2008 September 16 Tuesday
US Federal Reserve Rescues Insurer AIG
$1.1 trillion insurer American International Group (AIG) avoids collapse by a Fed takeover. Since AIG isn't a bank the Federal Deposition Insurance Corporation couldn't step in. So the Fed did the deed.
The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.
The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.
The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.
The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.
The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.
If the counterparty risk of an AIG collapse is as massive as some people say it is then the most surprising thing about the AIG crash is just how little the stock market went down as this crisis intensified. My interpretation: the big players on Wall Street knew that Ben Bernanke and Hank Paulson would find a way to prevent the house of credit default swap (CDS) cards from falling down. The threat was so massive that the disaster wouldn't be allowed to happen.
But how could the Fed intervene without legal authority from Congress to take over an insurance company? Before this deal was announced some commentators were opining that the Fed does not have the legal authority to lend tens of billions of dollars to an insurance company and become a big stock holder in it. Well, the law is what government entities decide is the law. Megan McArdle opines (correctly in my view) no major player is going to try to stop the Fed because noone wants responsibility for the problem.
It's probable that they don't actually have the legal right to do anything like this. Their authority is this: who's going to stop them? No one wants to take on responsibility for this mess themselves.
Megan has many thoughtful observations about which regulatory changes might reduce the risk of another massive financial failure.
Given AIG's role as a very large scale insurer of debt securities its collapse could have caused a massive disastrous chain reaction. I know some of you do not believe this. But seems likely to me.
What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s its role as an enormous provider of financial insurance, which effectively requires it cover losses suffered by other institutions in the instance of defaults of securities that they have purchased. That means A.I.G. is potentially on the hook for securities that were once considered safe.
If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of billions of dollars in debt securities, which in turn would have reduced their own capital and the value of their own debt.
“It would have been a chain reaction,” said Uwe Reinhardt, a professor of economics at Princeton University. “The spillover effects could have been incredible.”
What financial regulatory changes are needed to make the financial world less like a house of cards?
The Fed claims it won't lose money on the deal. Supposedly AIG is faced with a liquidity crisis, not an insolvency crisis.
According to the Fed’s statement on the deal, it has a two-year term, and will pay an interest rate of three-month Libor plus 850 basis points. Taxpayers are protected, the bank said, by the fact that the loan is collateralized by all of the assets of AIG and its subsidiaries. As of its most recent SEC filing, AIG was reporting assets of $ 1 trillion.
David Leonhardt of the New York Times wonders whether bailouts make things worse in the long run.
Barry Ritholtz — who runs an equity research firm in New York and writes The Big Picture, one of the best-read economics blogs — is going to publish a book soon making the case that the bailout actually helped cause the decline. The book is called, “Bailout Nation.” In it, Mr. Ritholtz sketches out an intriguing alternative history of Chrysler and Detroit.
If Chrysler had collapsed, he argues, vulture investors might have swooped in and reconstituted the company as a smaller automaker less tied to the failed strategies of Detroit’s Big Three and their unions. “If Chrysler goes belly up,” he says, “it also might have forced some deep introspection at Ford and G.M. and might have changed their attitude toward fuel efficiency and manufacturing quality.” Some of the bailout’s opponents — from free-market conservatives to Senator Gary Hart, then a rising Democrat — were making similar arguments three decades ago.
Well, I do not want to see most of the banks collapse like a bunch of dominoes just so some investors will learn some lessons. Sure, the Great Depression taught a whole generation to be wary about investments and debt. But do you want to live through that kind of educational experience? I don't.
As far as Detroit in the early 80s is concerned: the US Congress has kept the automakers in a slow death bear hug with the UAW. That's not the fault of the people who run the car companies. Also, a continuing focus on fuel efficiency would not have worked as gasoline prices fell and the car buyers decided they wanted big cars once again.
Randall (who appears to favour the nationalisation of private assets and/or believes that public servants are better able to manage insurance companies than anyone in the private sector) quotes:
The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.
Let me see if I understand: AIG's liquidity drops because of potential calls on its insurance contracts; AIG raises funds using those same contracts as collateral.
Yeah, that makes sense.
Randall, sorry for the cheap shot. Your concerns are well founded, its just the philosophy I have a trouble with.
