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The Two Sides of AIG

In this corner, as previously mentioned, Yves Smith goes for the slam dunk:

Let’s see, the credit default swaps market, due to some netting, is now somewhere north of $30 trillion (as opposed to its earlier “north of $60 trillion” level). Investment banks were believed to have hedged most of their exposure via offsetting contracts, but AIG wrote naked protection. And as jAIG itself is at risk of getting downgraded again, the collateral posting requirements keep rising.

Some analysts (including Chris Whalen of Institutional Risk Analytics) have offered theories as to how the government could void a lot of CDS (some have argued for getting rid of them altogether, others argue for eliminating them in cases where the protection buyer does not hold the underlying bond/exposure). Before you say, “they can’t do that”, recall the effective confiscation of gold in the Great Depression. rationing, wage and price controls, the suspension of habeus corpus. There is a good deal that the Feds could do if they chose to, trust me. But it’s easier to bill the poor chump taxpayer than take on the financiers, even after they done so much damage.

And in the other corner, I am joined by Felix Salmon, who rejects the slam:

The scandal here is not the size of the losses from the global financial meltdown — those are losses which sooner or later, in one form or another, would have had to be borne by the government anyway.

The problem, as obliquely noted by me (“So there is a viable, separable business that is making pennies [US$0.01] while the rest of the firm loses Benjamins [US$100.00]”) and explicitly declared by Yves is summarized well by Felix, in a statement to which I suspect all three of us would agree:

Rather, the scandal is that AIG could have earned billions of dollars by selling insurance against a meltdown, even as it was wholly incapable of paying out on those policies. I wouldn’t be surprised to learn that Hank Greenberg was still a billionaire, even as the policies his company wrote have cost the average American household some $1,600. It’s time for his wealth to be confiscated: it might be only a drop in the bucket compared to AIG’s total losses, but it would feel very right.

As I suggested yesterday of the successor-AIG, “So long as that board doesn’t include Hank Greenberg, I’ll be cautiously optimistic.”

The problem is that’s probably not the way to bet. More on that later; for now, keep watching Joe Nocera deliver the goods and summarize the issue:

Yet the government feels it has no choice: because of A.I.G.’s dubious business practices…it pretty much has the world’s financial system by the throat….

A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system. [edits mine*]

By the way, Joe, Yves, citing an early Bloomberg report, named some names:

Goldman Sachs Group Inc., Societe Generale SA, Deutsche Bank AG and Merrill Lynch & Co. are among the largest banks that bought swaps from AIG, according to a person familiar with the situation. The insurer handed over about $18.7 billion to financial firms in the three weeks after the September bailout, said the person, who declined to be named because the information hasn’t been made public.

*Which improves the NYT editing, since the fact of the “housing bubble” has nothing to do with AIG’s mis- and malfeasances.

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This Makes More Sense–or Does It?

Dr. Black (you know the site) links to AIG Strike Three. And unlike the Citi debacle previously discussed (relatively) positively and rather negatively here, this one makes some form of sense.

The difference comes down to the meaning of an accounting concept: ongoing concern.

More below the break (yes, this might get wonkish. It’s me, after all.)

The Big C and AIG are both large entities with several pieces. Some of those pieces are successful; some of them are AIG Financial Products. Some of them—Citibank branches and office space, for instance—fall somewhere in between.

What we do know is that it is currently not possible to slice and dice The Big C so that something would be left that would be an “ongoing concern.” Those assets that are part of the company are dwarfed by the liabilities, and run across business lines. It’s not as if you could just magically, say, sell Smith Barney, spinoff any remaining insurance business, and ritually execute Vikram Pandit and produce a working company from the remains. At best, it’s a Good Start. There’s a reason I refer to the company as The Big C: it’s in the lymph nodes, the brain, the lungs, and the brain. You probably couldn’t even survive with “just” the Retail and Private Banking operations.

Any auditor who releases The Big C’s next 10-Q and describes the firm as a(n) “(on)going concern”**—with the attendant implication that there is a functional business model there and that the firm can create the future unencumbered* cash flows to remain viable—should be barred from the accounting profession.

