What Should the Government Do About AIG?

Should the government help AIG (AIG)?

Should AIG be funded by the Fed?, by Willem Buiter: AIG, the largest US insurance company by assets, is reported to have asked the Fed for a $40bn ‘bridge loan’ to tide it over while it sells assets and attracts new equity. Unless such support is forthcoming, the company fears a downgrade by the rating agencies before it can shore up its capital base. Such a downgrade could further weaken its balance sheet, leading to a downward spiral and possible bankruptcy. While waiting for a Fed decision, AIG’s regulator, NY State Insurance Superintendent Eric Dinallo gave it special permission to access (i.e. to raid) $20 billion of capital in its subsidiaries to free up liquidity.

My first reaction to these stories was !*#\ӣ$%&?!!!

The activities of AIG that have got it into trouble are the provision of default insurance on mortgage-backed securities through a range of derivative contracts...

If an insurance company like AIG has become a highly leveraged financial institution deemed by the Fed to be too large, too interconnected or too politically connected to fail, and if it is as a result granted access to Federal Reserve resources..., then there has to be a regulatory quid-pro-quo. AIG is not a bank. It is not ... regulated at the Federal level at all. Insurance ... is regulated at the state level. So a financial institution that is large enough to cast a significant global shadow is regulated by some provincial official in New York State. ...

I hope the Fed will tell AIG to go away... But should the Fed decide that it is now responsible for all highly leveraged institutions it deems systemically important, then significant regulatory authority and oversight of the Fed over AIG should be (part of) the price.

The bridging loan should also be priced punitively and be secured against the best assets in the AIG group. The regulatory regime should involve serious capital requirements, liquidity requirements, reporting and governance requirements as well as the creation of a special resolution regime for AIG should it, in the view of the regulator (the Fed), be at risk of failing. ...

But before any money is lent by the Fed to AIG, even on the conditions outlined above, I would like to have the social cost-benefit analysis of this proposed transaction explained to me. Where is the market failure? Where are the systemic externalities associated with requiring AIG to sink or swim on its own? If the Fed were to provide funding to AIG, then, unless a convincing public interest/social welfare case is made (and I have not seen a single sensible argument in support of such an act), I would have to conclude that the political economy of the US had become one of crony capitalism and socialism for the rich and the well-connected.

Another view:

Wall Street’s Next Big Problem, by Michael Lewitt, Commentary, NY Times: ...When Lehman Brothers (LEH) filed for bankruptcy on Monday, it became the latest but surely not the last victim of the subprime mortgage collapse. ...

But there is a bigger potential failure lurking: the American International Group, the insurance giant. It poses a much larger threat to the financial system than Lehman Brothers ever did because it plays an integral role in several key markets: credit derivatives, mortgages, corporate loans and hedge funds.

Late Monday, A.I.G. was downgraded by the major credit rating agencies (which inexplicably still retain an enormous amount of power ... despite having gutted their credibility with unreliable ratings for mortgage-backed securities during the housing boom). This credit downgrade could require A.I.G. to post billions of dollars of additional collateral for its mortgage derivative contracts.

Fat chance. That’s collateral A.I.G. does not have. There is therefore a substantial possibility that A.I.G. will be unable to meet its obligations and be forced into liquidation. ... Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression.

A.I.G. does business with virtually every financial institution in the world. Most important, it is a central player in the unregulated, Brobdingnagian credit default swap market that is reported to be at least $60 trillion in size. ...

If A.I.G. collapsed, its hundreds of billions of dollars of mortgage-related assets would be added to those being sold by other financial institutions. This would just depress values further. The counterparties around the world to A.I.G.’s credit default swaps may be unable to collect on their trades. ... More failures, particularly of hedge funds, could follow.

Regulators knew that if Lehman went down, the world wouldn’t end. But Wall Street isn’t remotely prepared for the inestimable damage the financial system would suffer if A.I.G. collapsed.

While Gov. David A. Paterson of New York ... allowed A.I.G. to borrow $20 billion from its subsidiaries, that move will only postpone the day of reckoning. The Federal Reserve was also trying to arrange at least $70 billion in loans from investment banks, but it’s hard to see how Wall Street could come up with that much money.

More promisingly, A.I.G. asked the Federal Reserve for a bridge loan. True, there is no precedent for the central bank to extend assistance to an insurance company. But these are unprecedented times, and the Federal Reserve should provide A.I.G. with some form of financial support while the company liquidates its mortgage-related assets in an orderly manner.