I know most people reading this hate and deride the ancient science of Astrology and will laugh at me in contempt....but in England there is a very strange annual publication entitled 'Old Moore's Almanac (printed since 1690, on sale at newsagents for £2.00 nett, which prints some very strange and garish predictions for the year ahead based purely on astrological charts and predictions.
Most, in fact, do not come to pass, but the almanac for 2008 (published in late 2006), predicted financial disaster for the USA around March 2008 and September 2008.
Apparently these predictions were based on the baleful effects of Pluto and a recent eclipse on the moon of the chart of the signing of the Declaration of Independence......
Stephen, have you ever seen a Jehovah's witness die from refusing blood? You wish this for yourself and everyone else on purely fundamental ideological grounds? Fundamentally the entire financial system of the world is insolvent. If there were a run in the US alone on the uninsured bank deposits over the $100,000 FDIC insured limit (representing 38% of all money in the banking system), it would instantly vaporize ever bank in American.
And while most people criticizing the FEDs actions think only about their own bank deposits (mostly below $100,000), they forgot their employers probably have a payroll account that probably contains WAY more than $100,000 (I know my company's payroll account is far larger). People seem oblivious to this very real issue-- they should also fear the safety of their paychecks. I few links you might consider (from someone who does think we should let these institutions all collapse)
Stepehen, are you really sure you understand the strategy Bernanke-Paulson have been taking (protect depositors accounts)?
Bernanke believes the Great Depression was caused MORE by banks collapsing (and thereby choking families and businesses of their own savings) than by the enormous credit crunch which was the proximate cause of the event. To this end he is trying to avoid a repeat of 1928 and I must say it seeems a very reasonable approach to 'save the patient'.
In fact, I honestly think we are watching two of the greatest politicians of our lifetime (Bernanke and Paulson)-- I am simply stunned at how lucky we seem to be at having these two leaders in office at this time. Lierally they are men who are to finance today as Churchill was t England in WWII. Only they live in a much more "esoteric" space that most people do not understand.
I find it odd more people do not see it this way
"In fact, I honestly think we are watching two of the greatest politicians of our lifetime (Bernanke and Paulson)-- I am simply stunned at how lucky we seem to be at having these two leaders in office at this time. Lierally they are men who are to finance today as Churchill was t England in WWII. Only they live in a much more "esoteric" space that most people do not understand.
I find it odd more people do not see it this way"
More people do not see it that way because these men have inordinate control over the fate of millions all without the public having much, if any, say. This is very corrupt system of governance. The country should be guided by principles of freedom and individual liberty not by wealth creation. The moment the equation turns to wealth creation, then corruption will be rife.
Paulson and Bernanke do not deserve ultimate respect because they do not advance the Constitution and do not advocate for liberty. Morever, they do not summarily dictate how their actions increase or decrease individual liberty; such a move would be a major step forward.
Have you never had a family member cared for by a doctor and the family didn't understand everything the doctor was doing yet in the end the doctor 'saved' your family member. Things sometimes move too fast and are too complex to explain to everyone and when that happens, all we can do is hope we put good leaders in leardership positions (which is what our constitutional process is about, not micro managing every decision as they make it which will clearly never work in the world we live in). We live in a hyperspecialized world, in fact it is what gives us all our wealth in the first place if you didn't know? Read my PowerPoint http://lookingthruadifferentlens.blogspot.com/2008/01/i-be-giving-following-talk-to-business.html on my blog if you are interested- start at Part I. And trust in others is the price you have to pay in order to accept the benefit of that wealth. Why do you think Scandinavian nations are so rich in the first place?
Have you seen the TED spread today? http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND (was almost 3 for a little while today). It is the highest it has been since the mid 1970's
and even this comparison is misleading because of the differences in absolute interest rates between then and today (rates were much higher then). As a % of current interest, TED is telling us we are watching a financial event every bit as big as WW I or WW II and people just don't seem to get it. They just don't seem to understand how much debt we have created in western civilization. As far as we know, there is nothing like this in all of history.
Sorry, TED was briefly over three (I missed it). Amazing. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aQghMI6iC2GQ
"But do you want to live through that kind of educational experience? I don't."
Not really. (But maybe most people out there need a jolt like that.)
One thing that should definitely NOT be allowed is that CEOs land safely with any golden parachutes. In fact, NO decision makers in these companies or traders or investors (or whatever you call them) that have been involved in all of these dodgy dealings should be allowed to walk away with bonuses or any profits whatsoever.
