Bernanke's AIG

19 September 2008

The US Fed under Ben Bernanke has taken the unprecedented and controversial step of taking control of giant insurer AIG. What brought AIG to its knees and was Bernanke's move warranted? By Vivek Sharma

Early this week, the US Federal Reserve did something completely unprecedented and, until recently, almost unimaginable in free market economies. Chairman Ben Bernanke made an offer to the board of diectors of insurance company AIG, to acquire majority control in the insurer and extend a desperately needed credit line to help the company tide over a severe liquidity crisis.

The offer, which an AIG director reportedly described as onerous, was tilted completely in favour of the Fed and demanded the ouster of the current CEO. After deliberations, the AIG board accepted the offer. It didn't have much choice, the other option was to declare bankruptcy the next day.

Never before has a Fed chairman acted like the CEO of a vulture fund, swooping in to pick up companies in distress at garage sale valuations. That too an insurance company which is out of the Fed's purview and not a bank over which it has regulatory authority. The central bank having majority ownership of a commercial entity may not be very surprising in many countries, including India where the RBI owned our biggest bank SBI until recently. But in the US, such 'socialist' practices were unthinkable and nearly blasphemous.

But, these are extraordinary times and required extraordinary measures. Just like the AIG board, the Fed also didn't have much of a choice. The Fed determined that, "a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance". The choice was either bail out AIG or risk a complete financial meltdown.

What brought AIG down?

Now, AIG is not just another insurer. Since it was founded nearly a century ago, not in New York but in distant Shanghai, AIG has grown to become the second largest insurer in America and the world's biggest. With operations in over 130 countries and a customer base of 74 million worldwide, the company has a balance sheet size in excess of $1 trillion.