The Emperor Vespasian ruled Rome from July 1st, 69 A.D. until June 23rd, 79 A.D., after the Year of the Four Emperors. Vespasian may be considered Rome's first austerity-minded Caesar. (Chintzy is probably more accurate.) Having inherited all the debts of his predecessors, Vespasian cut the size of Rome's government to the bone and raised taxes all over the city.
Vespasian's most infamous tax was known as the vectigal urinae - the tax on public urinals. When Vespasian's son Titus complained about the undignified nature of the tax, Vespasian held out a coin and asked Titus if he was offended by the smell. Titus said no.
"Yet," Vespasian replied, "it comes from urine."
The phrase pecunia non olet ("money does not stink") is still used today to say that the value of money is not tainted by association. AIG (NYSE:AIG) may be the investment of the decade precisely because the company is tainted by its association with the subprime mortgage crash, the Troubled Assets Relief Program (TARP), and corporate excess.
Sturm und Drang
According to the most recent Harris Interactive poll gauging the reputation of 60 of the most widely recognizable companies, AIG (#60) continues to rate 3 points below the Unholy Trinity of BP (NYSE:BP), Halliburton (NYSE:HAL), and Goldman Sachs (NYSE:GS) in the eyes of John Q Public.
Fig. 1: Reputation Quotient (RQ) of 60 Well-Known Companies
(Source: Harris Interactive)
The level of anti-AIG angst is unprecedented, especially when you consider the chronic memory loss endemic to today's 24/7 media cycle.
Therein lies the opportunity. The U.S. Treasury Department has sold all its shares in the company for a nominal $23 billion profit. Now that AIG is about to be paroled on good behavior, a public relations offensive is in the offing.
In fact, the company's "Thank you, America" campaign was well on its way to rehabilitating the AIG's image with both the public and lawmakers until it was dragged back across the front pages by a quixotic $25 billion lawsuit by Starr International.
At the moment, AIG's C-level is focused like a laser on another objective: SIFI status. In the Q&A section of the AIG's 4Q 2012 earnings report, CFO David Herzog characterized -
the conversations with the Fed really as constructive, open, and frequent, I think is the clearest way I can describe that for you. So with that as a backdrop, we're not going to comment on specifics, but again, we continue to work with the Fed to prepare ourselves for what we believe will ultimately be designated as a SIFI.
And we've taken great steps to prepare ourselves through mock exams, through enhanced documentation of procedures and the like, and processes and risk limits and the like, working hand in hand with Sid Sankaran, our chief risk officer, and then our Treasury group in terms of providing reporting and controls around liquidity and stress tests and forecasts.
So as we prepare ourselves for eventual SIFI designation, we'll put ourselves as best we can to carry on with the capital management objectives that we've laid out.
What is SIFI?
A systemically important financial institution (SIFI) is a bank, insurance company, or other financial institution whose failure might trigger a financial crisis. If SIFI sounds an awful lot like "Too Big To Fail", that's because it is.
With its associated systemic risks to the international financial system, SIFI/TBTF is often presented as an outlier, an unintended consequence of Financial Services Modernization Act of 1999, and the rise of globalization in general.
In fact, major financial institutions, Congress, and the Federal Reserve have been aware of the implications of TBTF since 1984. Far from being unwitting participants on the creation of systemically important financial conglomerates, banks actively sought TBTF status. In fact, they routinely paid billions of dollars above fair market value for acquisitions in order to achieve it.
Working Paper No. 11-37
In Working Paper No. 11-37 published by the Federal Reserve Bank of Philadelphia entitled, "How Much Did Banks Pay To Become Too-Big-To-Fail And To Become Systemically Important?" Elijah Brewer III of DePaul University and Julapa Jagtiani of the Federal Reserve Bank of Philadelphia chronicle in exhaustive detail how the major financial organizations -
were willing to pay an added premium for mergers that would put them over the asset sizes that are commonly viewed as the thresholds for being TBTF. We estimate at least $15 billion in added premiums for the eight merger deals that brought the organizations to over $100 billion in assets.
Let's shine a light on what no one but the Federal Reserve seems to know.
