ATLANTA— The AIG bailout is a colossal, short-sited mistake! Radical position- I know. Many are saying this move staved off the collapse of the US economy and the start of a new Great Depression. But I think there are some big reasons to be worried about it. I’d love to hear your thoughts. Here are my four BIG reasons I think history will not look favorably on this decision.
1) It envokes the moral hazard of insuring market risk- meaning that highly risky market players are shielded from the financial ruin their decisions may cause. US taxpayers are put on the hook. This could spur continued, excessive risk taking in financial and other industries, if players believe the government will always bail them out.
2) There is now no clarity as to who gets bailed out and who does not. Why was Bear Stearns helped while Lehman was left to fail? Why now is AIG helped? There is confusion on Wall Street as to who gets help. The decisions are made by the government as much by fear as anything else. This exacerbates market anxiety. Instead, if the government let these players seek bankruptcy protection and allowed the markets to absorb the fallout, then markets would have long-term incentives to tighten their operational controls around risk management, thereby making them stronger going forward.
3) The more the government gets involved, the greater the cries for market regulation become. I agree- if I am one day going to be taxed more to fund all of this mess, then by all means regulate these guys! But more regulation will stifle capital markets and hamper economic growth. Let the markets handle their own mess- the markets can overcome this. It would be messy in the short-term, but would lead to stronger markets in the long-term. We cannot get lost in the fog of this crisis, as many on the political left are wanting to do. Over the long-term, lighter, more efficient regulation is what will help us remain a leading economy in the 21st century.
4) This move further hammers the Federal Reserve balance sheet, heightening the risk that the Fed itself could be hindered in its role as “lender of last resort.” Should the Federal Reserve begin to fail in that role, we will most certainly enter a Great Depression as panic would reign in the financial world. The Federal Reserve should take a less meddlesome approach in the markets. This will ensure they are not exposing themselves to too much unnecessary risk for which the American taxpayer would ultimately bear the burden.
The significance of American International Group, Inc. (AIG) to the markets is that AIG provides “insurance” to financial institutions to mitigate their exposure to the credit risk of certain mortgage-backed securities. This “insurance” is a type of financial derivative instrument called a credit-default swap. Note that it does not represent true “insurance” from a regulatory standpoint, but it acts as a type of insurance. Bloomberg reports, “Wall Street’s top firms, and the biggest companies in Europe and Asia, have bought protection on $441 billion of fixed-income assets from AIG.” The recent crisis at AIG has arisen because AIG bet heavily on the subprime mortgage market, selling massive amounts of credit-default swaps related to these securities. As we all know, mortgage-backed securities involving subprime loans have been failing and losing their value at record levels in the current environment. Accordingly, AIG is repeatedly having to make pay-outs under the settlement terms of their credit-default swaps. Further, AIG has had to take significant write-downs on the values of credit-default instruments that remain outstanding. For this reason, the Company has piled up $18.5 billion in losses in three quarters this year. It must be noted, however, that under the technicalities of relevant accounting rules, many of these losses are “paper” losses and do not represent true cash outlays by AIG during the period. True cash flow losses are less, totaling between $5 - $8 billion, according to some reports (which is still significant!).
Nonetheless, the bailout became urgent because Standard and Poor’s cut AIG’s credit rating on September 16th. This forced AIG to raise $25 billion in capital in a short period of time under liquidity terms of their credit-default swaps. It also forced them to pay higher interest charges on their obligations. Simultaneously, they were at risk of making more and more payouts on their swap instruments. Some suggest that had this been allowed to linger another week or more, AIG may have had to raise as much as $250 billion in capital. AIG entered a liquidity crisis and therefore the Federal Reserve moved in to bail them out. The government financed them with a staggering $85 billion in return for controlling interest in the Company- an unprecedented manuever in US financial history. (As an interesting frame of reference for past government liquidity bailouts, the IMF funded the entire country of South Korea $55 billion to prevent them from defaulting on certain obligations during the late 90′s Asian financial contagion).
The thinking at the Federal Reserve and the US Treasury went that if AIG failed, AIG could no longer provide a backstop against the write-down and failure of mortgage securities. Banking institutions and other entities across America and across the world hold credit-default swaps and other insurance provided by AIG. This would drive down the values of securities backed by AIG. Under mark-to-market accounting rules, these banks would be forced to take further asset write-downs on their balance sheets. Under bank liquidity rules, steadily declining paper asset values would force banks to raise more capital to offset their deposits and liabilities. Market capital is already constrained, meaning many would not be able to raise it. AIG’s failure could precipitate massive bank failures throughout the United States and Europe. Those banks that could raise capital would do so by selling securities (further driving down market prices and paper values), paying higher interest rates to attract depositors, and charging higher interest rates to customers to fund interest payments and tighten lending. This could cause a spiral of chaos. This would also keep long-term interest rates high, resulting in pricier mortgage products and risking further prolonging the current US housing crisis (which is at the core of all these troubles). The Federal Reserve and US Treasury determined they did not want to take this risk.
