Let's say that I'm a pension
fund, and I have money to lend to other people. And I want to lend it to other
people, because that way I can get interest on it instead of
it just kind of sitting and doing nothing. And if I lend it to someone
other than the government, I'll get better interest. So
let's say that there's-- so let me draw me, I'm
the pension fund. Maybe I'll drawn
me in magenta. So that's me, pension fund. And let's say that there's
some corporation, let's say it's GM. They make cars. I think you've heard of them. Some corporation, GM. Let's just call it
Corporation A. They need to borrow money, maybe
to buy a factory or to do something else, we're not
going to get involved in what they need the money for. And I'd like to lend
them the money. But there's an issue here. I am a pension fund. I manage the retirement fund
for the teachers of California, or for the
auto workers of Michigan, or whatever. And part of my charter says
that I can only invest in very, very, very safe
instruments. So I'm not allowed to go gamble
people's money, because this is people's retirement. So I can't do very fancy
things with it. I can only invest in things
that are rated AAA, or let's say AA. I'm just kind of making
this up on the fly. So AAA would be like
the highest rated securities, right? These are things that have a
very low chance of default. But Corporation A is only rated,
I don't know, let's say it's rated BB. And actually, this is a good
time to think about well who is doing all these ratings. And you might think, oh, it
surely is a government entity, because only the government
would be objective enough give all of these corporations
frankly objective ratings. But unfortunately, it's not. They're private entities,
that are actually paid to rate things. And I think I touched on it in
the video on collateralized debt obligations. But their incentives are
a little bit strange. Let's say I have Moody's. Moody's is one of the ratings
agencies, and they rate Corporation A as BB. So they've said, these guys,
they're pretty good, but they're not the U.S. government
or something. There's a chance that they can
go under, for whatever reasons, or they're sensitive
to the economy as a whole. And I say, man, I would love
to lend these guys money. I would love to lend
these guys the $1 billion that they need. And these guys are willing to
pay me 8% interest. But I can't do it, me as
a pension fund, I cannot lend them money. Because I'm only allowed
to lend money to A or above types of bonds. Or I can only buy A or above
type of instruments. So what do I do? This guy needs money. I have money to give him, but
his corporate credit rating, that was given by Moody's, just
isn't high enough for me to lend him the money. And this is where credit
default swaps come in. In an ideal world, I would give
Corporation A, I would give them $1 billion. And then maybe they would
annually give me, let me make up a number, 10% per year. And then this might have a term
for 10 years, and then after 10 years, they'll pay me
the $1 billon back and then I'll be happy. But as I said multiple times,
I can't do it, because they are BB rated. And my charter says I can only
invest in A rated bonds. So I go to another entity. And let's call this
entity AIG. And these entities are
essentially insurance companies on debt. And I'm calling this
one AIG because AIG actually did do this. But it could be anything. A lot of banks did this,
a lot of insurance companies did this. There are some companies that
just specialize in writing collateralized-- sorry, in
writing credit default swaps. What does AIG do for me? Well first of all, it's
important to note that Moody's has given AIG, I don't know,
let's give it a AA rating. I don't know what their
actual rating was. They said, you know what, they
are almost risk-free. They're almost like the
U.S. government. Moody's has looked at their
books, or supposedly, or hopefully has looked at their
books, and says, oh you know, if you loan them money,
they're good for it. So they have a very,
very high rating. Although, once again, you have
to worry about the incentive. Because who paid Moody's to
give them that rating? And whenever you're getting
paid to give a rating, you have to wonder about what your
incentives are, in terms of how you rate things. But anyway that's a discussion
for another video. But what AIG says is, you
know what pension fund? I know you want to lend
Corporation A money, and Corporation A wants to borrow
money from you, but you have this problem because
they're BB rated. So what we're going to
do is we're going to insure this bond. We're going to insure this loan
