N.Y. Official: AIG Veered from 'Core'

At testimony underway right now on Capitol Hill before Rep. Henry Waxman's (D-Calif.) House Oversight committee, Eric Dinallo, the superintendent of the New York State Insurance Dept., said AIG's troubles came when the insurance giant "got well away from its core competency of insurance."

Dinallo said AIG got too far into the credit-default swap market, or CDS. The CDS is a complex financial instrument in the bond market in which a bondholder hedges his or her bet against the bond failing by asking a third-party to insure it.

That's a legitimate and easy-to-regulate process, Dinallo said. The problem is that it accounts for only 10 percent of the CDS market.

The other 90 percent, Dinallo said, is what's known as a "naked" CDS, which is similar to naked shorting of a stock. And it's entirely unregulated.

Instead of getting a third party to insure the bond, two parties enter into a contract on whether the bond will default, essentially betting it will or won't. If it defaults, one side wins. If it doesn't, the other side wins.

The dollar value of the naked CDS market, Dinallo testified, accounts for more than the entire annual economic output of all the world's nations.

The problem is that neither party has any exposure to the bond's default. This is the ongoing theme of the entire current crisis: No one was willing to bear any burden for failure. The concept of failure -- be it of a risky mortgage or a corporate bond -- was financially engineered away and sent into a black hole with no one needing to take responsibility for it.

When the failure inevitably comes, it's the U.S. taxpayer -- and now, citizens all over the globe -- who are forced to take responsibility for it.

-- Frank Ahrens

October 7, 2008; 10:44 AM ET  | Category:  business
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I'm just wondering if the Masters of the Universe aboard this "unsinkable" ship have a Plan B -- something that perhaps may work from the ocean's floor, which is where we seem to be headed?

Posted by: Toney | October 7, 2008 11:58 AM

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