THE STASH MARCH 3, 2009
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Two quick AIG thoughts, both of them relating to who it is we're bailing out by propping up AIG.
First, as the Times points out in an editorial today, and Josh Marshall has repeatedly observed, one company that clearly had a lot to lose if AIG failed was Goldman Sachs, the former employer of Bush Treasury Secretary Hank Paulson. As the Times writes:
The serial A.I.G. bailouts are especially problematic for their connection to the Wall Street bank Goldman Sachs. At the time of the first A.I.G. rescue last fall, it was reported by Gretchen Morgenson in The Times that Goldman was A.I.G.’s largest trading partner, with some $20 billion of business tied into the insurer. Goldman has said that its exposure to risk from A.I.G. was offset, or hedged, by other investments.
What is certain is that Goldman has lots of friends in high places--yet one more reason why this bailout has to be as transparent as possible. Lloyd Blankfein, Goldman’s chief executive, was the only Wall Street executive at a September meeting at the New York Federal Reserve to discuss the initial A.I.G. bailout. Also involved in the discussion was the then head of the New York Fed, Timothy Geithner, who is now President Obama’s Treasury secretary.
It's worth adding, though I'm not entirely sure what the significance is or should be, that Paulson appointed AIG's current CEO, Edward Liddy, who'd been a member of the Goldman board. (Former AIG CEO Hank Greenberg reminded me of this in our interview yesterday.)
Second, as Tyler Cowen points out, riffing off another Times piece, the money we pour into AIG is actually propping up a lot of European institutions:
Here is some simple background:
If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.
No one wants to say it, but essentially the Fed has been bailing out European banks.
The inflation-adjusted cost of the Marshall plan has been estimated at about $115 billion in current dollars. If we end up spending $250 billion on AIG, how much of that sum will go to European financial institutions and might it someday exceed the scope of the Marshall plan? (I do not, by the way, think that central banks ought to treat foreign creditors differently.)
Then again, given the lead-footedness of Europe's own policymakers, there maybe worse things than our involvement here.
Update: I should clarify that I don't see a nefarious conspiracy at work here. I think it's unfortunate that we have to spend hundreds of billions of dollars bailing out not just AIG but, indirectly, Goldman and a lot of European institutions, but I don't really see an alternative. (I think of the benefits to Goldman et al as a kind of collateral damage.) I really believe AIG is too big to fail--that it's failure would cause the kind of global financial meltdown that would make Lehman look like a tiny spark.
Having said that, do I think Paulson's Goldman ties helped focus his mind a bit on the AIG problem? Absolutely. And I'm certainly open to seeing if various AIG counterparties like Goldman can take a hit on the contracts they entered into, so they can share the burden with the U.S. taxpayer. (Admittedly, I have no idea how this would work in practice. Thoughts welcome.)
At the very least, I think Treasury would help itself by being a little more transparent about who the counterparties are. In the absence of more information, people are apt to see this as a pure backroom deal for Goldman, which strikes me as unlikely.
Update II: Commenter roidubouloi, who's had a lot of smart thoughts on the financial crisis so far, weighs in with this:
A much smarter response to the potential "domino effect" would have been coordinated action with the Europeans to cordon off derivatives liabilities for the financial system and net them out to the gain or loss of the ultimate parties. This is an astonishingly inefficient way to protect the financial system because it involves paying billions to non-institutions who have no greater claim to be made whole than the millions of people who have just lost half their stake in the equity and real estate markets. It would have been far better to ID any critical losers from the quarantine of derivatives players and use the money to aid them directly. Billions are being poured into AIG so that some piece of it protects critical institutions.
That makes a lot of sense to me, depending on how feasible it is.
Update III: Please see my follow-up item pushing back a bit on the AIG-Goldman conspiracies...
--Noam Scheiber
8 comments
I just mentioned the swap lines in the Euro Depression post:
blogs.ft.com/.../254
We're doing more than just propping them up indirectly.
