When Corporate Giants Fall

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92444268-credit-default-swapWe’ve all heard the phrase, “Too Big to Fail,” which arose during the 2008 financial crisis. The phrase is used to describe why the government needed to bail out some companies. Before the crisis, these companies had greatly increased their profitability by creating, then selling complicated derivatives and traded risky loans, commodities, currencies and stocks. When the economy was booming they took over smaller firms and grew bigger.

It is clear that the bigger a company gets the harder they fall and more people stand to lose, however what does it mean to people who have no direct ties to these companies?

Let’s take a look at AIG, which is a multinational insurance company with total assets of over $550 Billion and approximately 63,000 employees. Most of its business was traditional insurance products and everything was going good for them. In 1994 a new financial swap agreement was invented by JP Morgan. These financial products were called Credit Default Swaps and AIG jumped on this bandwagon.

CreditDefaultSwapCredit Default Swaps are new financial products and because of it there is very, very little regulation… just kidding, there is no regulation. They can be thought of as a form of insurance policy for banks towards corporate debt and mortgages. It is used by banks to reduce their risk because, for example, if an individual stops paying their mortgage to their bank, then AIG would pay the bank.*

In 2007-2008 many people stopped paying their debt because they simply couldn’t afford them. Now it was time for AIG to pay up to the banks. However, because there was no regulation on Credit Default Swaps, AIG didn’t have to have a cash reserve for this case and they quickly ran to the Federal Government for bailout. If the Treasury Department and the Federal Reserve Bank had said “NO” to the $180 Billion bailout, the banks would have gone bankrupt because they were relying on AIG’s insurance money. This would have meant that if you went to an ATM for cash, there would have been none (seriously).

We can point fingers and blame many people and companies for many reasons for the crisis however that’s not going to do any good because solutions fix problems, not pointing fingers.

Politicians, lawyers, presidents and even corporation use the rule that if there is no regulation that prevents you from doing something, then it’s legal. Politicians use this to get millions of dollars in campaign contributions. Presidents use it to get things their way in the form of an executive order. Publicly traded companies use it to fulfill their mission by generating as much profit for their shareholders. Because in business, the goal is making money.

If the school allowed Billy to pick on little kids and take their lunch money, he would do it every day. However if the governing body of the school penalized Billy with detention, he might stop. But if he begins bullying again, they would suspend Billy or even kick him out of school if someone was injured. The reason Billy was penalized is because it is against the school’s rules to bully other people.

Since there is no regulation on Credit Default Swaps and very little regulation on the derivatives market, why should companies stop? If Billy is not being punished for taking other kid’s money and lunch everyday, do you think he will stop? The questions isn’t about morals because in the world of Finance, it is all about the bottom line; just like school is all about grades.

* Very, very simplified explanation

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