BOSTON

AS WITH BEAR STEARNS back in March, insurance behemoth American International Group Inc. (AIG) wrote huge policies it couldn’t pay on the American real-estate market using an unregulated insurance contract known as a credit default swap (CDS). Now the Federal Reserve will fork over $85 billion to keep AIG, as well as the home, auto and property insurance of millions, viable.

CDS are insurance contracts that allow the buyer, in exchange for a fee, to receive a payment if a specific negative credit event, like a default on a loan, occurs. CDSs, as with all insurance, allow buyers to get rid of downside risk in exchange for a premium. Unlike insurance, CDSs were not subject to any regulation whatsoever.

Understanding what happened with AIG means understanding the price of choosing not to regulate CDS as insurance. In 2000, New York State insurance regulators decided that CDSs were not insurance and that they were not going to regulate the market for them. The decision in New York mattered because that is where CDSs in the United States are traded. Months later, Congress passed the Commodity Futures Modernization Act, barring federal financial regulators from exercising jurisdiction over CDSs. The market for the contracts, which had been less than $900 billion in size, ballooned. Today the total value of outstanding CDSs contracts is estimated to be worth about $60 trillion. Nobody knows how big it is, because nobody regulates it. (Earlier this month, New York State insurance regulators decided they would regulate CDSs.)

Part of the CDS market’s growth owes to their use as insurance for mortgage-backed bonds. Uninsured, there was no way these bonds would have received the AAA ratings that made them so marketable. But backed by guarantees from insurers such as AIG, the pooled mortgages offering relatively high yields sold fast. The problem for those selling these mortgage-backed bonds was that as the debt became increasingly dodgy, the cost of insurance rose.

Insurance pricing is a function of risk-modeling. The modeling forecasts how much risk can be taken on without a financial institution’s going bust. Coin-flipping is the simplest risk model, with one side being profit and the other loss. Capital-adequacy requirements are essentially rules that regulate how much cash a company must have on hand before it flips the coin. Traditional insurance policies, subject to capital-adequacy rules enforced by regulators, becomes more expensive as risk increases.

It soon became clear that it was cheaper to insure these mortgage-backed bonds with CDSs than with regulated insurance. Nobody pointed out that regulators were not watching the capital adequacy of insurers writing CDS policies: Real-estate prices were skyrocketing and bond-rating agencies didn’t distinguish between CDSs and traditional bond insurance. AIG, forced to keep its mortgage-backed bond-underwriting activities competitive with those using CDSs, jumped into selling CDSs.

In its 2006 annual report, AIG told investors that it was unlikely that its CDS positions would create payment obligations, “even in severe recessionary market scenarios.” What happened? Like all companies eager to please shareholders, AIG wanted to flip the coin as much as possible to increase its chance of profit. The only part of its business where it could do this was where it created its own capital-adequacy requirements, its own risk models. With CDSs, the same people who had no incentive to limit risk created the risk models.

Unregulated markets are subject to one of the oldest principles in economics: adverse selection. Nobel Prize-winning economist George Akerlof illustrated the idea by focusing on the used-car market.

Consider the following: A used-car market is composed of good cars, called peaches, and bad cars, called lemons. The only thing buyers know about these cars is that they won’t be able to tell the difference between them until too late. Accordingly, the most a rational buyer will pay for any used car is the averaged price of a peach and a lemon. That price will always be less than a peach is worth. Owners of peaches won’t sell their cars because they know buyers won’t pay what they are worth. Owners of peaches keep their cars off the market, leaving the market disproportionately made up of lemons, driving down the average price of a used car further, making owners of peaches even less likely to put their cars on the market.

The principle applies to anything traded, including insurance. In mid-19th Century America, property insurance was a boom business, with fierce competition in an unregulated market. Some insurers priced their policies at a level sufficient to pay policyholders in the event of property loss. Others didn’t. At the point of purchase, one policy looked like another and nobody forced insurers to open their books and certify that they had the cash to pay up. Consequently, bad insurers (the lemons that couldn’t pay a claim) consistently underpriced good insurers (the peaches who could), since good insurers could only drop prices so far without becoming bad.

The Chicago fire of 1871 and similar events throughout the country during the mid-19th Century led states to begin regulating insurance. Of the thousands of homes and businesses destroyed by the Chicago fire, less than one-third of policyholders got paid. Bad insurers had driven out the good by underpricing them. In response, state regulators began to keep track of how much money insurers had at any given time. Insurers were not allowed to dip below a minimum. These capital-adequacy requirements got rid of the bad insurers and made sure that low prices were the result of good business and not worthless policies.

While a lemon of a used car might mean more money spent at the mechanic, lemon-insurance policies are a disaster. Insurance covers costs people otherwise couldn’t. If insurance money isn’t there, the house doesn’t get rebuilt, the car doesn’t get repaired and the medical bills lead to bankruptcy. The cost of lemons in the insurance market is too severe. Regulation kept lemons out of the market and kept the market functioning.

Like lemon insurance in 19th-Century Chicago, AIG is an example of bad insurance driving out the good. AIG’s CDS losses were so big that they would have left the company without the cash to pay its traditional, regulated insurance policies, which on their own had been doing just fine. The Federal Reserve basically gave AIG the cash to make sure that won’t happen. To pay the Fed back, AIG will most likely have to sell off all its peach-insurance business, which happens to be all of the business that was regulated. That means no more AIG.

Next time someone tells you how great the free market is, ask them how they know the difference between a peach and a lemon.

Arthur Kimball-Stanley, now a student at the Boston College Law School, is a former reporter for Dow Jones and The Providence Journal.