26 January 2010

Where's The AIG Beef?

The Prelude To The AIG Bailout

The financial crisis was mostly the result of a lot of bad credit decisions.

At the bottom were mortgage loans made to people whose ability to pay was dubious. The worked for a while because the housing bubble made it possible for lenders to get paid if the loans weren't paid as agreed by foreclosing, even if the borrower couldn't pay.

Then, these loans were bundled and repackaged into investments of varying levels of risk bought by people who overestimated their value. But, these bad decisions were made, in part, because huge, reputable financial companies, like major investment bankers and AIG were willing to promise that the losses wouldn't be to big with a form of guarantee called a credit default swap. Often lower tier financial companies made the initial guarantees and then limited their own liability by reinsuring their risk with larger companies.

When iffy borrowers started to stop paying their loans, and housing prices started to fall leaving insufficient collateral to cover the entire loans, bad debt losses from these loans started to mount and the investments based on these loans quickly became "toxic assets."

AIG was at the top of the pyramid. A tiny division of the company guaranteed or reguaranted mortgage based investments far beyond what it had any reasonable ability to make good on if the underlying loans went bad. And those loans did go bad.

What Did We Do And Why?

Testimony before Congress about AIG, leaked to an accounting profession blog, will establish that regulators knew that AIG was about to collapse and go bankrupt because its obligation to make good on these guarantees far exceeded its ability to pay them.

So far, so good. Some bad economic, regulatory and tax policies surely contributed to this situation, and almost everyone agrees that at least some reforms in these policies are necessary to prevent that from happening again. But, by the time that Federal government officials and Wall Street was on the verge of really understanding what a mess it was in as a result, what was done was done. The subprime industry was imploding, losses from mortgage backed investments were mounting, and the guarantees that had been made of these investments were in place and about to be called due.

To prevent AIG from collapsing and defaulting on its guarantees to lots of huge financial companies and banks, the Federal government stepped in, took over AIG, and made good on a lot of the promises that AIG had made which AIG wouldn't have been able to make good on by itself.

One of the most powerful questions Congress is considering, which our nation is considering in hindsight, having had the key information concealed from it at the time this was happening, is whether the Federal government did the right thing in dealing with this crisis.

Information leaked already strong suggests that our sitting Treasury Secretary, then heading the Federal Reserve Bank in New York, successfully urge AIG to engage in securities fraud to hid that fact that it was on the verge of collapse.

Thomas C. Baxter, general counsel of the Federal Reserve Bank of New York plans to tell Congress that:

a bankruptcy by the insurer “would have had catastrophic consequences for our financial system and our economy.” He called the decision to rescue A.I.G. “a difficult one,” but one that the Fed’s policymakers felt compelled to make.

Mr. Baxter explained that the New York Fed felt compelled to pay out A.I.G.’s counterparties in full to unwind derivative contracts because “there was little time, and substantial execution risk and attendant harm of not getting the deal done by the deadline of Nov. 10,” when A.I.G. was scheduled to report its earning and could face downgrades from credit ratings agencies. That would have led to more collateral calls and even greater liquidity problems for A.I.G., Mr. Baxter said.

He added, “Even in a best-case scenario, we did not expect that the counterparties would offer anything more than a modest discount to par.” Under the circumstance, he said, “the Federal Reserve had little or no bargaining power.”

In the event, the Federal government did invervene and take over AIG, making the government its principal owner. With bailout money, AIG made good on its obligations. Worse yet, the culpable senior managers at AIG still got huge bonuses despite the takeover.

In Hindsight, Were Bailouts A Good Decision?

Was the government right to intervene and take over AIG, or should have let the market and bankruptcy law run its course? Bankrutpcy law, after all, had been specifically amended to address the prospect of defaults on derivative contracts by major players in that part of the financial industry in 2005.

While Baxter and supporters of bailouts in this financial crisis and many past financial crisises have argued that they are necessary for the greater good, it is not at all clear from Main Street that these Chicken Littles were accurate in telling the public that the sky was falling.

Certainly, a great many big financial companies would have lost much more money, and at least some companies that survived would have been forced into bankruptcy (although not necessarily liquidation). Certainly, the money wouldn't have been there to pay the executives of the companies the eye popping bonuses that many of them received. Certainly, a great many investors, most of them wealthy, would have been far worse off than they are today. But, would this really have been a catastrophe for our financial system and economy?

The case that this is true simply has not been made convincingly.

Bailouts create a moral hazard. They encourage people to take risks because they know that if their luck is bad that they will not bear the full consequences of their bad decisions.

To some extent, government intervention simply postpones the inevitable, which may be one reason why the recession we are starting to emerge from has been longer than any other since the Great Depression. Markets generally act more quickly than government agencies or courts in metting out judgments on its economic decisions. But, I'm not aware of research that shows that short deep recessions are more harmful to the economy than long, more shallow recessions.

Bailouts also transfer wealth from the public to the people who would have taken deeper losses otherwise, and even public sector supporters of bailouts see this as an unfortunate consequence of a bailout, rather than an intended result.