The Fed cannot afford to stand on principle. The myth of free markets ended with the takeover of Fannie Mae (FNM) and Freddie Mac (FRE). Actually, it ended with their creation.

I agree with Willem Buiter that it would be best if we understood the market failures or the systemic externalities associated with the failure of AIG, that would allow us to better determine the appropriate course of action. But one thing to learn from this crisis is that financial markets are sufficiently interconnected and sufficiently complex so as to make it difficult to fully understand the risk we face with any action (or inaction). It's like trying to evaluate one of those opaque, sliced and diced, repackaged derivative securities we've heard so much about, nobody knows for sure how much risk is associated with the failure of AIG.

In that environment, and realizing that all past calls that the unfolding crisis would be contained -- that the crisis would not spread and endanger the broader economy -- have been wrong even with spreading walls of containment, my inclination is to play it safe. Unless we are very certain that telling AIG to "go away" will not endanger the overall economy, then protect jobs and the economy first and foremost by ensuring, minimally, that an orderly liquidation occurs. But Willem Buiter's right about the follow-up to any action, any help needs to be followed by "a regulatory quid-pro-quo."

Disclosure: None

Comments

[Philly Jim:]

Two of the biggest drains on the U.S. GDP - Welfare, Prisons. ...The benign element must be controlled before spreading further and destroying the whole. This money could be used to help businesses and invest in research and development and keep the U.S. ahead of the curve. Subprime.

2008 Sep 16 09:06 AM

[Jason Rines...:]

We all know what will happen here. Digital credits will be created and the taxpayer will foot the bill for all of this. Such action delays the inevitable and extends the pain for 300 million Americans whom will not run the treadmill forever of just existing to keep warm or buy Ramen noodles. It will be a depression and the house of cards will fall anyways. The Fed doesn't need a regulator it needs to be abolished. This Congress and the Administration are both responsible. America will be brighter when this all simply collapses, we face our six months of anarchy and remove the political apparatus that has become Fascist state rather then a true Republic. Some will flame me or think me mad, I am not. I called chance of recession 100% in June of 2007 along with a 50% chance of recession by 2011. Now there is NOT a chance of depression happening, it is how bad will civil unrest be at a certain point in time and would the military fire on it's citizens. Very sad.

I have been tempted to leave America for almost a year and a half now, but I will not leave innocents for plunder and destruction. We shall share our fate together and perhaps someday after the next great war some peace. But if history is a guide, I know this will not be anytime soon, although I do believe we will see one more short period of a decent economy before major hostilities break out. This is what it means to be Christian for all those far left liberals who thought God was dead in the 1960's and today. You stand your ground and are willing to die on behalf of others. To the conclusion gentlemen, best of luck!

2008 Sep 16 12:08 PM

[Jason Rines...:]

I meant 50% chance of depression. Too passionately caught up in this and have been for a long, long time.

2008 Sep 16 12:09 PM

[JasonC:]

Go ahead, leave America, you don't belong here.

Meanwhile, back on planet earth, yes the Fed has to save AIG. It can employ cut outs in the form a bank consortium to save face it if wants to, but functionally that is the bottom line. The Fed isn't going to let a JP Morgan or the like fail, so if JPM borrows $75 billion at the discount window and hands it onward to AIG at a modest markup, the Fed is still committed to stopping or eating any resulting loss. The cut out is make believe for the silly screechers pandering to populist doom mongering and chaos. It is also irrelevant.

As for the fine question what the market failure was, at least four things to fix. One, the CDS and the rest of the swap market needs a clearing house to net out trades, instead of letting them accumulate for years as huge counterparty risks. With a regulator, I might add. Notice nothing like this happens with futures or options at the Chicago exchanges - because they have daily netting and clearing and cash settlement. So that is one, and it would address the main issue with AIG right now.

Second is the opacity of the MBS business, and the solution there is simple - simplicity. Only two forms allowed for MBSs, and all existing ones to be refinanced into them. Form one, a whole loan, simplest possible. Form two, a 20% equity and 80% senior split, with the equity entirely retained by the issuer and not available for resale. Also considered equity for risk purposes.

Third, the underlying driver was the inability or unwillingness of the banking system to price houses. Everyone pretended any price the market would pay was a sound price. Men are substituting rules of thumb about downpayments for actually appraising the property. No, appraising by comps in the area doesn't count, that is just measuring the height of the bubble to justify itself. It needs to be by value as a rental property, and at quite conservative financing and "cap rates".