The Working Paper's assumptions are remarkably minimal. Quote:
If there is a significant value in achieving TBTF size, to capture expanded safety net access, banking organizations should be willing to pay more for those acquisitions that would enable them to reach such a size. (Working Paper 11-37, pg. 4)
If TBTF can be tacitly underwritten by the full Faith and Credit of the U.S. government (read: taxpayer bailout) it makes sense that said status is worth paying extra for. It's simply a question of size.
We find that the combined portfolio returns are significantly positive, suggesting that the market perceived the combination to be value enhancing. [emphasis mine] Moreover, after controlling for risk factors and economic environments, we find that the combined cumulative abnormal returns to the target and the acquiring banks increase significantly for those mergers that allow the merged firms to become TBTF.
Furthermore, our analysis of bond spreads before and after the mergers also indicates that the combined banking organizations face a lower funding cost after becoming TBTF through the merger." (Working Paper No. 11-37, pg. 5)
Fig. 2: TBTF Is Worth Paying For
The Birth of SIFI/TBTF
In 1984, the Comptroller of the Currency testified before the U.S. Congress on the bailout of Continental Illinois National Bank, implying that the banking agencies did not have the means to close any of the 11 largest multinational banks without the closure having a significant impact on the U.S. financial system.
Using an event study methodology, O'Hara and Shaw (1990) investigate the effects of the Comptroller of the Currency's 1984 announcement that some banking organizations were TBTF. They find that banking organizations deemed to be TBTF experienced a statistically significant positive average abnormal return of 1.3 percent on the day the Comptroller's announcement was made, with the highest returns going to the riskiest and very largest organizations.
In contrast, banking organizations not regarded as TBTF had median returns of -0.22 percent that day, and the banking organizations that were hurt the most were those just under the TBTF cutoff. These results thus suggest that becoming TBTF is valued by market participants and carries a wealth effect reflective of this perceived favorable treatment. (Working Paper No. 11-37, pg. 8)
The bond market rewarded TBTF debt as well:
In addition, Morgan and Stiroh (2005) find that the naming of the TBTF banking organizations by the Office of the Comptroller of the Currency [OCC] in 1984 elevated the bond ratings of those banking organizations (bank holding companies) about one notch compared to non-TBTF organizations, with subordinated note investors showing even more optimism than the rating agencies about future support for TBTF banking organizations. (Working Paper No. 11-37, pg. 8)
If the Philadelphia Fed's conclusions are correct, then SIFI/TBTF is a great business to be in.
The SIFI designation is usually considered a negative development by investors due to the fact that systemic status potentially hinders the ability for such firms to raise dividends or buy back shares.
But while this may be a valid issue for a major bank, it's unmitigated nonsense in AIG's case. The tax waiver that AIG was granted exempting the company from billions of dollars in future taxes gives AIG a competitive advantage that dwarfs the stricter capital regime imposed by the Dodd-Frank Act.
Fig. 3: AIG Tax Advantages 2013-2031
What could be more valuable to a multinational insurance company than for its business model to be implicitly guaranteed by the Full Faith and Credit of the U.S. government? Small wonder AIG isn't contesting its status as a SIFI and welcoming "the supervision as such." Regulations are only onerous if they are strictly enforced. Think about it this way: Three years from now, when some new financial scandal is rocking the nation, who's going to clamp down on sober, saintly AIG for hiking its dividend?
Every storm runs out of rain. There's a reason AIG is currently the favorite stock of hedge fund managers: public and institutional anger is an inherently ephemeral quality. Eventually, both Washington and the public will forget. The competitive advantage AIG reaps from tax breaks will last until 2031.
There's nothing ephemeral about that.
AIG is also overcapitalized and likely to engage in large scale share repurchases as soon as the Fed gives it the green light.
Meanwhile, the company is trading well below book value due to negative public sentiment (which will go away), Hurricane Sandy (resulting in higher premiums for the East Coast going forward) and investor anxiety over SIFI status (which slaps a federal guarantee on AIG's business model, ultimately increasing AIG's share price while reducing cost of capital.) AIG is celebrating its parole by aggressively expanding into China.
Thank you, Uncle Sam.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AIG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.