These people drive their companies AND the economy into the dirt -- and leave the tax payers with the bill -- and are allowed to profit from it? I don't think so.
Jun, you make a good point. The only problem is that the majority of the problem was caused by you and I and not by fraud. As I shared yesterday (and will share again) WE ALL have a hand in this debt problem: http://www.kwaves.com/debt_gdp.gif
And this is where it has led us today: http://www.interfluidity.com/posts/1205997488.shtml
I know mobs like their sacrificial offering, and where they exist I have no problem letting them rip the crooks apart. But you are kidding yourself if you think that anyone other than you and I are the main actors to blame collectively for this mess.
And while I do not know about you personally, I can say that (sadly) as a human trait, denial is a VERY ingrained behavior.
The only problem is that the majority of the problem was caused by you and I and not by fraud.
Sure. I agree -- to an extent. Our entire society is to blame 'cause most of us (not me, btw) are hocked up to our ears, both as individuals and as a nation (and so our many/most of our corporations, too, apparently).
But, some of us are more culpable than others. I was specifically talking about the likes of people dealing in Credit Default Swaps. These people should not be allowed to profit when we're having to bail them out:
Let's consider the simple heart of what credit derivatives are all about. A major investor has the opportunity to make an attractive-looking investment that involves taking a risk. For instance, a bank or insurance company sees an opportunity in lending to a corporation, but they are concerned about the financial safety of the corporation. They would prefer to keep most of the positive returns from the investment, but not take the risk of the company defaulting. So, as the employee of a company that creates financial derivatives (a credit swap in this case), what you do is promise – for a fee – to take the risk for them. Your company makes assumptions about how bad the risk will be, and based on those assumptions, you determine that this trade is profitable for your employer. You then personally take a nice chunk of those profits in your next bonus as a reward for having been smart enough to get your company into this lucrative transaction. And because this upfront booking of expected profits from these transactions is so lucrative, not only do you get an enhanced bonus -- but so do the other members of your group, your supervisor, their supervisor, and the president and other senior officers of the firm....
The key to your bonus this year is the particulars of the assumptions that your group makes about what those expected losses will be in the future. The lower the assumption for expected losses, then either the greater your profits in a given transaction, or the more competitive your bid, and the greater your chances of beating out competitors who are seeking the same “lucrative" business.
...then the key to making some serious personal money is making the right assumptions! Something that is equally plain to your peers at competitive firms.
These people have been playing dangerous games with dangerous consequences for PERSONAL profit. They should be made to pay some PERSONAL consequences -- not gain.
(For the record, I am not personally in debt and never have been. I own my own small farm am largely self-sufficient [yes, I'm one of those].)
Thai said: have you ever seen a Jehovah's witness die from refusing blood?
Isn't this scenario more like the guy who slashed his own wrists and is now demanding everyone give him their blood? Oh, and the guy isn't even promising not to slash his wrists again next year.
LOL!!! Nice point
Regarding democratic accountability: Are you really sure you want that? Bryan Caplan thinks voters are pretty ignorant: http://www.amazon.com/Myth-Rational-Voter-Democracies-Policies/dp/0691129428.
How many voters can even understand how commercial banks and investment banks work? How many can understand the consequences of assorted regulations and financial instruments?
I'm not going to totally shaft myself just to get even with Wall Street fat cats. A world wide bank panic would cost most of us our jobs. I think the stakes are really that high.
You ought to click thru on my link to Megan McArdle's thoughts on financial regulation reform. I think Megan's pretty smart (and have met her in person). I chide her libertarianism from time to time. But this is a subject on which she can think clearly.
Your point about payroll accounts is important. We need some sort of super-conservative banks that are safe places for parking large sums of money. Else the system just can't work.
Some people think we are not in danger of all the dominoes falling. I think they need to think hard about how banks work and how interrelated they all are.
I remember a world where there were two types of banks - commercial banks, and free market investment banks. Never the twain should meet.
Randall, we need to think in terms of three separate economies: the real economy, the banking economy and the fast-money economy.
All will suffer, but not equally. At the moment the government is busily 'rescuing' the fast-money economy - a choice that is actually worse than doing nothing.
you wrote: "IF there is any one period in history that our current debt cycle started to dramatically grow from, it would have to be the early 1980's when Ronald Regan was president. He (and his party) made the amazing discovery that the economy could grow IF the US governement both borrowed heavily AND spent heavily at the same time."