Considering all of the above, I have to admit that it seems pragmatic for the government to bail AIG out- given their pervasive influence in the market. If I were the Federal Reserve Chairman or the Treasury Secretary, I confess I would probably have given AIG the bailout. Having the resources of the US government at my disposal, I would not want to be blamed for inaction in the face of the near-term chaos AIG’s failure would likely have caused. But as a sober third-party observer, I worry that this AIG bailout was a mistake. While it would have been rocky, the AIG collapse instead should have been allowed to play out in the international markets- with the fallout and risks spread throughout the system. For the four reasons I gave above, I think this would have been better in the long-term for the US capital markets.
What are your thoughts? Am I crazy?
TennesseePaul
Stephen VanNuys
Brooklyn Daniel
The Freedom Thinker
The market is going for its second straight day of 400+ point gains. It would appear that the bail out isn’t entirely a bad idea. Global markets are soaring as well. Of course this could just be short term enthusiasm before a long term financial meltdown cripples the entire country. It’s a tough call to make.
If this were the ER and the financial markets were the patient, shouldn’t the Fed try and stop the bleeding?
Or it could be exactly as follows:
I made a poor investment. I didn’t get out of said investment when it was at its peak. I now face tremendous downside because the Company was poorly run (i.e. inappropriately charging insufficient premiums on credit default swaps/other risk management vehicles). Oh crap, it looks like the Company is truly going down the crapper. Wait, here comes my buddy Ben and my buddy Hank. Management no longer has to have its feet held to the fire for making bad decisions. Yay, I have been rescued and I can continue to act without regard for the risk that exists in the market. In fact, I can take on more risk, because what the hey. The US government is going to throw more money at it. Furthermore, they are going to reallocate capital away from industries that are viable and direct it to areas which have been determined to be nonviable by default rather than letting the market determine the flow of capital.
AIG bet that it could cover its risks in underwriting these loans. It lost. It should implode. I mean, for god’s sake, why is a business not held accountable yet everyone clamors about individuals own personal accountability in taking out loans they can’t afford?
This seems totally contrary to the same positions we would take on individuals personal decisions (i.e. premarital sex as a youth and having an abortion). If you are making the decision you have to bear the risk. Can’t pick and choose the situations in my eyes.
BaldManMoody: “I made a poor investment. I didn’t get out of said investment when it was at its peak.”
Perhaps you did get out of it at its peak. But “getting out of it” only entails passing the buck to some one else.
I agree that these companies should take the blunt hit. The loans shouldn’t have been made in the first place. I’ve heard some speak of this 1970′s regulatory law which strenuously encouraged lenders to lend to non-qualified persons. Couple that legal pressure with the free money of five years ago and you get a ton of bad loans.
This whole thing is a mess. People saw dollar signs and ignored the warning signs all the way up and down this chain. From those who borrowed beyond their means to those who foolishly lent to the unqualified people.
But at the same time, as an officer of the law do you leave the kids to the wolves if they walk into a bad neighborhood saying they should own up to their mistake?
The whole thing is a mess. I don’t think this spells the end of free market ideals. But I do think it underscores a need for balance between complete deregulation and total over regulation.
Of course, if you did “get out at its peak” in this environment you’d be blasted by the politicians and Mr. Biden would be telling you that it is your patriotic duty to pay 95% of your income in taxes under threat of imprisonment. It’s a new form of Patriotism in America. I think Biden picked it up after all those years on the Foreign Policy commission. “Hey, it worked in the USSR, North Korea, Cuba, North Vietnam, Venezuela and during the Ottoman Empire (boy I miss those days), I think America is ready for it now.”
BaldManMoody,
It’s great to see a good old blue-blooded, blue state liberal chiming in here. Good for you!
I’m with you, Go Obama!
How to give it to that TennesseePaul!
LordWakefield: Thanks for reading and commenting! What ever you’re going to give me I like it served with some Arby’s sauce and an Oreo
Regarding your use of the word “Government” do you mean Bush Administration? Must be a difficult reality for a Conservative Republican, no?
LordWakefield: Not sure what you mean. That might be a question for VanNuys as I didn’t write this article and I’m not a Republican. Perhaps he will see it when he gets back online.
How about we substitute “Conservative” for “Conservative Republican” would that make it easier for you TP?
Just for fun who did you not vote for in 2000 and 2004?
You’re submitted five of the eight posts here and to my knowledge are the only person connected with this site commenting, why stop now?
Oh and let’s stay on point and answer direct questions too, ok?
Correction:
“…who did you vote for in 2000 and 2004?”
Everyone: thanks for the commentary. I’ll try to make an efficient response.
LordWakefield: I may be misreading, but Bald Man is agreeing with me. We think the free markets should stand alone in this.
