How We Could Let AIG Fail, Sort Of

By James Kwak

Simon and I wrote an op-ed in the New York Times today, trying to debunk the idea that, as we put it, “A.I.G.’s traders are the people that we must depend on to save the United States economy.” The AIG (AIG) bonus fiasco, as I’ve written earlier, has been particularly useful in raising the political cost of the administration’s current bailout strategy. But, as I said then, “$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another.” And as far as the cost to the taxpayer is concerned, the big bill is for bailing out AIG’s creditors. In his op-ed in the Wall Street Journal today, Lucian Bebchuk wants to know why.

Now, the government has not explicitly guaranteed AIG’s liabilities. But the main reason for bailing out AIG in the first place was the fear that an uncontrolled failure would have ripple effects that would take down many other financial institutions who were dependent in some way on AIG; most commonly, they had bought insurance, in the form of credit default swaps, from AIG and were counting on being paid. And a major usage of bailout money has been to make whole AIG’s counterparties holding those credit default swaps, primarily investment banks trading on their own account or on behalf of their hedge fund customers.

I still think it was a mistake to let Lehman fail, because of the sudden panic it created. But we are in a very different situation today. Many people now believe that the government may decide to let bank creditors lose some of their money. As Bebchuk says, instead of continually giving AIG taxpayer money that is effectively used to bail out other banks (many of which are in Europe, allowing European governments to free-ride on the U.S.), the government could let AIG fail and bail out those other banks directly, thereby at least getting increased ownership stakes in return. Bebchuck also explains that AIG’s insurance subsidiaries would not become insolvent if the AIG holding company went bankrupt, because they have their own reserves. (Insurance operations are regulated on a state-by-state basis, and state regulators establish reserve requirements for insurers.) Furthermore, he argues, failure is not an all-or-nothing proposition:

For example, the government could place AIG in Chapter 11, but commit to provide supplemental coverage that would make up any difference between the value that creditors would get from AIG’S reorganization and, say, an 80% recovery. Such an approach could allow setting different haircuts for different classes of creditors.

I think that the government could let AIG fail, if - and this is a big if - it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors (not to mention employees - bankruptcy would settle this whole question of whether the bonus contracts are legally binding once and for all).

There was clearly no time to do this between September 15 and September 16. But the government by now has had six months to study the books of AIG and its major domestic counterparties. People are no longer willing to take it on faith that the future of the free world depends on an implicit blanket guarantee for AIG. At least we want to see some evidence.

Comments

[FrugalSam:]

The author brings up a valid point. Why isn't anyone looking into the books of the firms being bailed out instead of writing them blank checks ?

These contracts/agreements were written by human beings, however smart they might be. It would be worthwhile to hire the best guys to figure out what the exposure is instead of throwing endless amounts of money at it.

As a taxpayer, I would consider that to be a better use of my money than blindly bailing out everyone who is 'too big to fail'.

Mar 20 04:08 PM

[tshk1221:]

1. The government must lay off all the employees of AIG and replace them with new government employees. Pay for each employee must not be over $30,000 to $50,000 a year with no bonuses, 401(k)s, insurances or any type of fringe benefits whatsoever to save costs (tax payers' money).

2. The government must set insurance sales goals to these new government employees such as generation of $10,000,000 new life insurance policies a month per employee.

3. If any of the employee cannot meet this sales goal, the government must lay off under-performing employees one by one again to save more costs.

4. When there is no employee left other than a security guard, the government must declare itself Chapter 7 bankruptcy for AIG.

5. The politicians will handle the effects, good or bad, by blaming others and pinpointing scapegoats.

Mar 20 07:42 PM

[Alexander_M:]

tshk,

*dripping sarcasm*
Great response. The GRUBvernment is a great steward of capital. That statment is quite reassuring when you consider how "profitable" all the other institutions that they take over are. Look at Fannie and Freddie, models that the Free Market should all look up to. If only my company could burn through capital the way those morons do... it would be the model for all communist corporations to follow.

Long live Stalin!

Mar 21 12:26 AM

[cynewulf:]

I always thought bailouts were about loaning tax-payers money to rescue companys that would hopefully, eventually pay the money back, to the tax-payers. A.I.G. has recieved at least 173 BILLION dollars of tax-payers money and they have SPENT IT.They have given it to fat cats at other banks. Many of them foreign banks. they are not going to give the money back to A.I.G. They are being rewarded by American tax-payers for taking unreasonable risks with other peoples money .They are laughing all the way to the Deutche Bank, and in Dubai. A.I.G. cannot give this money back. It does not have the money It will never have the money.This was not a bailout. This was a theft, perpetrated against the American people.

Mar 21 01:07 AM

[morph366:]

The part of the AIG/banker's bonuses debacle that really is absurd is the government's claim that the banking industry need to retain the financial wizards as they may go elsewhere.
The promulgation of this "fear" seems to be even more cynical than the WMD's ruse that was used to justify the invasion of Iraq.
Most of the top talent in the banking world -globally - have no where else to go - and those who think otherwise must live on another planet.
Leave already please.
The real world could handle a proper wind down of AIG - and why not Citigroup while they're at it.

