Bailouts: AIG Vs. Irresponisble Borrowers

For the last day and a half, the financial press, politicians, and ordinary citizens are for the most part wringing their hands condemning the bailout of AIG by the Federal Reserve. Often, you will find statements like this.

Then came Mr Paulson’s retreat, executed with gritted teeth, as the government and the Fed reluctantly decided that the risks of letting AIG founder in the same way as Lehman were too great.

That frightened me.

There would be no justification for rescuing AIG under other circumstances. The chances of the average homeowner not getting an insurance claim paid if AIG’s holding company had been allowed to go under were slim, since its local property and casualty operations are sturdy and well-run.

Propping it up also creates moral hazard. Although its shareholders will lose most of their money, it encourages the idea that institutions can run amok in markets and will be bailed out. Indeed, the bigger they are and the worse they have behaved, the more likely it is to happen.

If you took what the conventional wisdom said at face value, you would think that business would continue as usual at AIG and all their irresponsible behavior would go unpunished. Furthermore, you would think that what the Fed did is unprecedented and way outside their scope. In fact, one of the Fed's primary function is to be the lender of last resort.



What's more the actual terms of the deal aren't exactly a bailout. AIG will receive a credit line for LIBOR + 8.5%. Furthermore, this credit line will last 24 months. This credit line is meant mostly to give AIG enough financial backing so that it can then sell itself off until their balance sheet is manageable. According to the last Fortune 500 list, AIG was 13th. It will likely be past my lifetime before the company ever sniffs the entire list again once this firesale is over. That isn't a bailout, but a lifeline.

About a month and a half ago, the Dodd/Frank bill became law. This law was supposed to address distressed borrowers. This bill is worth roughly $350 billion. The details of this bill haven't totally been worked out and it is set to roll out in the early part of October. Yet, the bill will give a "lifeline" to borrowers that are or have been behind on their mortgages. This bill will forgive these mortgage lates. They will qualify for FHA loans, a loan they would never qualify on their own with these lates. Furthermore, if these borrowers owe more than their property is worth, a likely scenario, their mortgage balances will artficially be drawn down below to value of their property. In other words, these borrowers, who borrowed irresponsibly, would not only get a rate they don't deserve but also possible have their entire balance lowered. Now, that is a bailout.

Yet, there is all sorts of handwringing over the so called bailout of AIG, and when the Dodd/Frank bill passed (a bill that is wholly corrupt in my opinion), we heard almost nothing from the media, the politicians, and the citizenry at large. The Dodd/Frank bill will backed by $350 billion in tax payer funds. AIG gets a credit line of $85 billion. AIG's interest rate is a moving rate in double digits. These irresponsible borrowers will get FIXED rates somewhere between 6 and 7 percent. That doesn't even account for the artificially lower mortgage balances that borrowers will get.The main problem with bailouts is the concept of moral hazard.

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his or her car, because the negative consequences of automobile theft are (partially) borne by the insurance company.

AIG will now be forced to liquidate its assets until the company is a shell of its former self. Irresponsible borrowers will be rewarded with not only a better rate but likely a better mortgage balance. Which of these two actions sounds like it creates a moral hazard? Yet, it is the so called bailout of AIG that has everyone up in arms. The passage of Dodd/Frank barely registered with any media, politicians, or citizens. That's too bad because it is the Dodd/Frank bill that everyone should be outraged about.