AIG is different. Think Enron: there are pieces of the business that are still viable (now, the insurance and re-insurance pieces; then, the power plants and transmission facilities), but they are dwarfed by the losses at AIGFP. So there is a viable, separable business that is making pennies while the rest of the firm loses Benjamins.

The difference is that there is a possible end in sight. AIG-Prime could go back to doing the things AIG knew how to do, and stay away from the things that made Hank Greenberg rich and pauperized U.S. taxpayers.***

So, if we were to assume that a leaner, less mean AIG will come out of this, can we look at the plan changes and say they point toward a goal?

Unlike The Big C, the answer is clearly “yes.”

Under the deal, the interest rate on AIG’s credit line from the government would be cut to match the three-month London Interbank Offered Rate (Libor), now about 1.26 percent, a source with direct knowledge of the matter said.

This is perfectly reasonable for the moment: AIG is a financial institution, the reconceived version will be a financial institution of respectable size and strength, and the current version has the strong support of the U.S. government, which can borrow well inside LIBOR. While I suspect the final company will end up looking more like State Farm than Morgan Stanley, it’s not out of the question that it could borrow at LIBOR, which is approximately a AA rating level anyway—a perfectly reasonable assumption for the reconstitution of a formerly-AAA company with some carryover liabilities.

The additional equity commitment would give AIG the ability to issue preferred stock to the government later, the sources said.

This would presumably be the reverse of the deal with The Big C: “equity” for debt. Again, a sign that regulators expect there to be a survivor/successor firm of the current mess.

The most interesting quote in the piece is:

[Robert Haines, senior insurance analyst at CreditSights] said. “The counterparties on most of the book are (European) banks that would be hammered if the U.S. walked away.”

Note that Mr. Haines does not speak of AIG as an independent entity. Note also that, in supporting the AIGFP fiasco/deals, the U.S. can reduce the overall size of the bailout needed while ensuring that domestic entities retain full access to capital markets. It doesn’t make anyone happy, but the option is worth keeping open.

Then we get to the meat of the deal:

AIG will also give the U.S. Federal Reserve a preferred interest in its American Life Insurance Co (Alico), which generates more than half of its revenue from Japan, and Hong Kong-based life insurance group American International Assurance Co (AIA) in return for reducing its debt, they said.

The U.S. doesn’t really want to own either of these, but they have a promise to be valuable assets.

The government likely will get a 5 percent cumulative dividend on its ownership stake in Alico and AIA, said one source. AIG had been trying to sell Alico and part of AIA in a bid to raise money to pay back the government.

Sales of these assets are still a possibility, with some bids already received, said one person. [italics mine]

Think very carefully about the italicized part above. Markets clear—but they don’t always flow well. Combining the two, it appears that the government is effectively giving AIG a bridge loan on those two entities. In the worst case, it will become a “pier loan” (h/t CR), but that’s not the way to bet, especially if others follow the Chinese model of buying international assets while they are cheaper.

The rest of the moves look as if the outlines of the new company are already falling into place:

AIG may also securitize some U.S. life insurance policies and give them to the government to further reduce its debt, the source said.

The company may securitize up to $10 billion under that plan, one of the sources said.

The debt-to-equity swap would help AIG repay much of the roughly $38 billion it has drawn from its government credit line, the source said.

Translation: we know this business, and can do it well and continue it.

Last year, AIG said it planned to sell all assets except its U.S. property and casualty business, foreign general insurance and an ownership interest in some foreign life operations, to pay back the government.

While the company has announced some sales, it has found it difficult to find buyers and get a good price for assets amid the financial crisis.

Translation, again: if the market ever comes back, this is what we plan to look like. And we will again be a “going concern.”

In short, unlike The Big C, there is a plan, there are moves afoot to move closer to the end game, and targets by which they plan to keep the viable parts of the business going. For instance,

The company now plans to spin off up to 20 percent of the property-casualty business in an initial public offering, said a person with direct knowledge of the plans.