- acria multa
March 3, 2009 at 3:45pm
A much smarter response to the potential "domino effect" would have been coordinated action with the Europeans to cordon off derivatives liabilities for the financial system and net them out to the gain or loss of the ultimate parties. This is an astonishingly inefficient way to protect the financial system because it involves paying billions to non-institutions who have no greater claim to be made whole than the millions of people who have just lost half their stake in the equity and real estate markets. It would have been far better to ID any critical losers from the quarantine of derivatives players and use the money to aid them directly. Billions are being poured into AIG so that some piece of it protects critical institutions. The whole thing is stupid beyond words and also more than likely futile. It s so inefficient that the system will be threatened by derivatives anyway after an inconceivable sum of money has been wasted.
- roidubouloi
March 3, 2009 at 4:28pm
What happened to the rest of the interview with Mo Greenberg of AIG? Why weren't there more tough q's like the ones in this thread?
Any chance of a do-over or an extension?
- teplukhin2you
March 3, 2009 at 5:26pm
What we need here is the government equivalent of CliffNotes.
Most of us can't come close to explaining the complex relationships between hedge funds, dirivatives, futures, CDOs, managed funds, securities, junk bonds, arbitrage etc etc etc.
This is from AARP:
* Almost three-fourths of those polled said they wish they had a better understanding of financial terms
*More than 80 percent found their car insurance policy easier to understand than a mutual fund prospectus
*Only 19 percent felt very confident in choosing the right investments, half the number who felt confident in their ability to select the right surgeon for a major operation
*Sixty-seven percent gave the financial services industry a “C” or lower in explaining savings and investing to consumers
*Respondents overwhelmingly felt that poor communication was intentional, whether to distract attention from fees, to focus on sales, to make the product seem more impressive or to intimidate the consumer.
george:
I particularly zeroed in on the last point. As per the credit card industry, financial transactions are couched in jargon so dense, abstruse and unintelligible virtually all of us sign on dotted lines only vaguely aware of what all the fine print means. And only the rich have access to advisers, accountants and lawyers to circumnavigate these labyrinthian twists and turns.
Of course, Republicans would start yammering about socialism and the nanny state. Well, fuck them. This is something any genuinely democratic republic would provide for its citizens.
We can be taken advantage of in car repair shops, the healthcare industry, real estate offices, law offices etc. No one has the time to be an expert about everything. In turn, an economy that revolves solely around the profit margin is by definition going to use every trick in the book to bolster the bottom line. So there should be a proactive Consumer Protection Agency that is adequately staffed and funded to go out into the field and track down business that are hell bent on ripping us off.
george walton
- iambiguous
March 3, 2009 at 6:46pm
Roi - you are really an invaluable resource on all this, as is Noam, who has been the best finance journalist out there, period.
Roi - I forward your posts to finance hubby (who is at a french bank with no connection to bailout) who thinks they are terrific.
- Wandreycer1
March 3, 2009 at 8:38pm
Thanks wandrey, really.
I am not at all sure why I write about this other than that I know a fair amount about it professionally and it relieves momentarily my seething frustration as I watch the mistakes being made by our government. If anyone out there gains a better understanding of what is transpiring, even if what they take away is not precisely my understanding, that is all to the good.
- roidubouloi
March 4, 2009 at 1:36am
I want to respond to Noam’s reservation about “feasibility.” We are not here discussing the natural universe, but an entirely human construction, the market and financial system. In thinking about feasibility, we should keep in mind that there may be things that the market cannot be induced to do that we can none-the-less do by fiat. We do not order about the natural world in the same way so feasibility has a different meaning there. This is our financial system, not the Almighty’s.
It is entirely within our power, technically, to declare that derivatives contracts are void and unenforceable as against public policy. That decision would have consequences some of which would not be ours to command, but it can be done. Political will and feasibility are a separate question. While the possibility of black-market activity may exist, I don’t think we need be too concerned about black-market derivatives transactions, for example.
