The Long Run Blog

Critical Thinking on Money, Finance, and Economics

AIG Revisited- Good Money After Bad?

Back in September, 2008 we discussed why a collapse of AIG would be so detrimental to the entire economy. Not that it wasn’t a moral hazard to save them, but rather that the ripple effects would extend well beyond Wall St. Julio recently pointed out that it would incompetent if the Fed did not perform due diligence to know the bonuses were in place. Whether they had enough time to determine that, I don’t know (it all happened so fast), but they did decide to save AIG for the larger purpose of preventing an entire economic collapase via a ripple effect of evil.

Recall that credit default swaps (CDS) and similar products at the heart of the AIG mess help companies insure against another company’s ability to pay. While widely used for speculation, they are also used to legitimately hedge risk. If assets on your books are valued at a certain level because of the insurance and the insurance disappears, suddenly you must write down the value of those assets. This would happen to other insurers, banks, lenders, leasors, and a variety of non-financial companies causing a ripple effect through the economy.

So, let’s recap a few facts about AIG to help clear up how the press is miscommunicating this:

  • Equity purchased by gov: $40 Billion
  • Loan drawn by the gov: $37 Billion
  • The Fed lend $20 Billion to an AIG subsidiary against $39 Billion in high quality collateral
  • The Fed lent $30 Billion to an entity containing collaterized by derivatives
  • $23 Billion in untapped loan facility from the Fed outstanding

These total the roughly $150 Billion figure so often quoted. In reality, $77B of taxpayer money is unsecured, $50B is fully collaterized and should not lose any money at the end of the day, and $23B has been allocated but not committed yet.

So, where does AIG stand now? It began the crisis with over $2.7 Trillion on the Financial Products’ (the evil division) “book”. That has be unwound down to $1.6 T according to Liddy’s testimony. Here is where the retention bonuses come in: some employees were contracted to stay until the books assigned to them have been “wound down” with as little loss as possible. In trader speak, a “book” is the sum of investment positions a trader is responsible for and “winding down” is the process of closing all positions so the net exposure is zero.

In testimony this week, Liddy claims that none of the employees were “responsible” for AIG’s dilemma. This may somewhat true since the group’s leadership was ousted long ago. Anyone who works for an intellectual business will tell you they often execute to the best of their ability instructions passed down. Strategy is not their responsibility, only execution. So it is quite possible these 70 odd employees facing national (worldwide?)derision are soldiers guilty by association. I wouldn’t stick my neck out and say that for sure though- just merely presenting the likely range of possibilities here.

Now back up and look at the Fed’s perspective back in September: The financial system is in seizure, major institutions are collapsing left and right, and here comes AIG with the big timebomb: $2.7 Trillion that could be sucked out of the economy instantly. If your task is to save the world from collapse for something around $100 Billion, that seems like a pretty good option doesn’t it? For $100B, you prevent the ripple effect of Trillions in one action. I can’t blame Bernanke for not doing enough homework that week (we can blame him for lack of foresight, but that is a different issue). Frankly, the decision was one of enormous complexity and tremendous unknowns. I would not have wanted to be Bernanke that day. Finance is a world of making big, weighty decisions quickly with highly imperfect information. And it could turn out to be the entirely wrong decision.

Having made the decision to save the world, the AIG book needs to be closed out. In order to wind down this gianormous book of derivatives, do you fire the entire staff and try to get new people to understand it all overnight which would no doubt cause more losses (who would even take that job)? Or do you try to retain those least responsible, but most capable from the existing team? Practically speaking, the answer is obvious. Morally and emotionally the answer is unpalatable. Thus we find outselves in the current outrage.

But, when the Fed took over AIG, the company was for all practical purposes bankrupt. They could have treated any existing pay contracts as such- null and void. Why Liddy and new management didn’t instead say “you are going to be out of job. We’ll pay your salary until you finish winding down the book.” Why they offered any retention bonus is a good question I’d like to know the answer to. We can guess that the book was so complicated that the Fed needed them badly. When someone makes a $300,000 salary and a $1 million bonus, they don’t care about the salary for an extra year, which gives them more leverage in negotiations. If this is the case, well the taxpayer made a deal with the devil and reinforced the message that if you screw up, screw up so big that you must get saved.

Since we can’t change the past, what should be done about AIG going forward? Should the Fed continue to pursue the strategy of limiting damage from trillions in derivatives? What will it cost? Or is the outrage and cost so great, the decision deemed so poor, that any additional penny is just throwing good money after bad? Frankly, I’d like not to waste another precious week on AIG and instead get to fixing more important problems.

This post is surely to be controversial. Keep in mind, I’m not defending the bonuses or AIG. I’m just trying to present a rational, factual assessment of the situation and how we got here. The nation will never make good decisions if they are fraught with emotion.

March 26, 2009 - Posted by | Econ Policy |

1 Comment »

  1. Dont think AIG did anything the rest of the western world hasn’t been doing for hundreds of years, just on a much bigger scale…

    Comment by findgoodtips | March 27, 2009 | Reply


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