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Tuesday, March 17, 2009

AIG and the Case Against the Nationalization of Banks

The populist backlash against AIG continues as folks from every quarter (here is one of the few articles in favor of keeping them) coming out against these bailouts. It almost seems like a contest to see who is the most outraged. What seems outrageous to me though is that we have spent several days now hyper analyzing these bonuses while it's nothing more than after thought that the tax payers continue to fund a company with absolutely no plan for anything close to long term viability.

Whatever your view of these bonuses, they amount to about $165 million. That is peanuts compared to the nearly $200 billion that the tax payers have sunk into AIG. While we scream and express moral outrage for these bonuses, there is no outrage that this company is in business strictly to make sure that everyone they owe gets paid.

This is what happens when a company gets nationalized. It becomes a political entity not a business entity. Whatever your view of these bonuses, their ultimate outcome will have negligible effect on the company's continued viability. Yet, no one, NO ONE, can produce a plan to keep this company viable in the long run. This continues to be the case even though we have sunk nearly $200 billion into the company. Yet, there is absolutely no outrage that we have sunk hundreds of billions into a failing entity. There is, however, outrage that we have paid out hundreds of billions to incompetent and corrupt executives.

Yet, the president has pronounced that the Treasury Secretary has been charged to do everything he can to make sure that these bonuses aren't paid. He's even said that no more bailout money will be given if these bonuses are given. Think about that. We have dropped nearly $200 billion into the company even though it can't be viable. Yet, we will stop bailing them out if they pay out hundreds of millions in bonuses.

This is happening because the average tax payer doesn't really understand what is going on with AIG. They don't know how to make them viable. They do, however, understand when executives get bonuses even though the company was bailed out with tax payer money. Of course, fixing problems because of their political rather than economic nature is no way to run a business. It is, however, the future if more banks and financial institutions get nationalized. Each and everyone will go through something like this. We will get outraged over something morally reprehensible yet financially negligible. We will all do it because we don't really all understand high finance (apparently those that run AIG don't understand it either), but we will do it when bonuses are paid out.

Make no mistake. If all banks, or even more banks, are nationalized we will go through the same sort of politicization of business that has happened with AIG. The current controversy surrounding AIG is the best example we have not to nationalize any of them.


Anonymous said...

Compare and contrast outrage over AIG bonuses which make up a small portion of the bailout funds, with earmarks, which make up a small portion of the budget funds.

mike volpe said...

Both lead to great outrage however earmarks made up a much larger part of the budget. The fact is that earmarks were part of a larger problem of the budget being bloated.

Anonymous said...

Why are we giving AIG money?

They certainly deserved to fail. So why did we bail them out? Because of the systemic fragility of the CDS market,r -- it's basically the same reason why the government stepped in to prevent Bear Stearns from being forced into liquidation. It feared a cascade of counterparty failures which could kill the entire financial system.

Here's the fear: AIG goes bust, and can no longer make good on the promises it made when it said that it would pay out on a CDS contract in the event that a certain credit defaults. Default protection sold by AIG, in other words, becomes worthless. Now let's say you're a CDS desk at, say, JP Morgan. You're buying and selling default protection all the time, and so long as the amount you've bought, on any given credit, is equal to the amount you've sold, you reckon that you have no net exposure.

The minute that AIG fails, everybody else's net position alters substantially, and in a very unpredictable way. The protection that JP Morgan bought from AIG is worthless, while the offsetting protection that JP Morgan sold to some hedge fund remains outstanding. So JP Morgan now has a large position it never wanted.

Now there's a good chance that JP Morgan will have hedged its counterparty risk to AIG -- but that doesn't make the risk go away, it just shunts it elsewhere in the financial system. And the web of connections between the thousands of counterparties in the CDS market is so complex that no one really has a clue who would have ended up holding the multi-billion-dollar bag. All those AIG losses which are currently being borne by the government wouldn't have disappeared if AIG had failed: they would simply have turned up somewhere else in the financial system.

But no one would have had a clue where in the financial system, exactly, those losses would have ultimately come to rest. And given the magnitude of the losses, you can be sure that no one would have wanted to have any kind of dealings with the poor schmucks who ended up on the hook for all those billions of dollars. And since those poor schmucks could be pretty much anybody, no one would do any kind of business with anybody else: you'd get settlement risk run amok. The entire global financial system could grind to a halt overnight, due to the inability of any given institution to persuade any other institution that it was actually solvent.

We don't know for sure that this kind of worst-case scenario would have happened if AIG had been allowed to fail. But we don't know that it wouldn't have happened -- and the US government felt that it simply couldn't take that kind of risk.

What's more, bailing out AIG had the pleasant side-effect of putting the entire global CDS market on a much stronger footing. Remember that CDS, like all derivatives, are a zero-sum game: for every loser, there's an equal and opposite winner. Very few institutions were net sellers of protection; AIG was by far the largest. So what that means is that the rest of the CDS market, ex AIG, is now a net winner to the exact extent that AIG is a loser: a hundred billion dollars or more. Given worries about the fragility of the CDS market and the systemic risks that it posed, bailing out the single largest net seller of protection essentially meant injecting a large amount of government cash into the part of the market that regulators were most worried about. It was quite an elegant solution, in its way: rather than trying to unpick the CDS knot institution by institution, you could just bail them all out at once by backstopping AIG.

Remember that what regulators were most worried about at the time was systemic risk. Whether or not AIG deserved the money was pretty much beside the point: the key thing was that if it didn't get the money, the entire global financial system would be put at risk of collapse. In which light, the cost of the AIG bailout looks positively modest, compared to its benefit.

mike volpe said...

While all of that may be true and rather well explained, had AIG gone into bankruptcy, it would have been liquidated and its creditors, their counter parties, would get relief. Now, it's true that there was no guarantee that all parties would be paid everything they were owed. That said, the nightmare scenario that you portray is overblown since AIG has plenty of assets to cover much of what they owe.

What this does is guarantee one of two things. Either AIG continues as an entity on our dime. Or it continues as a ghost entity weighed down by what they owe us.

Given that we first started bailing out AIG about half a year ago, the bankruptcy would have long been largely finished by now. It's counter parties would have been paid hopefully most of what they were owed by now as well. What would have happened is that AIG would have ceased to exist.

Anonymous said...

Neither of us can say whether a bankruptcy would have been success or not and it would have worked out as nicely as what you say.

We cant say this because neither of us are experts in credit default swaps, derivatives and the financials of AIG.

The Treasury has much more access to the financials and details of the various CD swaps than we do.

So given that they seem determined to prop it up even though it is so unpopular to do so, it shows the situation is more complicated than what you are proposing?

mike volpe said...

First of all, I didn't say it would work out nicely. My way would have however saved the taxpayers all sorts of money. Given that we, the tax payers, now own the company maybe the Treasury should be sharing this information with someone.

Given the manner in which this has all been handled, the Treasury "knowing what they are doing" is not something I am confident in.

I am not nearly as confident in the idea of "too big to fail" as you seem to be.