Why the U.S. Government Bailed Out AIG: A Detailed Analysis

Why Could AIG Have Been Considered a Falling Giant?

In 2008, American International Group (AIG) became a central figure in the global financial crisis. Once one of the world’s largest insurance companies, it engaged in extremely risky financial activities, including selling credit default swaps and investing heavily in complex securities called collateralized debt obligations (CDOs). When these bets went sour, AIG faced collapse, prompting the U.S. government to step in with a massive bailout because the company was considered "too big to fail." AIG eventually repaid taxpayers, but the bailout sparked widespread controversy and debate over government intervention and corporate risk-taking.

AIG’s Downfall Exploration

AIG's Rise Before the Fall

For decades, AIG was a global powerhouse in the business of selling insurance. But in September 2008, the company was on the brink of collapse.

The epicenter of the crisis was at an office in London, where a division of the company called AIG Financial Products (AIGFP) nearly caused the downfall of a pillar of American capitalism.

The AIGFP division sold insurance against investment losses. A typical policy might insure an investor against interest rate changes or some other event that would have an adverse impact on the investment.

But in the late 1990s, the AIGFP discovered a new way to make money.

Impact of the Housing Bubble on AIG

A financial product known as a collateralized debt obligation (CDO) became the darling of investment banks and other large institutions in the early 2000s. CDOs lump various types of debt from the very safe to the very risky into one bundle for sale to investors. The various types of debt are known as tranches.

Many large institutions holding mortgage-backed securities (MBS) created CDOs. These included tranches filled with subprime loans. That is, they were mortgages issued during the housing bubble to people who were ill-qualified to repay them. 

The AIGFP decided to cash in on the trend. It would insure CDOs against default through a financial product known as a credit default swap. The chances of having to pay out on this insurance seemed highly unlikely.

A big chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that defaults on these loans would be insignificant.

The Escalating Crisis at AIG

Foreclosures on home loans rose to high levels in 2007, and AIG had to pay out on what it had promised to cover. The AIGFP division ended up incurring about $25 billion in losses. Accounting issues within the division worsened the losses. This, in turn, lowered AIG's credit rating, forcing the firm to post collateral for its bondholders. That made the company's financial situation even more dire.

It was clear that AIG was in danger of insolvency. To prevent that, the federal government stepped in. But why was AIG saved by the government while other companies affected by the credit crunch weren't?

AIG: Too Big to Fail?

Simply put, AIG was considered too big to fail. A huge number of mutual funds, pension funds, and hedge funds invested in AIG or were insured by it, or both.

Investment banks with AIG-insured CDOs risked losing billions. For example, media reports indicated that Goldman Sachs Group, Inc. (NYSE: GS) had $20 billion tied into various aspects of AIG's business, although the firm denied that figure.

Money market funds, generally seen as safe investments for the individual investor, were also at risk since many had invested in AIG bonds. If AIG went down, it would send shockwaves through the already shaky money markets as millions lost money in investments that were supposed to be safe.

Who Was Safeguarded During AIG's Crisis?

However, customers of AIG's traditional business weren't at much risk. While the financial products section of the company was close to collapse, the much smaller retail insurance arm was still very much in business. In any case, each state has a regulatory agency that oversees insurance operations, and state governments have a guarantee clause that reimburses policyholders in cases of insolvency.

While policyholders were safe, other investors faced risks. And those investors, who ranged from individuals who had tucked their money away in a safe money market fund to giant hedge funds and pension funds with billions at stake, desperately needed someone to intervene.

Government Intervention in AIG's Crisis

While AIG hung on by a thread, negotiations took place among company executives and federal officials. Once it was determined that the company was too vital to the global economy to be allowed to collapse, a deal was struck to save the company in September 2008.

The Federal Reserve issued the initial loan to AIG in exchange for 79.9% of the company's equity. The original amount was listed at $85 billion and was to be repaid with interest.

Later, the deal's terms were altered, increasing the debt. The Federal Reserve and the Treasury Department poured even more money into AIG, bringing the total up to $142 billion.

The Aftermath of AIG's Bailout

AIG's bailout did not come without controversy.

Some questioned using taxpayer money to save a struggling insurance company. The use of public funds to pay out bonuses to AIG's officials in particular caused outrage.

However, others noted that the bailout actually benefited taxpayers in the end due to the interest paid on the loans. In fact, the government made a reported $22.7 billion in interest on the deal.

The Bottom Line

AIG played a central role in the 2008 financial crisis due to its risky investments in CDOs and credit default swaps. The company received a $150 billion government bailout that helped stabilize both AIG and the broader financial system. By 2013, AIG repaid its debt to taxpayers, marking a major recovery milestone despite the controversy over using public funds. The division largely responsible for its near-collapse, AIG Financial Products, filed for bankruptcy in 2022 after ceasing operations. AIG remains financially stable, having restored its strength and maintained solid credit ratings.