Fourth, no one should ever lend to a known deadbeat, and anyone who doesn't pay their debts needs to be blackballed all the more vigorously and for longer. This all started with welshing, and with reckless lending to men who had already missed mortgage payments, on the theory that the collateral would be enough to make lenders whole. Unsound all the way down. "If I don't trust a man, he won't get a dime from me on all the bonds in Christendom", JP Morgan.

OK, one fifth and final. The Fed properly tightened to break the real estate bubble, but it was a year late doing so. Rates were left too low for too long, and it encouraged the go-go recklessness of the original real estate bubble, in the first place. If you don't like the bust, don't tolerate the boom. Because one follows the other inevitably.

That is all - and all for the future. For now, the system is not private and it is not public, it is a hybrid with different responsibilities in different places. Everyone needs to accept that as the reality, and tell the ideologues to put a sock in it. This is the country and the world we live in, and no we aren't going to change it top to bottom while it is on fire. We instead should operate it as designed.

That means the Fed acts as a lender of last resort, willing to lend freely if at a penalty rate. You don't starve a panic. The Treasury's decision over the weekend was a blunder, and we'd all be a lot better off if they admitted as much. But whether they do or not, future actions need to be practical, not ideological purity tests. Allocate the loss, and get it behind us.

This too shall pass...

2008 Sep 16 02:02 PM

[Reinko:]

Oh oh, when will the Americans understand their own financial system?

Lehman is gone and thus the CDS markets are stirred a bit (CDS are credit default swaps, it is just a small 62,000 billion or 62 trillion US$ market).

Have you guys & girls still never looked at this nice total derivative stuff from the Basel based Bank for International Settlements?

Here is the link:

www.bis.org/statistics...

Does it not clearly say that Dec 2007 total contracts is 596,004 billion US$ so since it is not Sept 2008 total contracts are well above 600 trillion?

As a comparison, the US gross domestic product is about 14 trillion a year. Anyone trying to understand the present 'credit crisis' problems must think twice: The USA banks hold the overwhelming stuff of this 600 trillion joke...

That explains why AIG suddenly needs 70 to 80 billion US$ in order to deal with a 'sudden' liquidity crisis.

Use your brain and not your ass to write articles!

2008 Sep 16 06:32 PM

[mdmrjsds:]

From the table at the link provided by Reinko above, it looks like the notional amount for CDS is in the 60 trillion dollar range, but the actual underlying amount from the right is in the 2 trillion dollar range. Or, stated another way, the notional amount includes contracts on the same underlying approximately 30 times. How much of that will actually go bad, or is bad? No estimate of that in the table, but let's say 10% is currently bad or at risk, 200 billion.

That doesn't seem to be unreasonable for the firms themselves to work out. Put AIG in bankruptcy, sell the going concern parts to highest bidder. Then let the CDSs unwind. And learn.

There is little systemic risk here. Just a bunch of investors and managers who don't want to pay for their folly and lack of understanding of what they were doing. They certainly didn't exhibit fiduciary responsibility.

Even if the fed intervenes, AIG should be dismantled and sold off. As should any other firms that have to be rescued by the fed. They have failed in their responsibility to their shareholders and society; let the institutional knowledge embodying that incompetence pass away and allow someone else to take the responsibility they couldn't handle. An object lesson for the future as well.

2008 Sep 16 07:36 PM

[against cor...:]

All right, I've had it! Everyone keeps talking about "the fed" and "the government" like it is some 3rd party. The government is US, it's you and me. It's our retirement, our future, our children's future, our current and future economy, belonging to "we the people of the United States of America" !

Why do "we the people" truly need to spend our hard earned dollars to bail out a company that has made poor decisions with its investments and risks? Since when did this become the job of "we the people"?

Yes, AIG has far reaching tendrils in economies around the world, however, each investor, each country, each individual, each business took a risk when they invested with this company and the investments they have made.

Is "the government" going to pay the individual investors who have lost money on our retirement accounts, our personal savings? No I don't think so. Investment in anything other than a bank involves risk.

If "we the people" continue to bail out corporations who make decisions to hedge themselves in risky and marginal areas we are on our way to a different kind of America. The kind of America where big business is rewarded for bad business decisions because their "tendrils" extend so far.

America needs to focus on bringing in industry and alternative energy and creating an economy that works for "the people" who live and work here in the United States.

