The AIG Rescue: Can Bailout Capitalism Work?

| About: American International (AIG)

So much for the end of the Moral Hazard, according to preliminary reports the Fed is going to rescue AIG (NYSE:AIG) with a $85 Billion loan. 

From the WSJ:

The U.S. government announced an emergency rescue of American International Group Inc. -- one of the world's biggest insurers -- signaling the intensity of its concerns about the danger a collapse could pose to the financial system.

It's a dramatic turnabout for the federal government, which has strongly resisted overtures from AIG for an emergency loan or some intervention that would prevent the insurer from falling into bankruptcy.

Just last weekend, the government effectively pulled the plug on Lehman Brothers Holdings Inc., allowing the big investment bank to fail instead of giving it financial support.

The precise details of the government's plans were still being formulated late Tuesday. The primary option being hammered out involved the Fed providing AIG with a short-term "bridge" loan of $85 billion, according to people familiar with the situation. In exchange, the government would receive warrants in AIG representing the right to buy its stock, under certain conditions. That could put the government in a position to potentially control a private insurer, a historic move, particularly considering that AIG isn't directly regulated by the federal government.

The moves capped a day of high drama in Washington. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke convened in the early evening an unexpected meeting of top congressional leaders, including Sen. Harry Reid of Nevada, the majority leader, top members of the Senate Banking Committee and leaders, too, from the House.

Sen. Richard Shelby of Alabama said he didn't receive a "satisfactory" answer from Mr. Paulson in an early conversation about the ultimate scope of government intervention. "I laid out -- where do you stop? Where do you draw the line?"

The Federal Reserve appeared to be motivated in part by worries that Wall Street's financial crisis could begin to spill over into seemingly safe investments held by small investors, such as money-market funds that invest in AIG debt.

Indeed, on Tuesday the $62 billion Primary Fund from the Reserve, a New York money-market firm, said it "broke the buck" -- that is, its net asset value fell below the $1-a-share level that funds like this must maintain. Breaking the buck is an extremely rare occurrence. The fund was pinched by investments in bonds issued by now collapsing Lehman Brothers.

Money-market funds are supposed to be among the safest investments available. No fund in the $3.6 trillion money-market industry has lost money since 1994, when Orange County, Calif., went bankrupt. A number of money-market funds own securities issued by AIG. The firm is also a big insurer of some money-market instruments.

AIG's financial crisis intensified Monday night when its credit rating was downgraded, forcing it to post $14.5 billion in collateral. The insurer has far more than that in assets that it could sell, but it could not get the cash quickly enough to satisfy the collateral demands. That explains the interest in obtaining a bridge loan to carry it through. AIG's board approved the rescue Tuesday night.

As. Mr. Selby asked, where will the government "draw the line"?

Is the government planning on backstopping the entire economy in order to prevent a recession?

How far is the government willing to go with respect to the degree of their overall involvement (financial resources, governance and oversight, etc) with troubled companies? How far is the government planning on going with respect to getting into the "risk mitigation" business, in terms of constantly stepping into rescue Corporate America from its own incompetence? How far is the government willing to go in order to protect the economy from risk (or capitalism depending on your interpretation), in order to create a faux economy where nothing bad ever happens?

When it comes to the questions posed above, your guess is as good as mine.

The only "line" we know much about (at this point) is the one that defines who the government will help, and that line seems to be drawn in terms of how entrenched a particular company is into the larger economy. Because the bailouts/rescue/back-stops of Bear Stearns (NYSE:BSC), the Mortgage GSEs and now AIG (AIG) seemed to have been motivated more by the desire to protect their bond-holders, derivative holders, etc, etc, from facing significant financial risk (if not failing themselves) then it was about saving the companies receiving bailouts.

Of course, this scenario is arguably worse than a bailout (in of itself) as you're not only bailing out a bad company, you're also backstopping the risk of those who invested in an insolvent company/allowed themselves to get overexposed to same. Think about it: AIG will have to pay back the loan in order to free itself of partial government ownership, whilst the bond holders will simply get to enjoy the backstopping of their risk without having to pay the government one red cent for the privilege.

Doesn't that smell fishy to you? At the very least, anyone who holds AIG bonds, derivatives, et al, should be forced to surrender some of their gains to the government in exchange for the government protecting their investment.

Furthermore, if the government is going to engage in these sorts of activities more thought needs to be given towards how to funnel some of the financial benefits (assuming any exist) from these interventionists machinations back to the tax payers (special refunds, etc). It's absurd that the taxpayer provides the cash to rescue these malaise ridden companies, protect bond holders, etc, but isn't even in line to receive any of the benefits.

It's also not a bad idea to force bailed out companies to provide some sort of free or discounted service to low income Americans either.  Just think about it: we have millions of Americans in need of health insurance, whose tax dollars were just used to bailout an insurance company.

Yes, I know AIG doesn't provide primary care insurance products, only supplemental and accidental injury ones, however the irony of uninsured taxpayers funding the bailout of an insurance company is highly disturbing to say the least.

Final Thought: American economic policy appears to be evolving to a place where we allow the financial sector to run amuck via minimal restrictions, and the Government is the ultimate parachute that removes risk from the equation. How can our economy survive if this is the way things are going to be on a go-forward basis?

I'm not so much questioning the government's rescue of AIG as I am the policies that got us to this point, policies that I don't see the government making any move to fix. Without a marked change to the way we regulate the financial sector, manage the economy, etc, we're just going to keep winding up back in these situations.

I.e. "minimal regulation/bailout capitalism" isn't exactly a sustainable economic model.

You can read the entire article from the WSJ here.

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The WSJ: "U.S. Plans Rescue of AIG to Halt Crisis; Central Banks Inject Cash as Credit Dries Up" -- Matthew Karnitsching, Deborah Solomon and Liam Piven, September 16, 2008.

Disclosure: The author doesn't own a position in any of the companies mentioned in this article.

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