By: Dividend Sensei
A bankruptcy isn’t the only way to lose your money either. Sometimes a company can avoid Ch 11 but only at the cost of such rampant share dilution as to nearly wipe out existing investors. For example during the financial crisis AIG nearly went under, and threatened to take the entire global financial system with it. The trouble was with one particular subsidiary headquartered in London called AIG Financial Products or AIGFP. AIGFP sold insurance against investment going bad, say due to wild swings in interest rates or economic downturns.
In the late 90’s AIGFP came up with a new product, called the credit default swap or CDS, which was insurance on collateralized debt obligations or CDOs. Basically this meant insuring a group of bundled loans, such as mortgages, against default. To AIG’s thinking these were gloriously profitable products, since in theory a widely diversified group of mortgages from all over the country could never default at once.
So the chances of ever having to pay out on these policies was very low, or so its models told it. And in the meantime it could collect the premium and invest it into other income producing assets, as all insurance companies due with unclaimed premium (insurance float). Of course it turns out that those mortgages were not in fact low risk AAA investments, but rather subprime loans made to borrowers who had no business buying houses. This includes the infamous NINJA, (no job, no income, no asset) mortgage with a variable and super low teaser rate.
As long as housing prices were rising homeowners could refinance because the equity in their homes was increasing and interest rates were still low by historical standards. Or they could sell the house for a profit and just pay off the mortgage entirely. But when the Fed started to raise rates in the mid 2000s and those variable rate loans starting resetting at much higher rates? Well then the entire house of cards came crumbling down.
The delinquency rate for US mortgages rose six fold in a matter of months, housing prices crashed, and underwater homeowners just handed back the keys and stopped making payments. At the time nearly 20% of AIG’s revenue was coming from AIGFP and most of that was from selling credit default swaps on mortgage based CDOs. That was insurance on the derivatives that other financial institutions all over the world had been using to make enormously leveraged bets on the housing bubble.