THEN collateral provisions trigger in derivatives (CDS) contracts,
THEN AIG bankruptcy,
THEN systemic meltdown.
So the AIG counterparties played chicken with the Fed and got 100 cents on the dollar for $60 billion in derivatives contracts. Paid for by you and me and our kids :-/
If I have any of this wrong, experts please correct me -- I'm just trying to understand how the world works.
WSJ: ... The implicit deadline looming was Nov. 10, 2008, the day AIG was scheduled to report its third-quarter financial results. Fed officials knew the company's anticipated $25 billion quarterly loss wasn't going to be greeted favorably by major credit-rating firms, according to a person familiar with the matter.
Another downgrade would force AIG to pay out billions more to its counterparties and could give banks the right to terminate contracts and keep the collateral—moves that would likely send the insurer spiraling toward bankruptcy.
On Nov. 5, the New York Fed received a presentation, a 44-page analysis put together by a unit of BlackRock Inc., saying that the banks had significant bargaining power with AIG and had little incentive to cancel the contracts unless they received par, or 100 cents, on the dollar.
The next two days, Fed officials negotiated with executives at AIG's trading partners. [Goldman, foreign banks, ...]
"The concession negotiations did not go favorably…we've given up," Mr. Bergin wrote in an email to New York Fed colleagues at 7:11 p.m. on Nov 7.
The Fed decided to pay off the banks in full, viewing that as the quickest way to get them to agree to tear up the contracts.
See earlier post Les Grandes Ecoles: AIG and Goldman edition.