The following editorial appeared in the Miami Herald on Wednesday, March 4:

Investment wizard Warren Buffet once observed, “It’s when the tide goes out that you find out who has been swimming naked.” With the economy contracting, insurance giant AIG stands exposed as the biggest naked swimmer of all.

The company made a huge bet that real-estate prices would always go up, never preparing for the day when it might have to cover its losses. As the world’s biggest insurer, however, its failure would cripple the global financial system, which is why the government believes it has no choice but to intervene.

AIG insured hundreds of billions of dollars in subprime mortgages that had been turned into securitized debt – pools of loans converted into securities. These pools often consisted of mortgages that could not be repaid. When push came to shove, AIG was caught short. The failure of its mistaken investment strategy was compounded by a failure to set aside enough reserve for the risk it bore.

The result is that AIG must either stay in business with government help or go into default. In such a scenario, there are no good options, but what analysts describe as the “least worse” option is a government rescue. This has already entailed a huge cost to the American taxpayer – $170 billion, including this week’s latest round of outlays – and there will probably be more in the future.

It’s not fair to ask taxpayers to bear this burden, but default could be worse. It would create enormous collateral damage. Hundreds of banks and institutions already on shaky ground would have to write down immense losses because the toxic assets they hold would no longer be insured. That includes pension funds. Every individual and business that depends on credit would be adversely affected.

Under close questioning by members of Congress on Tuesday, Fed Chairman Ben Bernanke refused to describe AIG as a “zombie institution,” – i.e., dead but still on its feet due to artificial government support. The government, he insisted, has a plan to make things right by “containing the contagion” spread by AIG and toxic assets and breaking AIG up into pieces – some of which are still profitable.

Bernanke said AIG had been “ambushed by its financial products division,” the whiz kids who made all those bad bets on toxic assets. The first step to recovery will be making sure that they’re all fired.

Bernanke also said he would support the Obama administration’s promise of “regulatory reform.” Any such reform must ensure that regulators take their job seriously, which would be a refreshing change from the trend of the recent past. And regulators must make sure that no company ever gets so big that its failure threatens the global economy.

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