Also, crucially, the financial industry's phobia of bankruptcy seems misplaced. It is not at all obvious allowing Lehman Brothers, a major investment bank, to go bankrupt, did any more harm to the economy than the approach taken with AIG and Bear Sterns, which was to intervene with a government bailout that the government had no legal obligation to provide. GM and Chrysler (neither financial firms, but both iconic U.S. companies deeply impacted by the financial crisis) likewise both had relatively quick, painless bankruptcies.

In both approaches, ordinary operationally profitable day to day businesses of the firms that had made bets that went bad in the financial crisis were segregated from the parts of those firms involved in the financial crisis and continued to do business with little distruption to ordinary customers. The decisions made in the Lehman Brothers bankruptcy that salvaged what could be salvaged from the enterprise were made quickly.

Once the economically functional parts of these financial giants are separated economically from their profligate divisions, inside or outside of bankruptcy, a lot of the horrors that their collapse allegedly would lead to seem much less frightening.

The financial crisis utterly wiped out the subprime and alt-A mortgage lending industry from top to bottom. Almost all the mortgage lenders that participated seriously in this business ceases to exist, and new investments in these loans ceased to be available. Yet, I have yet to see anyone seriously complain that our economy is worse off without this industry.

Perhaps, if the credit default swap defaults of AIG and the financial institutions downstream from it had been allowed to run its course, the broker to broker credit default swamp market, and perhaps even the proprietary trading arms of all of the major investment banks, would have disappeared as subparts of the financial industry as well. Would this really have been a bad thing for the American economy? Or would it simply have achieved what financial regulatory proposals from the Obama administration and Congress are likely to do anyway, but quicker and with less government involvement?

Intervening to bail out major financial institutions didn't prevent the worst recession since the Great Depression. It certainly isn't manifestly obvious that we would have been worse off if the Federal government hadn't poured hundreds of billions of dollars (maybe trillions) into these bailouts. And, the bailouts themselves were the moral equivalent of the federal government urging everyone in the economy (at at least the financial industry) to panic, which they dutifully did. The harm done by this symbolic message may have outweighed on substantive economic benefit of the bailouts.

One of the remarkable things we learned over the quarter century of only briefly interrupted prosperity before the financial crisis was that the stock market has decoupled itself to a great extent from the "real economy." Huge stock market crashes do not necessarily imply harm to the larger economy. Wall Street believes itself to be the very heart of the American economy. But, it is equally plausible that the collapse of the housing bubble in places like California, Nevada, Arizona and Florida, which caused the financial industry to experience such vast dislocations, rather the the secondary disclocations suffered in the financial industry itself, are mostly to blame for our current sour economy. The country has lost far more construction jobs than it has finacial sector jobs.

What More Do We Need To Know?

Of course, the final tally isn't in. The bailouts didn't come without a price. The government has now displaced private investors who were largely wiped out as the principal owner of AIG, Fannie Mae, Freddie Mac, General Motors, Chrysler, and a few other notable firms. Bailout loans that were made to major commercial banks are well on their way to being repaid. While AIG took a major loss in the financial crisis that a Federal bailout financed, it is a profitable business on an operating basis. Most of these institutions were close to having liabilities equal to their assets, on the books at least, as of the last financial reporting period before the federal government intervened, even though they had dire liquidity problems, in part due to a common investment banking business model that financed long term investments with short term loans.

The true cost of the bailouts made during the financial crisis is not the amount of money that the federal government has provided, but the amount of amount that the federal government does not get back in the end. It appears that the losses the government takes on its bailout financing moves will not be worst case scenario disasters. If the government comes close to breaking even on the AIG bailout, the decision to take that step doesn't look nearly so craven.

Also, while the investor class was clearly spared greater harm than it would otherwise have suffered as a result of government intervention, it has still taken a huge hit. In most of the firms that the government bailed out, the equity owners of those firms had already been all but wiped out by the markets before the government stepped in. Investors still lost the vast majority of their pre-crisis investment at AIG and Bear Sterns and Fannie Mae and Freddie Mac, and are left with no certainty that their residual equity will regain much value. Likewise, owners of banks that the FDIC has intervened to shut down, like Washington Mutual and IndyMac, have been wiped out. Generous financial sector executive compensation packages have come under intense scrutiny and we are likely to seem at least some reforms that damp those pay packages.

Fundamentally, the question I keep asking when I hear senior financial sector executive argue that the bailouts were necessary for our own good is "where's the beef?"

What harms would we have resulted if AIG or Bear Sterns had been allowed to go bankrupt? What did ad hoc government intervention make possible that could not have been provided in bankruptcy? Who won? Who lost? What difference would it have made to the average American?

Until those questions are answered with real specificity, the steps the government took to bailout private companies in the financial crisis remain deeply suspect. We, the American people, have yet to receive any real solid evidence that these massive bailouts, which AIG exemplifies, have done anything other than cushion the blow for the reckless rich.

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