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AIG - The Fall of a Giant (Part 2)

|Includes: American International Group Inc (AIG)

Note: I just submitted the Part 1 of my post on AIG. This is a continuation and was also published back in April 2009 on my personal blog at streetsharp.com.


This is a continuation of my previous post on AIG.

I do not share the opinion that AIG is too big to fail. AIG seems to be super-confident that the government will save them and keep giving them more money no matter what. They know they can get away with anything and that thought itself poses grave danger to the economy and tax-payers. The government needs to stop giving money to AIG and come up with a better plan. Washington needs to stop clamoring about the $165 million in bonuses and start worrying about the more severe risks associated with AIG. Debating and arguing over these bonuses at such a critical time is utter nonsense and a prodigious waste of time given the fact that Washington is very much responsible for the mess that AIG has created. The regulators just turned their face the other way when AIG exploited loopholes in the system to mint billions in credit-derivatives. I guess, for AIG it was worth it to spend millions in lobbying since no one questioned them as to why they were running an insurance company like a hedge fund. Ben Bernanke also couldn’t hide his frustration in a recent speech. “If there is a single episode that has made me more angry, I can’t think of one other than AIG. AIG exploited a huge gap in the regulatory system, there was no oversight of the financial products division, this was a hedge fund basically that was attached to a large and stable insurance company.”

The government has already given AIG $170 billion and this might not be enough. AIG could very well have over a trillion dollars lost in insuring toxic assets. How much more burden on the tax-payers can the government afford? Add to it the fact that AIG is not the only institution that needs bailout money from US government. One cannot ignore the risk of hyperinflation with trillions of dollars in debt and incessant printing of money. The last thing we want is that we go from one economic turmoil to another.

It’s important to note here that the traditional insurance business of AIG is still stable and profitable. So are some of their other units. The main culprit here is AIG’s Financial Products (AIG FP) division which single-handedly brought the entire organization to it’s knees. So why can’t AIG be split-up thereby separating the FP division? That way, at least the regular insurance business can be handled by more competent organizations. AIG also has other lines of businesses including aircraft leasing, international life/casualty/property insurance etc. which can be split and sold off. The government can then plan the restructuring of AIG’s FP unit.

But the best option for AIG is Chapter 11. AIG’s bankruptcy can help the tax-payers and the economy in the long run. My main issue with government’s current plan is that no one knows how much more money AIG might need to write-off all the losses. It could be another $170 billion or more. How does the government intend to justify that? AIG is not worth the money being poured into it under the excuse of ‘it needs to be bailed out because it’s too big to fail.”  It’s also very important to know what happened to the $170 billion that the government has already given to AIG. As I had mentioned in my previous post, several institutions and hedge funds bought CDS from AIG to hedge (protect/insure) their investment in collateralized debt obligations (complex derivatives based on subprime mortgages). When the housing bubble burst, the CDOs started becoming worthless and as a result AIG had to make huge payments to these institutions. AIG soon ran out of money but we had barely seen the tip of the iceberg as far as toxic assets were concerned. AIG still owed several billions but there was no money left. This is when the government intervened and saved AIG by giving them $170 billion in less than a year. A substantial part of this $170 billion went to the CDS counterparties. In this case the counterparties were the big institutions who invested heavily in mortgage-backed securities and bought insurance against that investment from AIG. Any guesses as to who those counterparties were? Goldman Sachs, Merrill Lynch, Bank of America, JP Morgan, Citigroup and even foreign institutions like UBS,  Societe Generale, Deutsche Bank etc – they all got a chunk of the bailout money. There are several problems with this entire setup:

1. These counterparties were paid in full. There were no negotiations. In these tough times, when everyone including common folks out there are taking huge losses, why were these institutions allowed to take 100% repayment?

2. Several foreign banks are AIG counterparties and they were paid in full as well. In fact Societe Generale (France) and Deutsche Bank (Germany) received the highest payout from AIG – $12 billion each. The tax-payers money is used to bailout AIG and that money is than passed on to foreign banks.

3. Many US banks have already received several billions directly from the government in the form of bailout money. In addition to that they are now getting full payouts from AIG (also government bailout money).

4. Goldman had come out and said several times that it had no material exposure to AIG and it still received one of the largest payouts from AIG.

Putting all these issues aside, our elected representatives are discussing the $165 million in AIG bonuses.  Just for the record, $165 million is 0.1% of what has already been given to AIG in bailout. The worse part is that AIG troubles are far from over. I am sorry but I refuse to accept this as a solution to save the economy from another ‘great depression’. These big financial institutions are receiving bailout money directly from the government as well as through AIG and all this for the ridiculous investment decisions they made with no sense of risk management. Systemic risk is not going to just evaporate if the fundamental problem is not solved.

Let AIG go bankrupt. Let these big institutions who bought CDS try and figure out how to save themselves without the help of government money. Let the governments of foreign banks handle their own problems. These big banks and their governments have enough money to survive – they don’t need US taxpayer’s money. The economy will have a temporary setback but in the long run USA will be saved. Creating trillions of dollars of debt will eventually break this economy and then it would be too late to realize that saving AIG and its counterparties was a big mistake. The US government can let AIG file for Chapter 11 and still leave options open for the counterparties to receive government aid if needed albeit with stricter regulations and tougher negotiations (unlike the recent 100 cents on the dollar fiasco). But there is no need to let these banks get money from the government as well as through AIG (which is also coming from the government). After AIG’s bankruptcy, the banks can be subjected to thorough stress test and depending on how well they have managed the crisis, the government can negotiate further bailout terms as needed. Also, the regular insurance policyholders shouldn’t have to worry since their policies would be backed by the insurance subsidiaries’ reserves and state insurance funds.

I understand it’s all easier said than done but we need an alternative plan and we need it right away. The current plan is just not working and all it might be doing is prolonging the inevitable economic collapse.