The business would be renamed to differentiate it from AIG, and have its own board of directors.

So long as that board doesn’t include Hank Greenberg, I’ll be cautiously optimistic. The other piece of spinoff is more problematic:

To aid the auction of at least one major asset, the government could help potential buyers of aircraft lessor International Lease Finance Corp with financing, the sources said.

ILFC has some debt coming due in 2009 and, if needed, AIG could use its new equity commitment to help potential buyers with that, one of the sources said.

This is a piece that probably still needs to exist for non-business reasons, at which point we might be able to argue that there could be a Public Good in government support of its sale. Under any condition, it doesn’t fit into the trimmed-down model of AIG-Prime that appears to be envisioned.

None of this means there won’t be another round—asset sales are very dependent on buyers—or that they should be paying non-contractual bonuses this month (which they are). The company still needs to reach its full restructuring, and this is not exactly a prime time to be a seller in the marketplace. But at least this restructuring/new bailout has a clear Endgame in sight.

*I use “unencumbered” in place of the usual “free” for the sake of clarity.
**It appears that “Ongoing concern” is used in the U.K., “going concern” in the U.S. I won’t pretend to know which will be the standard as accounting standards are weakened standardized.
***This is, of course, another case where I will point to the results and ask how anyone can take “we’ll get 2/3s of the money back” seriously. But that dead horse has been soundly beaten for the moment, so I’ll leave the tanning of the hide to Yves (She likes the new deal a lot less than I do) and Paul (who hasn’t discussed it yet, since he’s still rewriting 2 Henry VI and checking out The Great Solvent North) and the rest.

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WAPO on AIG III

Robert Waldmann

ended my last post 5 minutes ago wishing for part III of the saga and here it is !
The final act for AIG by Robert O’Harrow Jr. and Brady Dennis

The collapse was, of course, quick when it came. One interesting fact is that AIG Financial Products (AIGFP) stopped writing new CDSs in 2005. Another is that, until then, they had little idea what they were doing.

In fall 2005, Eugene Park was asked to take over Alan Frost’s responsibilities at Financial Products. Frost had done exceedingly well in marketing the credit-default swaps to Wall Street, and was getting a promotion. He would now report to Cassano directly on other strategic projects.

Park …was worried about the subprime component of the CDO market. He had examined the annual report of a company involved in the subprime business. He was stunned, he told his colleagues at the time.

What a fascinating new idea — how about examining the annual report of a firm whose securities one insures. I mean not all of them (what a bore) but just one.

From this passage it seems that AIGFP just assumed that mortgages were what they had been in the past. I mean it’s not their problem. The non bank mortgage lenders were loaning all they could, because they figured they could pass on the risk (well sometimes risk sometimes certainty of default) to people making CDOs who could pass it on to people buying CDOs who could pass it on to AIGFP which doesn’t seem to have wondered what they were insuring.

I give you a hint. If you tell the world that you are glad to bear all of some vaguely defined kind of risk, then it will get riskier.

AIG was a major factor in the market:

Financial Products had $2.7 trillion worth of swap contracts and positions; 50,000 outstanding trades; 2,000 firms involved on the other side of those trades; and 450 employees in six offices around the world.

That’s $ 6 billion in exposure per employee!

Obviously AIGFP had decided that to write CDSs on AAA rated securities was to get money for nothing. They couldn’t possibly examine the securities they were insuring. Notice how Frost’s role was described: “Frost had done exceedingly well in marketing the credit-default swaps to Wall Street.” You can do very well at selling something if you are charging too low a price.

I guess they can blame the credit rating agencies. In fact they do, but not for rating toxic sludge AAA but for rating them AA. The final words “There was no system in place to account for the fact that the company might not be a Triple A forever.”

In fact AIG hasn’t paid out on CDSs, they ran $150 billion short of ready cash, because they had to post collateral: ‘If additional downgrades occurred, either in AIG’s credit rating or in the CDO ratings, Financial Products would have to come up with tens of billions of dollars in collateral it did not have.’

