I have been resisting the growing tendency to label our current woes as the Great Depression II. The conventional statistics of our economy today are nowhere near the misery of the 1930s. However, the proposed 90% tax on certain executive bonuses has convinced me that we are in for a decade of stagnation.

To recap: Back in September 2008, the giant insurer AIG was on the brink of bankruptcy when the Federal Reserve rushed in with an $85 billion rescue package. (There have been subsequent bailouts, bringing the total infusion thus far to $170 billion.) At that point the government seized AIG, and among other things it replaced its CEO with Edward Liddy, the very person Congress was recently interrogating about the bonus payments.

The reason AIG was in such dire straits had nothing to do with its conventional insurance business, which remained strong. Instead, it was AIG’s Financial Products division that brought the corporation to its knees. This group had dabbled in complex assets tied to subprime mortgages, and been left holding the bag when borrowers began defaulting at much higher rates than expected.

Beyond directly holding some of these “toxic” assets, AIG was also crippled by its massive issuance of credit default swaps. These are insurance policies that guarantee the buyer a certain monetary payoff if “credit events” occur. For example, a hedge fund might hold $1 million in bonds issued by GM. To protect itself from a GM default on its bond payments, the hedge fund can buy a credit default swap from a company like AIG.

As the housing and financial markets deteriorated last summer, the companies who had bought credit default swaps from AIG became nervous. They worried that AIG would suffer so many claims that it couldn’t satisfy them all. So AIG’s counterparties insisted that AIG post collateral to back up their contractual obligations. It was these “margin calls” that finally killed the company. Continued...