Why why WHY does our federal government keep bailing out AIG? Simple.

Ok, I’ve racked my brain over this one. And I’ve finally figured it out. It’s very simple. It’s so simple I was missing it even though it is right there out in the open. Big duh on me.

It’s because the US Government is a counterparty to AIG’s credit default swaps. You know, CDS, the insurance policies that were written against the mortgage and other credit securities that you remember from the beginning of this little debacle. A counterparty is the one who is on the hook if the buyer of the insurance comes to collect. They’re on the hook because they have the right to receive the income from the insurance payments that the buyer made. Like any insurer, they receive payments with the understanding that if something bad happens, they pay money back out.

The US Government may possibly be the biggest counterparty of all. And something bad has happened.

You ask, how is that possible? That can’t be right. You’re crazy. We didn’t give those crappy politicians permission to speculate with our money. We haven’t seen any insurance payment income. How can our government be one of the ones on the hook for this? We didn’t agree to this.

They (we) didn’t have to speculate or agree to this. It works like this.

Remember the FDIC?

The FDIC insures depositors. When a bank goes under, the FDIC pays the depositors. This prevents bank runs. The FDIC is now warning that its funds could go negative this year because of all the banks that have gone under already. It tried to raise fees recently to cover for that and all the little banks across the country screamed because the proposed fees would eat up all of their 2008 income. Gone. But if the FDIC goes under, the bank runs begin. It wouldn’t take much of a spark at this point.

These are your neighborhood banks, and savings & loans, and credit unions. They aren’t Wall Street. They are small town banks with small town names. Drive down Main Street of any small town and you’ll know the name of the town because it’s right there on the LED sign of the most prominently placed bank in town. These are the banks where the local farmers do business, and the town gas stations, and the little grocery stores and cafes.

The FDIC could not possibly cover all of the deposits in all of those banks at the same time. Not even close. It was never meant to. Such a situation, where all of the banks went under at the same time, would be a total disaster. It would be like hurricane Katrina taking out the entire country. The FDIC is just insurance, not God.

Mr. Ben Bernanke, our Princeton economist-Great Depression expert-Chairman of the U.S. Federal Reserve is well aware that the loss of the localized small town banks was the last straw that put this country into the Capital-D Depression and kept it there for so long. It sucked the blood right out of the heartland if you’ll forgive the expression. Once those banks were gone, it became extremely difficult for the federal government to pump money back into those areas. There was no infrastructure left to pump money through and no local banker who knew everyone by name to know who deserved a loan. There was no clear way to distribute funds. The economy shriveled and dried up everywhere.

If so much as one single bank is a counterparty to AIG credit default swaps, then the FDIC is also a counterparty, and if the FDIC is a counterparty, then the U.S. government is a counterparty.

The media talks about credit default swaps (CDS) as if they are these big pieces of paper sitting in a vault and about counterparties as if there is this one person or hedge fund or some shadowy entity holding a single piece of paper as if it’s a betting stub, just waiting for it to pay off big [cue evil laughter]. Who cares about evil financial masterminds? Let’s just not pay that bet, right?

But that’s not exactly the situation. Wall Street securitized the CDSs too. That’s how they sold so many and so much, estimated to be more than the GDP of the entire world. They chopped them up into little bits and sold them to investors all over the planet. Is your 401K or your pension invested in a bond fund? Then you might be invested in part of a CDS. Correction: you ARE invested in a CDS.

How many localized small town banks own some of these AAA rated-supposedly-safe securities (bonds) and are therefore counterparties? 1? 20? ALL OF THEM? Do you want to take bets on it? This stuff was sold to school boards and pensions. Where do you think the school boards and pensions got them? They bought them through their trusted local financial advisor / banker.

I don’t think I’m exaggerating to think that if AIG fails then every single small bank in the country is at dire risk. And by extension the FDIC. And therefore the United States government. It’s right there in front of us. That’s what we’re facing. That’s why the government is feeding the bottomless pit of AIG.

Because it’s holding us hostage.

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