I believe that existing unregulated derivatives contracts, CDOs, CDSs and the like represent a profound threat to the world financial system and thus to the world economy and should be summarily declared void for that reason. At the same time, I don’t see any reason arbitrarily to redistribute the gains and losses that would occur from doing so from where they would lie if the contracts were all settled at their net values at the point in time of their repudiation. That is, there is no particular reason to favor the losers over the winners as of that moment. To that end, I would, if I were the financial czar of the world, remove all of the voided contracts to a government agency charged with valuing them and netting them out so that each participant would succeed to a due from or due to the agency.
If, after netting, all of the net debtors were solvent, then all of the net creditors would be paid in full. That is unlikely. Some of the debtors would surely be insolvent else this wouldn’t be such a problem in the first place and the US government would not be pouring hundreds of billions into AIG. The insolvent debtors would have to kick in their stock to the agency, which would realize its value and add it to the pool of payments from solvent debtors. In that manner, a final settlement would be achieved, all derivatives creditors would share in the losses due to the insolvencies due to derivatives trading, and the whole thing would be put to rest without destroying our financial institutions and without any of the chain reaction that is so feared. A net debtor either pays its tab or kicks in its equity. If some institution is insolvent because the net realization on its derivatives bets puts it under water, so it goes. The system cannot be made to pay more than it has.
I met today with an old friend who worked for years as a lawyer at the SEC and we talked about this. He wondered aloud whether voiding contracts in this way would be “taking” requiring compensation. I don’t think so. Whenever there is legislation that affects the use of property, there are winners and losers. When the gains and loses are broadly though unevenly distributed, we do not treat it as a taking. Of course, the libertarians referred to in Jeffrey Rosen’s piece today about the bail-out would like it to be treated thus, but they have neither history nor case law on their side. Between the bankruptcy powers,, tax powers, and the authority to regulate interstate commerce, the Congress surely has enough power to do this even though outstanding contracts and inchoate property rights are affected.
To give an example, if the government decides to prohibit trade in a drug because it is harmful to public health and safety, there is no obligation to compensate the manufacturer or other parties who may have outstanding contracts to buy or sell. The chips just fall. So too here. If outstanding derivatives contracts are a threat to the economy, and they are, they can be rendered unenforceable by fiat. It is certainly feasible to do this. And, by settling the claims against insolvents with stock, it is also possible to insulate the financial system from adverse consequences. It matters not whether Bob or Jim owns Citibank. If Citibank owes Jim and cannot pay, then existing shareholder Bob loses his stake. This is not a threat to the economy, only to Bob.
This is something that desperately needs to be done in order to cleanse the system of the overhang of derivatives contracts. There will be winners and losers. So what? We already have vast numbers of losers who, without ever dealing in this stuff, have lost their wealth because of the effect that the wheeling and dealing in derivatives has had on the financial system and on the economy. There is no reason at all to be more solicitous of derivatives traders and contract parties than of the millions they have damaged, whether blameworthy or not.
- roidubouloi
March 4, 2009 at 5:10pm
The basic point here is that we do not have the ability to eliminate losses that have occurred. Somebody must bear them. What we can do is bring them all to rest so that they are the problem of someone with finality. Right now, the system is completely jammed up because of the uncertainty about where the losses will finally end up. No one knows who is creditworthy and who is not. If we settled the losses, then the losers would lose and the system would be able to resume normal functioning. Certainly, there should be some equity in the settlement of the losses which is why I have advocated strongly that investors in insolvent banks should just be wiped out. But we cannot expect god-like perfection. We can be pretty sure that any reasonably equitable settlement would be far more equitable than the completely arbitrary way in which the market has distributed losses to this point. Thus, we have no reason to be concerned about the comparatively more modest inequities that would result from the fiat settlement of losses still in the system.
- roidubouloi
March 4, 2009 at 5:50pm