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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 (NYSE: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.

Source: How We Could Let AIG Fail, Sort Of