STEVE INSKEEP, Host:
Now that the U.S. government will effectively control AIG, it's in the insurance business. To understand how that happened and what it means, we're joined by NPR's Adam Davidson who has been covering this story. If we say, "we're in the insurance business," we collectively, what are we in the business of doing now, Adam?
ADAM DAVIDSON: Well, AIG is in the business of almost every aspect of insurance. They are particularly huge in, sort of, big industrial commercial insurance. I believe they are the largest commercial and industrial insurer in America. But they don't leave it at that. I mean, they've got car insurance lines, life insurance lines, all sorts of lines, and all over the world. They're huge in the U.S., but they were actually founded in Shanghai. Their U.S. business has become their biggest business. And their headquarters, at least until yesterday, was in New York City. They are just one of these massive conglomerates. But at the core, it's insurance.
INSKEEP: So how did such a big and storied company go so wrong?
DAVIDSON: Well, most of the stuff they know how to do, the insurance stuff, they're doing quite well at, even now. But a few years ago, they got into this weird little corner of the finance world. And, boy, did they make a hash of it. It's called the credit default swap business. Basically that's a form of bond insurance. Doesn't that sound dull? Doesn't that sound like something that wouldn't bring down a company, let alone the economy? Bond insurance.
INSKEEP: That means somebody defaults on a bond, and these guys are selling insurance against that possibility of default?
DAVIDSON: Exactly. You're a bank, and you own a whole bunch of bonds. You're worried that the Port Authority of New York or General Electric or whatever might go belly up. There's a small chance. And you'd lose the income you get from your bonds. So AIG covers it. Well, they thought that was regular insurance just like any other insurance line.
So if you're insuring houses or cars, say, you insure a lot of houses, and you figure that if any one house burns down, you've got enough other houses paying premiums, and that will cover the claims you have to pay out. And any one house burning down doesn't increase the likelihood that lots of other houses will burn down. That doesn't apply to bond insurance. And as far as we can tell, AIG didn't quite think this one through. Once one bond starts defaulting, it dramatically increases the likelihood of other bonds defaulting.
INSKEEP: All because people lose confidence in the whole market.
DAVIDSON: Exactly. People lose confidence in the market. Interest rates go crazy. It's harder for bond issuers for the Port Authority of New York or General Electric to get new capital to cover their bonds. It creates a cascading effect.
INSKEEP: But why did they go into this business if they didn't really understand what it was?
DAVIDSON: Money, lots and lots and lots of money. This credit default swap business went from nothing. It didn't exist 11 or 12 years ago, basically. And now it's a $70 trillion business. And AIG had in their head - we now know it was a bit foolish - that, hey, we know insurance better than anyone. We're going to get into that business.
INSKEEP: Adam Davidson, you just said a $70 trillion business. Does the unbelievable scale of that business explain why AIG's failure would be such a disaster?
DAVIDSON: It's the unbelievable size of the business, and more. Unlike other financial instruments, these CDS's, these credit default swaps, are very much not transparent. Nobody knows exactly who has them and where they got them from. So the fear is that AIG has basically insured banks all over the world - hundreds of banks, trillions of dollars worth of insurance coverage - and that if AIG went under, it would cause so much uncertainty that banks would simply stop lending money to each other.
And we think of banks lending money to the rest of us. But banks lending money to each other on a daily, hourly constant basis, that is what creates the movement of the global economy. If that stops, global economic activity stops. And we don't know that that would have happened, but it seemed like a real possibility. And that was why the government decided to step in.
INSKEEP: Explaining the unexplainable, NPR's Adam Davidson. Thanks very much.
DAVIDSON: Thank you, Steve.
INSKEEP: And he's part of a team that keeps trying to explain this mess at NPR's "Planet Money" blog which you can find at npr.org/money.