Also, by government I do mean the Bush Administration. Bush has definitely not been a perfect conservative. He signed the knee-jerk Sarbanes-Oxley Act, the No Child Left Behind Act (expanding the federal role in education), new and unfunded Medicare entitlements, massive increases in government spending, etc. etc. No- in this regard, I’m not in favor of things Bush has done. But for these same reasons, you can rest assured I’m not an Obama supporter. I’ll be posting more on that soon.
TP: I don’t dispute that this helped in the short-term. It’s the long-term view that I’m trying to take. What precedents are being set. How will this influence the behaviors of market players over the upcoming several years (both businesses and the government). The economy is global now. No one player or country controls it. I argue that’s the case of the US economy- the US government’s ability to “control” it is increasingly limited, the further globalization expands. There is a popular misconception to the contrary about this (particularly among blue state liberals). Because of this reality, we have to constantly be assessing how to keep the US economy competitive in that environment. Keeping the costs of excessive regulation out of it is one big way. Avoiding creating an environment where market players take on excessive risk at the expense of the US taxpayer is another.
LordWakefield: “Who did I vote for?”
How about we stay on point here? Isn’t this article about AIG and corporate bailouts?
I would speculate you voted for Kerry. He used the same tactic in his 2004 campaign:
Your off topic question also seems to imply a misconception. If a man votes for a particular candidate he must therefore jealously support that candidates every move and word.
If, after any particular candidate is elected into office, an appauling action is committed by that candidate, those who originally supported him can still be appauled and disapprove of his actions.
Typically an appauling action is an action which runs counter to his campaign and party platform and/or value system. In the case of George Bush this would be massive expansion of Government, Corporate Bailouts, Leagalized Torture and other issues.
I voted for Mr. Bush over Mr. Kerry, but that doesn’t mean I’m please that President Bush governed as I expected John Kerry would.
It’s at this juncture where I begin to agree with BaldManMoody as well as Larry Elder. The difference between a Republican and a Democrat? Maybe a dimes worth.
VanNuys: I know what you’re saying. I agree as well. Just thought I’d put some questions out there to get the conversation going.
Are you suggesting that the current corporate bailouts and the Bush Administration are not directly linked?
First off, you know nothing about me and “speculation” is obviously not your strong suit.
FYI, I have never in my voting lifetime cast a ballot for a Republican or Democrat for President and that voting lifetime goes back to Reagan. I must be truthful though this election is shaping up to be the exception, but with that being said it is far from a lock at this point.
One question though, are you going to vote for McCain even though Bush has sold you out right across the board? Remember McCain has promised to follow Bush’s lead regarding domestic and foreign policy.
Just a quick note, brevity is the habit of those who are both learned and confident, but that comes with age and wisdom.
LordWakefield: I don’t think anyone could reasonably say the corporate bailouts are not linked to the Bush Administration. He is in fact calling for them. So I guess the next question would be, how do you mean ‘linked’?
Well I wasn’t at all intending to go that route, but now that you mention it let’s start with massive deregulation, which of course there is a very recent history of, and that history provides a blueprint for very successful white collar crime (low risk, high reward)! Understand that it really started with Reagan and has run unabated ever since and right through the Clinton Administration! I mean Clinton signed NAFTA into existence and was a huge supporter of the WTO so he was just greasing the Reagan machine and man has he profited from it! Bush has not only done that but entered into a quagmire in the Middle East that has already outlasted and outspent (adjusted for inflation) WWII and guess who has profited the most and sacrificed the least?
I mean honestly Republicans, Conservatives and Conservative Republicans have over the last eight years destroyed this country, no?
Wakefield – you bring up a great point on regulation. (I’m paraphrasing a post I left on my other blog here). I’m going to blog about deregulation later this week (when I have time). As you might guess, I still favor light regulation. The questions for the pro-regulation lobby are- what does that regulation look like and how do you enforce it without further crippling our financial system? Come back and visit us later this week- would love your reactions. I think debate about regulation should be happening, b/c once this recent crisis passes (which it will, though not for a while), we still need to be positioning our economy to be competitive in the global economy. We cannot lose site of the big picture and make knee-jerk regulatory responses that put too many kinks and costs into the system with little benefit(as I believe occurred w/ the Sarbanes-Oxley Act, which increased regulation and was also passed by a Republican Congress). Other questions for the pro-regulation lobby include why did Fannie Mae and Freddie Mac fail when they had an entire government agency dedicated to regulating them? And why are the famously unregulated hedge funds coming through this crisis fairly cleanly, with few major failures?
Finally, I do not think it is a coincidence that lighter regulation starting with Reagan precipitated an unprecedented period of 25 years of largely stable economic growth with low inflation, etc. I think Clinton was wise to keep it going. I envision this recent crisis will embolden the re-regulation lobby, however. And accordingly I predict higher inflation and much more stagnant economic growth over the upcoming 5 – 7 years, until people return to their senses. : ) (I expect you to heavily disagree with this view).
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