding the AIG debacle, one argument is being shuffled around the media. AIG, it seems, paid out their share of the bailout money to (*sarcastic gasp*) Goldman Sachs and JP Morgan and other investment banks! Frank Rich at the New York Times and Eliot Spitzer (reminder again: how did he leave office? Oh, yeah--in disgrace after cheating on his wife with hookers.) at Slate have both pushed this line of reasoning.

Uh, guys? Am I missing something? AIG paying out to these banks is the whole point of the bailout.

AIG, you see, is an insurance company. That means they sell insurance policies, and many of those policies were bought by major financial firms.

Finance, you see, is the business of risk management. We can see from the current debacle that financiers didn't manage their risk particularly well. Their firms are now hemorrhaging money. One reason for that is because even their safety nets have collapsed. AIG was one of the main safety nets.

When firms were chopping up subprime mortgages into little bits and selling them as securities, they were at least smart enough to try to insulate themselves from loss by buying insurance policies from providers like AIG. The problem with AIG is that it sold too many of these policies. Now, when everything is going to hell in a handbasket, the firms with the policies are calling them in. AIG ran out of money to pay. That is whey it needed a bailout.

(NB: I'm not discussing whether the bailout was a good or a bad idea, but only that the money was supposed to go to other firms.)

Imagine if suddenly, everyone with a car insurance policy got into a major wreck at the same time. State Farm, Geico, and all the other insurers would struggle to pay everyone back because there would be more demand for payment than actual cash available. Insurers like them bank on (and use actuaries for) figuring how much they should expect to be paying in any given time period. They use that to figure how much cash to have on-hand. AIG did the same thing but on a much, much larger scale. It just didn't expect the maelstrom.

So, what happens with the money from the bailout? When it is not being spent on executive bonuses, it is being paid out to the holders of policies. The government decided AIG couldn't fail--and this is something people don't tend to understand in this whole financial mess--because if it failed, the financial firms would have no safety net, and they would lose even more than they had already. Imagine you wrecked your car, but the insurance you had bought no longer applied because the insurer couldn't pay you. Suddenly, instead of being responsible for a few hundred dollars in repairs, you are liable for thousands. The government didn't want the same thing to happen in the financial world; banks couldn't pay the 'hundreds' (of billions), let alone the 'thousands', and bailing out the insurer costs way less than bailing out the policy holder.

Though, then again, we bailed the banks out, too.