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Tuesday, September 16, 2008


Should the government help 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 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 and Freddie Mac. 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."

Update: From Dealbook:

The prospects of a private market solution to the deterioration of the American International Group appeared to be faltering on Tuesday, as talks involving the Federal Reserve and several banks turned to the possibility of using government money to shore up the ailing insurance giant, people briefed on the negotiations said Tuesday morning.

Fed officials were still meeting with A.I.G., JPMorgan Chase, Goldman Sachs, Morgan Stanley and others at the Federal Reserve Bank of New York Tuesday morning to discuss possible options. It isn’t clear that any solution, including one involving government money, will emerge, this person said.

If a financing solution is not reached, A.I.G. may file for bankruptcy as soon as Wednesday...

    Posted by on Tuesday, September 16, 2008 at 02:07 AM in Economics, Financial System, Monetary Policy, Regulation | Permalink  TrackBack (0)  Comments (109)


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