AIG was downgraded from AAA to AA when Eliot “socks on” Spitzer caught him cooking the books.

On March 14, 2005, Greenberg stepped down amid allegations about his involvement in a questionable deal and accounting practices at AIG. The next day, the Fitch Ratings service downgraded AIG’s credit rating to AA. The two other major rating services, Moody’s and Standard & Poor’s, soon followed suit.

I guess that explains why he didn’t go after anyone with a pitchfork.

Back to my usual anti CDS rant after the jump.

I’d say that was crazy. Given AIGs exposure they shouldn’t have been rated AA. I ask for the nth time, what is the point of a CDS ? Why can’t AIG issue AIG bonds and use the proceeds to buy assets rather than insuring them ? I think it is clear. If AIG had issued 3 trillion in debt they wouldn’t be rated AA. CDSs written appear on the balance sheet at market value. This is nonsense. In the long run, the two actions (write a CDS on assets or sell debt and buy those assets) have the same impact on AIG’s book equity, in the short run the only difference is that AIG can be forced to post collateral (which can be seized in full even if it is in chapter 11 and mere bond-holders have to wait and get cents on the dollar) if it writes CDSs.

I think that it is strictly better for bondholders if AIG issues debt and buys assets than if it insures those assets (I am considering the premia paid on CDSs). I think the only reason to do it with CDSs is to trick regulators and ratings agencies about AIGs liabilities.

On a basically different topic, I cut some boring stuff out of one of my posts and put it here.

Now I think it is fairly likely that, if they they had stuck to CDSs on corporate bonds, AIGFP would have done very well just as they would have done issuing AAA bonds of their own and buying AA bonds.

My guess is that, at first, the money was there to be made because of excessively prudent rules and regulations. It is also there, because prudential regulations do not consider covariances so a diversified pool of AAA bonds is treated as if it is as risky as one AAA bond. This is necessary as there was no covariance rating agency which was worthy of the trust earned by the credit rating agencies. Thus the only variable which was independently estimated with some reliability (back then in 1998) was the risk of default of a single instrument.

My current view is that this would be a reasonable approach to prudential regulation if there weren’t firms like AIG financial products. The entities subject to the rules and regulations are large enough that they can diversify their portfolio at a very modest cost. They don’t bear risk for the fun of it. It is safe to assume that they will diversify without being specifically required to do so … unless there is a financial engineering industry which sets up special purpose entities with diversified portfolios and issues single securities whose ratings are high because of that diversification. This means that the diversification (by the SPE) suddenly relaxes the prudential requirement.

By pre-diversifying the financial engineers reduce the further reduction in risk available from diversification. The limiting case would be reached if all securities were put in a huge pool which was cut into tranches. At that point, the risk of default on any portfolio of, say all existing AA securities would be as high as the risk of default on a single security, because there would only be one AA security. Thus for the same prudential regulations, banks would be allowed to bear much more risk.

This is not socially useful. If prudential regulations are optimally adjusted to take into account the increased correlation of different assets, then nothing is accomplished. Otherwise the regulations are effectively changed by agents who can pocket the expected value of future public bailouts.

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AIG in WAPO II

Robert Waldmann

The second of three parts of Dennis and O’Harrow’s series on the downfall of AIG introduces two new features—credit default saps and Joseph Cassano. Together the two managed to bring down AIG.

Thus far we have only read about how AIG got into the business of writing CDSs — it seemed too good to be true — money for nothing. My guess is that the first ones they wrote did amount to money for almost nothing. However such opportunities are few and if one considers one year’s money for nothing as the minimum acceptable profits for next year you will end up getting money for a while for destroying the world’s largest insurance company.

To me the interesting part is how they got into the CDS market

in early 1998: …

… a new kind of contract known as a credit-default swap. For a fee, the firm essentially would insure a company’s corporate debt in case of default. The model showed that these swaps could be a moneymaker for the decade-old firm and its parent, insurance giant AIG, with a 99.85 percent chance of never having to pay out.

The computer model was based on years of historical data about the ups and downs of corporate debt, essentially the bonds that corporations sell to finance their operations.

