It is now a well known fact that Paulson-Bernanke team put together a faulty rescue plan in the first go. But did it only start with the TARP or did they fail to act when the time was ripe? By the time AIG was ailing, it was more than just clear that money was drying up in the stock markets and almost all the prime indices were showing a downward trend. Did the Fed-Treasury duo act too late? If not, why could they NOT bring their act together?

Just to provide a background here, consider a typical scenario of a person hoping to buy a home. This person/debt/loan could be classified either sub-prime or prime depending on his ability to pay back the loan he chooses to avail for the purchase of his house. Since banks always need money to be in circulation, they usually sell these instruments to an investment bank like Lehman Brothers which in turn simply breaks them up into smaller units and repackage them to be again bought by foreign entities or a different investor. The flow of money is complete when the person repays the loan and the bank retains its cut on the loan and passes the rest upwards, in this case to Lehman Brothers and they in turn take their cut and deliver the remains to the final buyer. The cut is usually always taken from the interest or other fees and so the final buyer would always benefit from the surplus.

Now, where exactly does AIG come in picture? In good faith, AIG agrees to insure these financial instruments in the hope that borrowers will be able to repay back their debts, which means that the riskier the mortgage, the higher will be the price required to insure it. Banks in turn pay a premium for these insurance policies. AIG stands to gain if the borrower repays back the debt on time. But if they don’t, AIG has to pay up and of late it has been paying out too much. This practice is called Credit Default Swaps or CDS. Before its fall, AIG had deep roots with Lehman Brothers, so much so that even the rent of Lehman Brothers’ London office was insured by the American International Group.

Since the general sentiment way back then was that the real estate market was on the rise, banks were rather reckless on their terms of lending. This ensured that the banks provided a large number of sub-prime loans. Trouble began brewing when home buyers began buying homes that they could not afford or availed of loans they could not repay. This led to distress sale of real estate across the troubled regions leading to a total collapse of prices. Even after foreclosures, banks could not recover a significant amount of the loan to be able to pay off their liabilities.

The chain was now breaking. This led to defaults on part of the banks which led AIG to shell out the insurance amount to the concerned parties. This went on till the investment banks began failing because of the dried up capital and also rendered them unable to pay any more to the foreign entities and investors who had bought these instruments in the first place. All this and little more led Lehman Brothers to file Chapter 11. This created what is now referred to as ‘toxic assets’ which nobody wants to buy but everybody wants to rid their balance sheets of. Toxic assets are primarily bad loans and mortgages which have not been honored for ideally more than 90 days.

To be continued…