Mar 21 06:46 AM

[pacman1947:]

James,
I was with your analysis and critique until I saw this part, "...let AIG fail, if - and this is a big if - it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day."

I violently disagree with any premise that the taxpayer should have any liability whatsoever for the gambling debts of these issuers of derivatives.

No company is too big to fail. They are too big because our anti-trust laws were broken and no one enforced the law. Insurance, brokerage, and banking should have never been allowed to combine under one roof. The failures must go through bankruptcy proceedings and let the chips fall where they may. If it means that some executives do prison time for their acts of fraud, then I'm willing to have taxpayers pick up the tab for confiscation of their assets, clawback of their past bonuses, and corresponding issuance of prison term life sentences.

We must punish those who committed these crimes. Rewarding incompetence, failure, fraud, and hubris does not bring closure. It's time for a different approach to that chosen by Washington.

Mar 21 09:16 AM

[friar tuck:]

what happens to the common stock holders if aig goes chapter 11?

Mar 21 11:08 AM

[bthomas:]

What has already happened to them? Apply adverb here: They're ____!


On Mar 21 11:08 AM friar tuck wrote:

> what happens to the common stock holders if aig goes chapter 11?

Mar 21 11:25 AM

[reality chk:]

Iam not a financial expert. I can not make sense of this financial institution's books. But I know a little something about the real world, and things like Responsibility, Honor, Honesty, Accountability, Moral and Legal compliane within society.
Question: Would AIG still be paying bonusses today without the Federal money?
The answer is NO!
The federal money was intended to keep the company afloat with it's creditors.
These people ran this company into the ground taking with them the entire US and World Economies.
This in not a matter of principal, or stand up for your rights debate.
Any reasonable person would expect to share their company's success.
Question: Where is the company success here?
This company was and still is one (1) thread away from falling into the abyss.
Clearly the AIG management and employees do NOT have a sense of responsibility nor accountability.
Question: Where is the shared sacrifice?
Like it or not, the federal government (the Taxpayer) now owns this company until the federal money is paid back. Remember when you take out a loan they put a lien on your property. Or AIG with their superstar employees can return the federal money and then they can pay the bonusses. no problems.
There is a lot of stink associated with this deal usualy that means there is something rotten that causes the stink. It is Self Centered, Greed, Corruption, Conspiracy, Incopetence, Coverup and lies.
These people should be in JAIL. Nothing to debate here.
Clearly these people have been isolated on this financial dreamworld island for so long they have lost their sense of reality. 73 of these superstars are getting a bonus of $1M or more. usualy a bonus is about 20% of their annual wage. That means these superstars are making over $5M/year and getting a $1M bonus on top. Yep. They are in their own little world. GET REAL...
Working for the Auto industry I have learned how to take a beating and I have the scars to prove it. Seems nowday everyone that has driven a car is an expert on the auto industry, just look at the articles, the reports, the blogs, Thousand each day beating up on the auto industry. We have done nothing wrong, We only employed people for 100 years and making cars and trucks that people want. We have done nothing imoral, nothing ilegal.
We are victims of this recesion caused by the financial meltdown. The tooth fairy did not do this one night and we all woke up into it. But we all have to deal with it. My company has made major changes in the way they do business at every level we all have given back and will continue to give back wages, benefits, work rules and change the way we do business even down to rationing office supplies, utilities, and materials. We have become creative on how to share resources and to cut cost, not on how to swindle the taxpayers so that "I get my bonus and screw you".
Analysts and Journalist have turned into spin doctors, but the bottom line is The Taxpayers Rights must be protected.

Mar 21 12:10 PM

[klarsolo:]

How about we don't come up with new plans every other day, abrogate older plans at whim and instead follow through with one consistent strategy? Wouldn't that maybe be of some help in times of extreme uncertainty? We've already committed all these billions. Backing out and changing everything will not do us any good.

Mar 21 08:08 PM

[biomedlives:]

Let's remember that the capitalists running AIG, BofA, Citicorp, WaMu, Bear Stearns,... have been lousy stewards of capital of late.


On Mar 21 12:26 AM Alexander_M wrote:

> tshk,
>
> *dripping sarcasm*
> Great response. The GRUBvernment is a great steward of capital.
> That statment is quite reassuring when you consider how "profitable"
> all the other institutions that they take over are. Look at Fannie
> and Freddie, models that the Free Market should all look up to.
> If only my company could burn through capital the way those morons
> do... it would be the model for all communist corporations to follow.
>
>
> Long live Stalin!
>

Mar 21 10:31 PM

[chleoku:]

Well I do not believe in bail-out, both AIG and GM. Without a real gut-wrenching fix to the company from top to bottom, from management to contracts, there is no getting to the bottom of this mess:

www.wealthalchemist.co...