Today you're mentioning unparalleled debt again. I'm new here, but:
I ask you, how could a gov't spend itself into a black-hole of debt if it were still constrained by a gold-standard, or by any type of convertible currency? Ans: it couldn't. The most epic gov't-constrained-by-gold anecdote was depicted by Disraeli, scrambling for funds to buy the Suez for his doting monarch. If he couldn't have found them, Her Majesty's gov't couldn't have bought it. Unimaginable in today's world, where the US gov't buys/does anything it damn well wants, from F16s to Medicare drugs to AIG bailouts, without a second thought. Don't tell me a gold-standard doesn't matter ! My numbers need revision, but overall the following is on target: http://docgrubb.wordpress.com/2008/02/26/conspiracy-theoryor-reality/
And another thing. Convertible currency constrained not just government, but the people from overspending. Our trade deficit ballooned because we had no restraint. Trade under REAL money is like an American Express card: you have to "pay up" each month. And if your country runs out of gold reserves, they quit taking your currency, and you CAN't buy from them - and currency bleeding stops. On the other hand, FIAT money, or currency backed by,say, dollar hegemony, is like a VISA card - the debt can rack up because the other nation has no recourse. You site how spending went threw the roof in the '80's after we "learned" how to spend. That was just a fews years after Nixon's Shock - no international exchange of gold. You mention human nature; a kid w/ an American Express card can cause a headache for dad. A kid w/ a VISA can bankrupt him.
Now that the Fed owns 70-some percent of AIG, I expect to horrible legislation and administrative law that favors insurers over the insured. I almost wish the government had used the 'Social Security Trust Fund' to buy AIG, and of course distributed the stock to SS payors in individual accounts. At least we'd have some privatization of SS out of this.
"a kid w/ an American Express card can cause a headache for dad. A kid w/ a VISA can bankrupt him" LOL!!!!!!!!!! :-)
Partisans can selectively fish thru the history of financial regulation and find stuff that favors one party or the other. But you need to step back and look for bigger causes. I suspect our biggest problem is that the Great Depression is too faded a memory.
Government debt is one problem with its own set of causes. Corporate and banking debt have a different set of causes. Personal debt has yet another set of causes. Is government debt really our biggest financial problem? I suspect not. I would rate personal debt higher and also debt in the form of complex financial instruments held by banks and other financial institutions as a bigger problem as well.
The US government's own biggest financial problem is unfunded entitlements. These future costs (really future promises to pay entitlements - mostly for old people) are way bigger than the US gov't debt accumulated so far.
Not all financial deregulation (or lack of regulation) is a problem. Private equity firms are taking some big losses. Some are shutting down. But they aren't intermediaries. They aren't insurers of financial instruments held by banks. They move huge sums of money around. But their lack of regulation isn't causing a crisis and Hank Paulson doesn't think he needs to save them in order to prevent a financial panic.
Under-regulation or mis-regulation only matters for institutions that are dominoes.
I consider myself to be a reasonbly smart person, but I have to admit that I know almost nothing when it comes to finances, though due to this crisis I am going to try to learn more. I mean, I know that a lot of obviously bad loans were given and taken (thanks to massive corruption amongst both businesses and consumers of home loans).
If even a large part of the cognitive elite are ignorant on financial matters, just think how ignorant the average voter must be. I vote for managerialism in this case (ie, control by the fed) big time.
My AE and VISA bit was an analogy to international monetary policy and trade under Bretton Woods vs. dollar hegemony. There is nothing funny about the whole mess. Was the analogy over your head? Do you typically heap ridicule on new posters to this site?
casus, I read Thai's reply to be an appreciation of your analogy. Appreciation can exist regardless of whether one agrees or disagrees with the substance of the post.
casusbelli, no ridicule at all. I thought it a wonderfully ironic analogy and it made me smile-laugh. Isn't laughter usually a recognition of a fundamental truth?
No insult intended at all
I always wonder.... why the Fed saved AIG and all these but not Lehman Bro. and Merill Lynch....
I hope I am wrong but Paulson used to be the head of Goldman. Delaying the rescue practically
killed 2 of the major competitors of Goldman... Goldman does well in the future... should benefit
Paulson's package offered by Goldman. Someone please tell me I am wrong! FH