that you're giving to Corporate B. What we want in return for that
is an insurance premium. We want you to pay us
a little bit of this interest every year. If you pay us a little bit of
this interest every year, we will insure this payment. So you get 10% a year, and
you give us 1% a year. So you give us 1% a year. And this is also 1%-- just
to learn a little bit of financial jargon-- this is also
someone would say 100 basis points. One basis point is
1/100th of 1%. So 1% of the same thing
as 100 basis points. 2% is the same thing as
200 basis points. So you pay me 100 basis points
of the 10% per year, and in exchange, I will give you
insurance on A's debt. And in fact, it might have not
even been structured this way. It might have been structured
so that Corporation A right here, before even issuing the
bonds, they include this insurance with the bond. So instead of giving 10%, they
cut out 1% to insure it. And then these essentially
become AA bonds. And why is that? Well, they're BB, but you're
being insured by someone who is AA. So all of the sudden, these
bonds, because they're being insured by this entity that
is AA, which Moody's has determined is AA, these bonds
are now good enough for my pension fund to hold. Because I said, you know what
even if corporation A goes under, I have this AA
guy insuring it. And so I'm fine. So this is the equivalent
of holding AA bonds. And what's my effective
interest rate? I'm getting 9% per
year, right? I'm getting 10% per year from
Corporation B, and then I have to pay 1% to AIG. And if Corporation B goes under
tomorrow, AIG is going to give me my $1 billion back. And you might say, Sal,
this sounds like a pretty good situation. And this is where it starts
to get a little bit shady. Because AIG, they're not just
insuring my debt or my loan that I gave to corporation A. And think about it, AIG didn't
have to do anything. AIG didn't have to put
up any collateral. AIG didn't say, you know what,
out of all of our assets, here is $1 billion that we're going
to set aside, just in case Corporation A doesn't pay. Right? You would think that if you
wanted to be guaranteed that this money was going to come to
you, this AIG corporation would have to set
aside the money. But they didn't have
to do that. They just have to say, hey,
Moody's has said we're AA, we're good for debt. We're good for insurance. So you just pay us 1% a year
and trust us, or trust Moody's, that we really are
good for the money. They never had to set
aside the money. You're just going on a leap
of faith that, if and when Corporation A defaults,
AIG is going to be good for the money. Now this is where it
gets interesting. Let me erase Moody's from the
screen-- actually, maybe I'll go down here. AIG didn't just insure
my debt. Let's say that there is
Corporation C's debt. Let's say that they're B-- I
don't know, all these ratings have different terminology. They're B+ rated. Right? And let's say there's $10
billion of debt that they borrow from some other party. And in return, they give 11%. And this is Pension Fund B. And this pension fund had
the same problem. They can only buy A-rated
or above bonds. AIG also insures their
debt that they gave to Corporation C. Maybe they'll pay them--
Corporation C is maybe a little bit riskier, so out of
the 11% I have to pay maybe 150 basis points. Or 1 and 1/2%, that's the
same thing as 1%. And in exchange, they
insure C's debt. Now something very interesting
can happen here. AIG all of the sudden
has an excellent business model, right? Because they were able to get
this AA rating from Moody's, they can just keep insuring
other people's debt, and they don't have to put any
money aside, right? They don't have to give their
assets to anyone else. And they just get these
income streams, right? From my pension fund
they're getting 1% per year of $1 billion. From this pension fund, they're
getting 1 and 1/2%, 150 basis points, per year. And they can do this, frankly,
as much as they want. They could do this
a thousand times. And as long as Moody's doesn't
get suspicious. As long as Moody's doesn't
start saying, hey, wait a second, AIG, you only have $100
billion in assets, but you have insured $1 trillion
of other people's debt. Something shady going on, I'm
going to lower your rating. As long as that doesn't happen,
this AIG corporation can just keep insuring
more and more debt. And frankly, as long as none
of that debt goes bad, they just get this excellent income
stream, and their CEO will get excellent bonuses. I think you start to see where
you're having a single point of failure and a house of cards,
and I'll continue that in the next video.