The Constitution does not call for the bail out of "corporate entities" this is an outrage! This the absolute slap in the face to those of us who faithfully pay our taxes- to bail out an insurance company with MY MONEY - SHAME ON US, EVERY ONE OF US! We are "the fed" Let everyone know if you are as outraged as I am. This is not what my tax dollars are for!

2008 Sep 16 08:54 PM

[JasonC:]

"Why do "we the people" truly need to spend our hard earned dollars to bail out a company that has made poor decisions with its investments and risks?"

Simple, you will lose far more if you don't. The economy is not a zero sum game, and the government will lose far more in a general crash and panic than it every would in these targeted workouts.

Interventions to allow the banks to open Monday and Tuesday already cost central banks 10 times what a Lehman bailout would have cost. Saving AIG, no option, only way to save the previous mistake, will cost 3-4 times what it would have cost to liquidate Lehman in an orderly fashion instead. Listening to boneheaded populist ignorance like that you are displaying already cost them. Listening longer would cost another 10 times as much.

"Since when did this become the job of "we the people"?"

In 1913 the government deliberately took that role from major private bankers by legislation creating the Fed. The nation's representatives thought the way the 1907 panic had run wasn't exactly sound for the future - everyone's fortunes had ridden on the character and leadership of a single private banker named JP Morgan.

This responsibility redoubled in the 1930s during the depression, when all US bank deposits received federal deposit insurance. Which puts the treasury mediately "on the hook" in the event of general bank failure (the FDIC immediately).

Your hard earned dollars, my friend, are debts of the federal reserve, nothing else. And they don't exist if the banks don't open tomorrow morning. Once again, they do not *exist* - you have *no* money, at all, unless the banks open tomorrow morning.

The first 2 days of this week, the central banks had to add $320 billion in freshly created central bank credits to keep the banks open. It took $134 billion just to prevent complete chaos over the day's settlement of Lehman liabilities, which JP Morgan Chase had to conduct on behalf of the Fed. $78 billion of that was paid back by the close of business Tuesday.

These measures did not succeed in keeping the rate on fed funds at the Fed's desired target level of 2%. In fact it rose as high as 10% at times. Without intervention, there wouldn't be a banking system tomorrow morning. You know how much you'd own then? Bumpkis. Nada. "But I have specially hard assets, yada yada". Fine, eat them. If no one else has any dollars they aren't worth jack squat.

Grow up people. The world is not your little ideological fantasy and morality tale. You don't lose money when the financial system is kept alive and functioning. You need the financial system like you need oxygen. The utterly reckless attacks on finance and financiers will destroy you, personally, if you continue to indulge in them. Cut it out. Instantly. It isn't a game.

2008 Sep 16 09:39 PM

[ObjectiveFu...:]

Hmm, small world. "A certain amount of dogmatism and pigheadedness is necessary in science" ... and while hosing down the schadenfreude set on financial blogs. Nice work, Jason! I expect to see Paulson quoting you soon.

2008 Sep 17 12:28 AM

[Jason Rines...:]

Man Jason C, you are so openly hostile these last few days. I won't counter your immature comment that I should leave America. Choosing to stay and serve your country is an act of honor and sacrifice. Do you believe you'll fix America all alone with your rage?

Some of your ideas aren't half bad. So I recommend you offer your service to the American public and contact your Congressman/women and arrange a meeting. Then, consider running for Congress in 2012 to serve the American people. Until then, consider perhaps calming the rage buddy, it only clouds judgement and decision-making.


On Sep 16 02:02 PM JasonC wrote:

