Tuesday, March 17, 2009

Meltdown for Beginners

It has been months since my last blog, and the bad news on the economy has been coming fast and furiously. With the latest bailout of AIG insurance, now totaling $170 Billion, I was lucky to find a great blog site that explains how the problem was created in simple examples designed for beginners to understand at Financial Crisis for Beginners and a broadcast from NPR that you can listen to at http://www.thisamericanlife.org/Radio_Episode.aspx?sched=1242.

With the global economic growth around the turn of the century, new wealth was created. This new wealth, about $35 Trillion, started chasing investments that could not keep up with the demand. The mortgage backed securities expanded at a rate that was ridiculous in an attempt to keep up with the demand. Loan standards were tossed out the window so that more mortgages could be issued and mortgage backed securities could be created. They were then sold to countries around the globe and insured by various investment banks and AIG.

To protect against default, banks and AIG sold Credit Default Swaps (CDS). Unfortunately, there were no reserves set aside in the event of default. While a 12% default rate was used for the calculations of risk, we are entering a 40% default rate. AIG alone insured about $500 Billion of these. There is no way they could stay in business and cover these global losses. 460 employees of AIG were responsible for the creation and sale of the CDS, but 30,000 employees of the company are painted with the dirty brush.

Again, for a more detailed explanation of the financial meltdown, please visit the NPR link and the blog site mentioned above.

Rennie Gabriel

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