Let 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 at that way I can get interest out of it instead it is kind of sitting and doing nothing. And if lend it to someone other than the government I get better interest. So let me draw on the—I’m the pension fund. Maybe I’ll draw it in magenta. So that’s me, pension fund.

Pension fund and let say that there's some corporation, I don’t know let say its GM. they make cars, some corporation GM. Let's call it corporation A. Corporation A, they need to borrow money maybe to buy a factory or to do something else we’re not going to get involve in what they need the money for and I'd like to lend them the money, but there's an issue here. I'm 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 retirements. So I can't do very fancy things with it.

So I can only invest in things that are already triple A or let say double A. I'm just kind of making this up on flies. So triple A 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 let say its rated double B and actually this is a good time to think about. Who’s doing all of these ratings? And you might think, “Oh, it surely is the government entity because only the government would be objective enough to 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.

But let say I have Moody’s. Moody’s is one of the rating agencies and they rate corporation A as double B so they’ve said, you know, this guys they're pretty good but they like the US 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, you know I would love to lend this guys money”. I would love to lend this guys the, I don’t know, the billion dollars 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 the money because I'm only allowed to lend money to single A or above types of bonds or I can only by at single A or above type of instruments. So what do I do? This guy needs money, I have money to give him but his kind of corporate credit rating that was given by Moody’s just isn’t high enough for me to lend them the money. And this is where credit defaults lapse come in.

So In ideal world I would give corporation A I would give him a billion dollars and then maybe they would annually give me 10% per year and then this might have a term for ten years and after ten years they’ll pay me the billion dollars back and then I'll be happy. But as I said multiple times I can't do it because they are double B 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 AIG because AIG was actually did do this. But it could be anything a lot of banks did this, a lot of insurance companies did this, there were some companies that just specialized in writing collateralized and writing credit default swap.

But anyway, what is AIG do for me? Well first of all it’s important to know that Moody’s has given AIG double A rating, I don’t know what they're actual rating was. They said, you know what, they are almost risk free, they're almost like the US Government. Moody’s has look at their books or supposedly or hopefully has look at their books and says, “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 there is, you know, 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, “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 double B rated.” So we’re going to do is we’re going to ensure this bond, we’re going to ensure this loan that you're giving to corporate B. So what we just 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 these payments. So you get 10% a year and you give us 1% a year.

So 1% a year and this is also 1% just to learn a little bit of financial jargon this also, you know, someone who say a 100 basis points. One basis point is 100 of a percent so 1% is the same thing as a 100 basis points, 2% is a same thing as 200 basis points. So you pay me a 100 basis points of the 10% per year and in exchange I would give you insurance on A’s debt and in fact it might have not even been structure this way, it might have been structure so that corporation A right here before even issuing the bonds they include this insurance with the bonds so instead of giving 10% they cut out 1% to insure it and then this essentially become double A bonds and why is that?

Well this is they are double B but you're being insured by someone who is double A so all of the sudden these bonds because they are being insure by this entity that is double A which Moody’s has determined this double A these bonds are now good enough for my pension fund to hold because I say, you know what even if corporation A goes under I have this double A guy insuring it and so I'm fine.

So this is equivalent of holding double A bonds and what's my effective interest rate? Well 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 the tomorrow AIG is going to give my billion dollars back and you might say, “Hey Sal, this sounds like a pretty good situation.”

And this is where it’s 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, “Oh you know what? Out of all of our assets here is a billion dollars that we’re going to set aside just incase corporation A doesn’t pay.” 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 double A, 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 so you're just kind of going on a little fate that if and when corporation A defaults AIG is going to be good for the money. Now, this is where it gets interesting. AIG didn’t just insure my debt let say that there is corporation C’s debt. Let say they're B+ rated and let say there is $10 billion of debt that they borrow from some other party.

$10 billion and then they 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, so AIG also insure us their debt that they gave to corporations C. So maybe they’ll pay them corporation C as maybe a little bit riskier so out of the 11% I have to pay maybe 150 basis points or 1/2% that’s the same thing as 1% and in the exchange they insure C debt.

Now something very interesting can happen here. AIG all of the sudden has it excellent business model because they were able to get this double A rating from Moody’s they can just keep insuring other people’s debt and they don’t have to put any money aside, they don’t have to give their assets to anyone else and they just got these income streams. From my pension fund they're getting 1% per year of the billion dollars. From this pension fund they're getting ½% or 150 basis points per year and they could do this frankly as much as they want. They can do this a thousand times and as long as Moody’s doesn’t get suspicious, as long as Moody say it doest start saying, “Hey, wait a second AIG you only have a $100 billion dollars and asset s but you have ensured a trillion dollars other peoples debt.

Something shady going on I am going to lower ratings as long as that doesn’t happen this AIG Corporation can just keep insuring more and more debt and frankly as long as at that debt goes bad they just get this excellent income streams and their CEO will get excellent bonuses. Anyway I think you start to see where you’re having a single point of failure in a kind of a house of cards and I'll continue that in the next video.