My guess is that the model was right and that returns on writing (less than 10 year) CDSs on corporate debt were huge while the risk was nothing that AIG couldn’t handle. This profit opportunity could exist because of binding prudential regulations — banks worried about capital requirements and managers of endowments and pension funds with rules requiring much of their assets to be AAA corporate debt or safer would be willing to pay much more than the actuarially fair premium for a CDS on, say, AA debt. Given the correlation of default on different AA bonds, writing CDS on a broad array of them is essentially money for nothing. The most likely value for payouts is zero and the expected value plus, say, 10 standard deviations would be less than the fees.

I have bolded the two factors which convince me that the model might have been reasonable when it was written. First this was corporate debt not new financial products so the ratings were based on decades of experience and not on, say, the assumption that the probability of a nationwide average house price decline is zero (an actual assumption made by Standard and Poor’s really). Second, I sure hope the “years” also amounted to decades including recessions and such. The use of sample frequencies to estimate probabilities is always risky, but if the sample size is a few years during an unprecedented house price boom, it is insane.

The problem is that once one has gotten money for nothing it is very hard to convince oneself that there is no more to be had.

The aim of this article seems to be to describe Hubris* — the pride that came before a fall. This is an old theme in drama — the oldest. I always read about it when I read stories of financial collapses. I suspect that it might be added, because it makes a morality play out of math. I suppose it might often be relevant because of human nature. However, I also think it is particularly relevant to finance.

The efficient markets hypothesis (adjusted for inflation) says you don’t find hundred dollar bills on the sidewalk. It is false. However, you don’t find a hundred dollar bill on the same concrete square day after day. It is possible for financial operators to find an anomaly and make a huge profit with moderate risk. At best they can find two or three. There don’t seem to be many of those who don’t conclude that they are geniuses who can find such profit opportunities year after year. A shining exception is Andrew Lahde who made a killing and cashed in. However, he isn’t in the business anymore.

I don’t see a solution to this problem. You have to put up either with people who think they are geniuses, because they have been very successful or who have something to prove. In particular, I think the replacement of Tom Savage by Joseph Cassano may have been very costly for AIG (Savage really retired according to all accounts). The huge profits made by Savage and Sosin (his predecessor) set a standard which Cassano was determined to surpass. It is very unwise to employ someone who considers finding hundred dollar bills on the sidewalk to be barely adequate.

It is also interesting that Cassano is not a quant:

A Brooklyn College graduate, the 42-year-old Cassano was not one of the “quants” who had mastered the quantitative analysis and risk assessment on which the firm had been built. He had no expertise in the art of hedging. But he had excelled in the world of accounting and credit — the “back office,” as it is known on Wall Street.

Now quants are clearly dangerous, but at least they know the silly assumptions they made when writing their models. In particular they must understand the fact that quantitative models require parameter estimates which are definitely not reliable unless based on large amounts of data. I don’t think someone who is good in the back office understands that estimates based on small samples are not just less precise but also have distributions which can’t be determined at all based on available data.

Anyway, the third article in the series should be bloody.

* I’m pretentious enough to use the word but I won’t spell it correctly as Brad does.

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WAPO on AIG

Robert Waldmann

Over at the Washington Post, Robert O’Harrow Jr. and Brady Dennis have a fairly interesting first of 3 articles on what went wrong at AIG. Of course, they tend to stress personalities and personal conflicts, but they do slip in some good points about economics.

I’d say the key bit was that AIG made a deal and only later noticed that they had made a suboptimal choice of incentive structures.

Under the joint-venture agreement, Financial Products received its profits upfront, even if the transactions took 30 years to play out. AIG would be on the hook if something went wrong down the road, not Sosin and his team, who took their pay immediately.

Could that cause problems ? Naaahh no way efficient markets imply that short term profits are just like long term profits (impossible).

The rest of my thoughts on the first third of the long sad story comes after the jump.

Greenberg was proud and protective of his company’s AAA credit rating, one of only a handful in the world.

