There’s nothing fundamentally wrong with the core insurance business units of AIG (NYSE:AIG). The company’s downfall was an accumulation of misplaced bets on credit default swaps.

By the best estimates of the Bank for International Settlements (BIS) the notional value of credit default swaps is some $62 trillion.

A credit default swap (CDS) is like an insurance policy. It’s a financial derivative that a debt holder can use to hedge against the default by a debtor corporation. A CDS can also be used to speculate.

A subsidiary of AIG wrote insurance in the form of credit default swaps. It offered buyers insurance protection against losses on debts and loans of borrowers to the tune of $447 billion.

But the mix was toxic.

It also sold insurance on esoteric asset-backed security pools — collateralized debt obligations (CDOs), pools of subprime mortgages, pools of Alt-A mortgages, prime mortgage pools and collateralized loan obligations. The subsidiary collected a lot of premium income. Its earnings were robust.

When the housing market collapsed imploding home prices resulted in rising foreclosures. The mortgage pools AIG insured began to fall in value. The credit crisis also began to take its toll on leveraged loans, and it saw mounting losses on the loan pools it had insured. In 2007, the company was starting to feel serious heat.

From its humble beginnings in China in 1919, through the 40-year tenure of CEO Maurice R. “Hank” Greenberg, which ended ignominiously for Greenberg in 2006, AIG grew aggressively. Greenberg grew and diversified the insurance giant, ultimately amassing a trillion-dollar balance sheet.

But not everything was Kosher.

In an effort to assuage analysts and maintain leverage the firm entered into sham transactions to affect the appearance on its balance sheet of $500 million of loan-loss reserves, which analysts had been questioning as formerly declining. The result was a 2006 Securities and Exchange Commission enforcement action, a $1.6 billion settlement and the removal of Greenberg. Greenberg is still fighting civil charges related to his actions at the firm.

As 2007 progressed, so did the losses on AIG’s books and credit default swaps.

Once again, it appears that AIG tried to manage the problem through accounting maneuvers. Last February, for instance, AIG said,”its auditor had found a material weakness in its accounting.”

It had not been properly valuing its CDO liabilities and swap-related write-downs. The losses were revealed to be in excess of $20 billion through this year’s first quarter. The SEC is once again investigating, as are criminal prosecutors at the U.S. Justice Department and the U.S. Attorney’s Office in Brooklyn.

After writing down assets against gains elsewhere, AIG posted cumulative losses of $18 billion over the last three quarters. In February, AIG posted $5.3 billion in collateral against credit default swap contracts it had written. In April, AIG had to post an additional $4.4 billion in collateral. When rating agencies Standard & Poor’s, Moody’s Investors Service (MCO) and Fitch Ratings Inc., lowered the firm’s ratings last Monday evening, it triggered an additional $14 billion collateral call as margin against AIG’s credit default swaps.

The company didn’t have the cash.

Indeed, the dire need for cash collateral on top of mounting losses on warehoused CDO “assets” on the company’s balance sheet necessitated a massive infusion of capital. That’s what happened to AIG.

But once again, there’s the story… and there’s the story behind the story.

There’s a problem - an inherently systemic problem - and it has to do with how structured investments like tranched collateralized debt obligations (CDOs), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and credit default swaps on them and on corporate debts and loans are actually valued.

Individually, CDOs are hard to value. Suffice it to say, legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. (CRAY) supercomputer 48 hours. Now try and value credit default swaps on them!

Because there are so many different individual CDO securities, and because there are so many credit default swaps on so many of these CDOs, and so many swaps on individually referenced entity debts and loans, the only way to value them in a portfolio is by indexing.

That’s right: there are indexes. And guess what? You can trade the indexes! Markit Group Ltd., of London, constructs and manages the CDX, ABX, CMBX and LCDX family of credit-default-swap indexes. Investopedia has a decent little tutorial.

Here’s the problem: if you own a portfolio of CDOs and the only way to value them (or, at least, to develop a valuation that others are reasonably certain to respect) is by looking at them through the prism of an index of credit default swaps on them, you’re at the mercy of the index. Your portfolio - your securities - may not be so bad. But you may not really know based on mortgage-duration analysis and foreclosure events that you can’t calculate. So you value, or mark-to-market, against the closest index.

Here’s the rub. What if other speculators are selling short - betting in anticipation of that index going down? What if large portfolio-hedgers are selling short the index to hedge the portfolio they can’t sell because no one will buy it - because no one knows what it’s worth?

It’s crazy. And it gets worse.

What if you’re running a profitable company that needs to borrow money but credit default swaps (bets against your ability to pay back your debt) are expensive by virtue of speculators fear and greed, such that, if any bank looks at where the CDS pricing on your paper is trading, they tell you: “Sorry, but we can’t lend you money because the market for credit default swaps thinks you’re a bad bet.”

You don’t get the loan. You can’t build your factory. You can’t produce, and you have nothing to sell. The upshot: Now you actually are going out of business. Is this self-fulfilling?

Ponder this: Last Monday, as AIG was initially seeking $20 billion in capital and actually had it in hand (by virtue of a deal with New York insurance regulators), traders were bidding up credit default swaps on AIG’s debt and loans so furiously that based on the insurance premiums traders were actually paying for default insurance on AIG… the company was already dead. Self-fulfilling?

Credit default swaps are creating a downward spiral in the capital markets, driving up the cost of capital and squeezing out all manner of borrowers. And these speculative bets run amok are undermining all U.S. Federal Reserve and U.S. Treasury Department efforts to “liquefy” the system. If this keeps up, the credit default market could sink the U.S. economy into a recession/depression that will make the Great Depression look like a day at the beach.

Anyone got a towel?

Source: The Inside Story of the Collapse of AIG