On the morning of September 16, 2008, the world financial markets were within a whisker of a collapse of epic proportions in which hundreds of banks around the world could have failed, and tens or more of hedge funds would have closed, and money market funds around the world would have “broken the buck.” It could have been calamitous if AIG had failed. How did the world financial community become so fragile that the failure of one large insurance company could bring down an entire system? The answer is that it was an unfortunate combination of factors that individually would have only caused contained damage, but together threatened banks and financial institutions around the world.
One factor was an accounting convention imposed on public reporting companies that required that certain securities be marked to market if there is a market for the securities. This convention is knows as Fair Value Accounting, and was imposed by the Financial Accounting Standards and the SEC to require companies to mark the securities they hold to market. If a bank is holding mortgage debt and has properly marked that debt to market, that had already lowered the bank's total capital as that debt declined in value. If the bank is holding bonds, the bank marks those bonds to market.
If there is a market in certain bonds that have a risk of default, but that default is insured against, then that market reflects a higher price for such bonds because the risk of default has been “swapped” away by the purchase of insurance on the bond. If the insurance company guaranteeing the payment of principal and interest of that bond - i.e. the insurance company that swapped the risk of default for an upfront payment (the premium) - is weakened by a decline in the value of its assets, then the holder of the bond and other similar holders are going to either mark that bond to the lower market or sell that bond, further depressing the price of that bond. This is what occurred when AIG was threatened with bankruptcy - the risk of the default swap not being honored impaired the fair value of the bonds, and banks had to write down or sell those bonds. On many, many bond issues, a collapse of AIG could have caused any number of financial institutions to become insolvent.
It was not known what other participants were involved in the credit default swap market, but many hedge funds operated in this market. Hedge funds had also borrowed heavily against the bond portfolios they held in order to enhance their return on those bonds, and the hedge funds purchased credit default swap insurance to attenuate the risk of a bond default. As word of AIG's potential collapse spread, the hedge funds and some banks decided to liquidate their portfolios. However, with everyone trying to sell the weak bonds, the market for such bonds disappeared; there were simply no buyers. Mark to market fair value rules would indicate a zero or very low value on such securities. Further, as the collateral in the hedge funds declined in value (the bonds), the hedge funds had to come up with more capital as collateral for the borrowing the hedge funds did to purchase the bonds that were at risk of default. Accordingly, the hedge funds were also liquidating not just the bonds at risk of default but any other asset that was liquid to raise capital for more collateral.
Without a market for the high risk bonds, financial institutions had to sell their more liquid securities, which drove the price of those securities down, and mark to market accounting required lowering the values of those bonds as well. With capital disappearing from the balance sheet because of mark to market rules, many banks around the world ran the risk of insolvency and therefore closure by their regulators.
Regulators feared that a global collapse of some major banking and financial institutions would cause so much fear and disruption that many banks would cease to operate. Depositors, it was feared, would run to their bank to pull out their money if the banks were threatened with failure. This would cause a further run on the bank's weakened capital. Thus, it was determined that the simplest way to get some breathing room to figure out the scope of the problem would be to support AIG, rather than try to get a financial system up and running again after a major collapse.