The AAA, awarded after an examination by the bond-rating firms, sent a resounding signal to clients that they could always sleep well at night, that AIG was in no danger of failing. The more secure a company, the more cheaply it could borrow money — a fact that would be pivotal to Financial Products’ success.

This is, I think, a large part of the problem right there. An AAA rating is very valuable and any firm well into AAA territory has unused credibility which can be sold by borrowing at AAA rates and buying risky assets. The rating was just worth too much to leave sitting there, so it was destroyed.

Sosin and Rackson hoped that everyone would get rich, but they had their sights set on something more. They wanted to tear down walls they saw as impediments to innovation, the “fiefdoms” that were standard practice at other Wall Street firms. Their vision required a collaborative culture and a computer system that no one else had. For six months, the group worked on constructing “the position analysis and storage system,” or PASS. They called it simply “the system.”

It enabled Financial Products to bring a rare discipline to complex trades. By maintaining market, accounting and transaction details in one place, Sosin (Howard Sosin founder of “Financial products”which was a joint venture with AIG and eventually brought the firm down) and his people could track the constantly changing value of a trade’s components in a way no other firm could.

The advantages of this approach are clear — only by keeping track of such data in one place can a firm estimate the risk of its portfolio. The (by then long obsolete) very old approach effectively valued assets based on their own risk not their firm portfolio betal. However, the disadvantage should also be clear. An accounting “Fiefdom” mgiht also be called keeping the accountants independent from the traders. The unification elminates oversight. I can see how a trader might trust himself to manage risk too and consider separate departments a waste of resources. I can also see how Greenberg might agree as explained by O’Hara and Denis’s version of the negotiations with Sosin on the joint venture (their quotation marks)

Greenberg had little extra time for the nuts-and-bolts details that Sosin sought to negotiate. “I don’t really know much about this,” he told Matthews. “You go talk to these people.”

Greenberg did notice that he had a problem

Greenberg’s love of his joint venture’s revenue could not overcome his desire for greater control. He chafed at the deal, worrying that he had given Sosin too much freedom.

One detail in particular nagged at Greenberg. Under the joint-venture agreement, Financial Products received its profits upfront, even if the transactions took 30 years to play out. AIG would be on the hook if something went wrong down the road, not Sosin and his team, who took their pay immediately.

Ooops. This is just dumb dumb dumb. If the managers of “Financial Products” understand that the gap in the market which they discovered and monopolized is now full of competitors *and* see a bubble coming, the sharp thing to do is to ride the bubble getting short term profits safely in the bank. Paying based Mark to market profits is little better than paying on and mark to model (made up) profits. I think this mistake requires the influence of market fundamentalists who assume that there can’t possibly be bubbles.

The full argument is that bubbles are against investors rational self interest, and if asset prices are largely determined by delegated managers like Sosin, then contracts must have been written to align their interests with, in this case, AIGs shareholders so there is no need to worry that incentive contract encourage money managers to buy into bubbles because bubbles can’t exists because … Ah yes the argument is clearly circular nonsense.

So Greenberg broke with Sosin (who stopped being a genius when he didn’t have access to an AAA rating) and solved the problem by handling financial products (minus a 150 million golden parachute also).

Savage, a 44-year-old Midwestern math whiz, had just been named the new president of Financial Products. With the honor came explicit expectations, which Greenberg made clear: “You guys up at FP ever do anything to my Triple A rating, and I’m coming after you with a pitchfork.”

My advice ? Buy pitchfork futures.

“With a PhD from Claremont Graduate University in California, Savage”

Greenberg also wanted to change the way Financial Products’ employees divvied up its share of the profits. Under the previous arrangement, Sosin and his crew had the right to book immediate profits on the long-term deals. Greenberg thought there was a powerful incentive to go after millions of dollars in short-term gains while leaving AIG and its shareholders responsible for potential losses for years to come.

Savage agreed with Greenberg that Financial Products employees should defer half of their compensation for several years, depending on the length of the deals being done

Problem solved. Instant access to merely 15% of booked profits on megadeals couldn’t distort anyone’s incentives. I mean half of a gigantic conflict of interests is still a gigantic conflict of interests.