> Go ahead, leave America, you don't belong here.
>
> Meanwhile, back on planet earth, yes the Fed has to save AIG. It
> can employ cut outs in the form a bank consortium to save face it
> if wants to, but functionally that is the bottom line. The Fed isn't
> going to let a JP Morgan or the like fail, so if JPM borrows $75
> billion at the discount window and hands it onward to AIG at a modest
> markup, the Fed is still committed to stopping or eating any resulting
> loss. The cut out is make believe for the silly screechers pandering
> to populist doom mongering and chaos. It is also irrelevant.
>
> As for the fine question what the market failure was, at least four
> things to fix. One, the CDS and the rest of the swap market needs
> a clearing house to net out trades, instead of letting them accumulate
> for years as huge counterparty risks. With a regulator, I might add.
> Notice nothing like this happens with futures or options at the Chicago
> exchanges - because they have daily netting and clearing and cash
> settlement. So that is one, and it would address the main issue with
> AIG right now.
>
> Second is the opacity of the MBS business, and the solution there
> is simple - simplicity. Only two forms allowed for MBSs, and all
> existing ones to be refinanced into them. Form one, a whole loan,
> simplest possible. Form two, a 20% equity and 80% senior split, with
> the equity entirely retained by the issuer and not available for
> resale. Also considered equity for risk purposes.
>
> Third, the underlying driver was the inability or unwillingness of
> the banking system to price houses. Everyone pretended any price
> the market would pay was a sound price. Men are substituting rules
> of thumb about downpayments for actually appraising the property.
> No, appraising by comps in the area doesn't count, that is just measuring
> the height of the bubble to justify itself. It needs to be by value
> as a rental property, and at quite conservative financing and "cap
> rates".
>
> Fourth, no one should ever lend to a known deadbeat, and anyone who
> doesn't pay their debts needs to be blackballed all the more vigorously
> and for longer. This all started with welshing, and with reckless
> lending to men who had already missed mortgage payments, on the theory
> that the collateral would be enough to make lenders whole. Unsound
> all the way down. "If I don't trust a man, he won't get a dime from
> me on all the bonds in Christendom", JP Morgan.
>
> OK, one fifth and final. The Fed properly tightened to break the
> real estate bubble, but it was a year late doing so. Rates were left
> too low for too long, and it encouraged the go-go recklessness of
> the original real estate bubble, in the first place. If you don't
> like the bust, don't tolerate the boom. Because one follows the other
> inevitably.
>
> That is all - and all for the future. For now, the system is not
> private and it is not public, it is a hybrid with different responsibilities
> in different places. Everyone needs to accept that as the reality,
> and tell the ideologues to put a sock in it. This is the country
> and the world we live in, and no we aren't going to change it top
> to bottom while it is on fire. We instead should operate it as designed.
>
>
> That means the Fed acts as a lender of last resort, willing to lend
> freely if at a penalty rate. You don't starve a panic. The Treasury's
> decision over the weekend was a blunder, and we'd all be a lot better
> off if they admitted as much. But whether they do or not, future
> actions need to be practical, not ideological purity tests. Allocate
> the loss, and get it behind us.
>
> This too shall pass...

2008 Sep 17 11:09 AM

[Jason Rines...:]

I completely agree Against Corporate Welfare, but the cause has already occured and now we are seeing the damage that has been done as effect. You get the government you elect. When times are good but the top is stealing the wealth and leaving a dead rotting husk for the population, you vote to elect good leadership. Historically, when the pain and the check comes due to the American people (as this HAS happened before but probably not at this magnitude) voter revolution occurs. But I don't expect this until 2012. It historically takes about 4 years of immense pain to get voters to conduct research into whom the corrupt are in Washington and vote them out and I am really reffering to the House of Representatives which of course represents 'We the People'


On Sep 16 08:54 PM against corporate welfarenull wrote:

> All right, I've had it! Everyone keeps talking about "the fed" and
> "the government" like it is some 3rd party. The government is US,
> it's you and me. It's our retirement, our future, our children's
> future, our current and future economy, belonging to "we the people
> of the United States of America" !
>
> Why do "we the people" truly need to spend our hard earned dollars
> to bail out a company that has made poor decisions with its investments
> and risks? Since when did this become the job of "we the people"?
>
>
> Yes, AIG has far reaching tendrils in economies around the world,
> however, each investor, each country, each individual, each business
> took a risk when they invested with this company and the investments
> they have made.
>
> Is "the government" going to pay the individual investors who have
> lost money on our retirement accounts, our personal savings? No I
> don't think so. Investment in anything other than a bank involves
> risk.
>
> If "we the people" continue to bail out corporations who make decisions
> to hedge themselves in risky and marginal areas we are on our way
> to a different kind of America. The kind of America where big business
> is rewarded for bad business decisions because their "tendrils" extend
> so far.
>
> America needs to focus on bringing in industry and alternative energy
> and creating an economy that works for "the people" who live and
> work here in the United States.
>
> The Constitution does not call for the bail out of "corporate entities"
> this is an outrage! This the absolute slap in the face to those of
> us who faithfully pay our taxes- to bail out an insurance company
> with MY MONEY - SHAME ON US, EVERY ONE OF US! We are "the fed" Let
> everyone know if you are as outraged as I am. This is not what my
> tax dollars are for!

2008 Sep 17 11:16 AM