Mar 21 11:26 PM

[helplessobs...:]

The bonus issue has stirred up the taxpayer and from now on he cannot be ignored when spending issues come up. The AIG Holding Company is toast and will be in bankruptcy court by year's end and the taxpayers will be then seeking more blood. Someone has to pay for all this trouble - I for one can see the beginnings with the threats on AIG employees, good and bad.

Mar 22 12:21 AM

[User 380632:]

The best way to bring AIG is allowing Hank Greenberg back at AIG. He is passionate and not from Harvard. Hank's ability to create wealth makes him an American Hero and his vision is what this company needs. Hank kept risk control within means of AIG and didn't ran AIG like a Hedgefund. Currently, politicians with no motivation and lack of ideas are running this countries finances like a circus, with no one in charge. Let us keep Investments and banks seperate with proper anti trust laws and risk control. In the mean time Treasury should settle those swaps with counterparties without busting our country.

Mar 22 09:22 AM

[reality chk:]

GM got $13B in federal loan money attached to a book of terms and conditions, in order to satisfy the Senate circus masters Shelby , Corker and the likes. GM has benn implementing everything the government asked for and more on their own. AIG on the other hand does not beleive in compliance with the terms and conditions even if they are non existant. Basicaly AIG to this point has been given a free ride, Why? Because no-one in congress understands what AIG and the rest of the financial intitutions do. But havin driven a car , well ! that make them all experts on the auto industry.


On Mar 21 11:26 PM chleoku wrote:

> Well I do not believe in bail-out, both AIG and GM. Without a real
> gut-wrenching fix to the company from top to bottom, from management
> to contracts, there is no getting to the bottom of this mess:
>
> www.wealthalchemist.co...
>

Mar 22 12:14 PM

[morning reader:]

Bail outs are outrageous, but the money is not a gift. Instead of coming up new ways to seize companies, we should follow through and support one strategy. aig posses too much systematic risk.

Mar 22 01:44 PM

[William Cowie:]

From what I've seen, AIG's counterparties are spread pretty far and wide. If AIG failed, it sounds like many institutions will suffer losses, but not more than a handful of those losses would be fatal. It also sounds like Paulson (ex-Goldman Sachs) made sure GS got its money first.

OK, now that the Golden Sacks have been replenished, can we please get on with shutting AIG down? Let the other mystery counterparties take their losses and move on. Uncle Sam wasn't their counterparty, AIG was. AIG failed. That should be their loss, not ours. The world will not come to an end.

Mar 22 04:06 PM

[CPST1:]

The Bonus:

A) Should we save the company? (forfiet bonus)

B) Should we take what isn't our to begin with and therefore alienate the company, its customers, and the public at large?

Mar 22 07:03 PM

[Deumlaokeng:]

Finally someone is taking note that the bailout of AIG is not aimed at AIG but to third parties, most specifically European banks who were stupid enough to buy the crap credit default swaps. I think the concept of dealing with these third parties directly to save those who might be worth saving is the correct direction. We need to let AIG fall now and not a moment later.

AIG is, apart from its financial gambling division, simply an insurance company. I would imagine that its customers could find insurance elsewhere. I've certainly had my business insurance company cancel on me and tell me to take a hike, and I have done the same when I found similar business insurance for half the price. The worse that can happen to most of AIG's customers would be to lose some value in their current insurance premiums. And the government might want to temporarily back up some casualty claims up to a limit, akin to FDIC insurance. But all the insurance companies use pretty much the same statistics, the same actuarial data, so some other insurance company should be able to offer up similar insurance at similar prices to those of AIG. In fact, I can't think of many things in the business world that are more easily replaced then insurance. Sure it is a pain in the derriere to shop for insurance, but it is not difficult. Alas, if only the insurance was the problem instead of the debts to the wealthy and powerful who control the strings of our puppets in government.

Mar 22 08:33 PM

[long roh:]

Many are assuming that the payments to counterparties are dead losses. That may be true to a certain extent. However, CDS and other derivative instruments (like liquidity puts) *sometimes* provide for the exchange of the security for its face value in the event of certain defaults. Thus, the payouts to other banks may not have been simply cash settlement, and it could be that AIG now holds the distressed securities that were insured. If that is the case, the government might eventually see some return on those securities and recoup some of the bailout funds. To let AIG fail now would mean the government would unload those securities, which would be counterproductive. It would also mean kissing the prior bailout money goodbye. That's the real issue. So, yes, the systemic risk of AIG might now be surmountable, but for the government to wash its hands of the mess at this point would mean writing-off the prior bailout funds completely, and banks would still need more capital because an AIG bankruptcy dumped a bunch of illiquid securities on the market, forcing further write-downs.

The silver lining is that the U.S. dollar is still the world's reserve currency and we own the printing press.

Mar 25 01:43 PM