Savage said. “Hank Greenberg’s a great man. And I’m willing, when I talk to him, to say, you know, I’m in the presence of a great man and that’s worth something.”

I don’t want to know how much dealing with such a great financial genius was worth to Savage.

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FYI: AIG’s new money deal

mmckinl mentioned the new AIG deal.

Naked Capitalism has a post by Yves Smith regarding the new and improved AIG plan titled: The looting continues (Bannana republic watch). It reviews a WSJ article and notes that AIG is getting a rate cut (5.5 point reduction) with more money for a longer term (5 years instead of 2, is this to protect the money class through this first term liberal hippie commune period?) and we are buying junk at $0.50 on the dollar thus potentially setting up a windfall for those who already bought crap for less. The author’s position is also that WSJ is doing their usual water toting for the money from money class.

In the end the author quotes a 1994 article by Nobel prize winner George Akerlof and Paul Romer : Looting: The economic underworld of bankruptcy for profit.

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

I would ask: Is AIG the linchpin to assuring the financialization of our economy is extended well beyond Bush’s and prior neo-liberal economic policy hawks (DLC, Blue Dogs, Clinton) legacy?

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Saying It All

Unlike Fannie and Freddie, AIG was royally and truly doomed. The Fed tells us so:

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe. [emphases mine]

The notes are for two years at LIBOR + 850. Yes, you read that correctly: 8.50% over the London Interbank Offer Rate.

Three month LIBOR is currently around 2.81%. That makes the all-in Cost of Funds at par right now 11.31%

For comparison, Ford bonds in the secondary market, are yielding around 9.50% for similar maturities.

And the Fed is the only entity willing to offer such terms.

Let’s ignore that they’re making the same mistake they did with Fannie and Freddie, creating a structure that ties the firm to its past mistakes, providing no incentive or changes to the business process, and all the while socializing the risk. Let us just repeat the dismal chorus:

The Fed is the only entity willing to offer AIG terms that are about 180 bp wide of where Ford Motor Credit is trading.

Come to think of it, let’s not ignore the mistakes, for after giving Daniel “son-of-Roger-acts-like-Harry” Mudd $14MM to Just Go Away:

The Fed is the only entity willing to offer AIG terms that are about 180 bp wide of where Ford Motor Credit is trading, and Hank Greenberg—who ran the firm into the ground but remains a major shareholder and on the Board of Directors—will still have a piece of the “nationalised” firm.

Privatize the profits, socialise the risk. Paul Kedrosky is correct when he says we should not throw around phrases such as “moral hazard” and “risk homeostasis,” yet we are left once again to realize and document that those who were paid to be responsible shirked their duties, and we must now wonder—the year after Hurwitz, Maskin, and Meyerson were awarded the Riksbank “Nobel” in Economics whether anyone who has been running and regulating financial firms for the past seven years really understands mechanism design, or even “creative destruction.”

David Leonhardt tries to put a positive spin on things. In the immortal words of Tom Paxton, he “fails miserably” when he also tells the truth:

But if you take a moment to think through the full Chrysler story, you start to realize that it’s setting a really low bar. The Chrysler bailout may have saved the company, but it did nothing, after all, to stop Detroit’s long, sad decline.

He goes on to cite Barry Ritholtz‘s forthcoming book, Bailout Nation:

If Chrysler had collapsed, [Ritholtz] 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.

Instead, the bailout and import quotas fooled the automakers into thinking they could keep doing business as usual. In 1980, Detroit sold about 80 percent of all new vehicles in this country, according to Autodata. Today, it sells just 45 percent.

So let’s be optimistic. In thirty years, we may not have much of the vestiges of AIG to kick around any more, and American insurance companies will look on these as “the good old days.”

Come to think of it, when did optimism and pessimism come to the same result?

UPDATE: Brad DeLong summarizes the situation in one line:

LIBOR + 8.5%—now that’s lending freely at a penalty rate! They’ve given AIG a credit card!

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