"Lawmakers continued to fume over the $165 million in retention bonuses to employees at AIG's financial products division, the unit that created the credit-default swaps and other financial derivatives that brought AIG to the brink of bankruptcy in September."
I think I understand a credit default swap. Maybe. Here goes:
Say you loan a friend $10,000 for one year at 10% interest. If all goes well, you will make $1,000 profit. But what if you are a little nervous that your buddy won't pay you back? What if you could find someone to insure the loan for, say, 2% of the return. So you find a guy who promises to pay you the $11,000 if your buddy fails to and for that guarantee you'll pay that guy $200. That agreement is a credit default swap. If your buddy doesn't default, you've made a net of $800 and the third person has made $200 for nothing but issuing the promise.
Let's use the same example with a home. You loan someone $200,000 at 5% interest and take a lien on the house. You, once again, are worried about the debtor making the payments and you really don't want to be in the business of foreclosing on the home and reselling it. You again create a credit default swap with a third person who promises to pay off the mortgage (and get the house) if the debtor defaults and his fee is, say, 1% a year for that guarantee.
The guys issuing the credit default swaps are making a fortune so long as everyone keeps paying their mortgage.
Now take the above example and multiply it hundreds of thousands of times with billions of dollars.
Here's the really crazy part: It seems like you could also buy a credit default swap even if you had nothing to do with the borrowing or the lending. And credit default swaps weren't limited to mortgages. One of the examples used in This America Life was that one involving GM issuing a $50,000 bond to Person X. If you thought that GM was going under and wouldn't be able to make the bond payment to Person X, you (even though you had nothing to do with GM or the bond or Person X) could buy a credit default swap on that bond. For some fee, a company would promise to pay you $50,000 if GM was unable to meet it's $50,000 obligation to Person X. The greater the risk that GM would go under, the greater the fee.
Insane? You bet. And once all the mortgage holders and all the companies couldn't pay back their loans, all the credit default swaps kicked in and the chaos began.
AIG apparently issued a ton of credit default swaps on the bet that they would never have to make them good. Most of the government bailout money has been used by AIG to pay off it's obligations under the credit default swaps. The government feared that if it didn't provide the money, it would have a domino effect (since most of the companies owed money from AIG under the credit default swaps had issued their own credit default swaps.)
And, it's my understanding the credit default swaps were completely unregulated. There was no limit on who could issue them. And there was no requirement that any company disclose how many credit default swaps it held. So when you went to AIG to purchase a credit default swap, you had no idea how many it already held.
The above is probably completely over-simplified and possibly completely inacurate, but it makes sense to me. But I'm open (as always) to listen to those that are smarter than me.
Edit: Time magazine reported in its March 30, 2009 issue that AIG is still on the hook for $300 billion in credit default swaps. "Yet the company has a book value of $50 billion." (p. 27)