Yesterday I read a post on yahoo finance where the SEC wants to limit a firm’s ability to bet against their clients http://finance.yahoo.com/news/SEC-moves-to-limit-firms-bets-rb-4093524071.html?x=0 (sorry i don’t know how to change it to look nice). The way I understand the AIG case is that the smarter people working at companies such as Goldman sachs and other investment bankers were able to force other institutions to create a market of buying and selling bundles of mortgages that were so diced up with higher level math that the bundles were able to be classified as safe AAA ratings. When they realized that the derivatives were so unsafe they were able to pass the buck along to AIG and Leehman brothers and have them create insurance for these bundled mortgages in which the investment bankers knew that they were doomed to fail. In this process they are no longer liable for the derivatives and are able to make a pretty penny from the insurance. The insurance companies such as AIG are left with the obligation to pay out when these faulty looking mortgages fail. If the mortgages were classified correctly then there would be no way AIG would insure them.
The article states that the SEC wants to restrict the way an institution can sell a bad financial product (so heavily bundled that it looks good) and as soon as it is not theirs anymore to go and bet against it. In the case of AIG it would make perfect sense that this would need to be done to save the institutions who are being left with bad bundled product, but a line needs to be determined because it may also limit an institution’s ability to hedge themselves and protect themselves.
I like the way that the SEC is thinking, because it is unfair that an institution can hide the true value of a product and sell high to another institution, then turning around and betting against the product, knowing it will fail. I only worry that even with a rule like this in place that the smart workers in investment banking will be able to find a loophole and still find ways to bet against bad bundles that they just sold as good bundles.