Thursday, March 19, 2009

American International Gaffe

Given that this AIG thing just will. not. die. I feel the need to comment briefly on what has become a truly ludicrous story.  Let's begin with the fact that I am entirely sympathetic to the populist and general pitchfork-wielding ire that is out there at the moment.  Every morning I walk past Morgan Stanley's headquarters on the way to work, and the other day I thought I saw John Mack standing out front surrounded by a bunch of television cameras.  My immediate and visceral desire was to hock a huge lugie in the  bum's face and yell crook.  Fortunately no pitchfork was ready-to-hand.  That being said, however, I think we should try to think through what's really at stake in these bailout and not let our instincts or the media lead us astray wehn it comes to trying to do the greatest good for the greatest number in this financial and economic crisis.

So first, let's talk about why we bailed out AIG in the first place.  We bailed out AIG because we let them write tons of insurance that they couldn't possibly have paid off.  And it looked like they might well have to pay it off, given how bad things were getting.  The people who had bought this insurance -- Goldman Sachs, Morgan Stanley, various hedge funds through their prime brokers and banks -- were counting on it paying out if things went bad.  In other words, these entities were using AIG as a counterparty in a hedge.  Having theoretically hedged the risk of some bad stuff happening, they could then go out and invest as if that bad stuff couldn't happen.  This is the whole idea of a hedge.  If these companies hadn't been able to buy this insurance, they almost certainly would have been more cautious and concerend about the bad stuff happening. 

So now, what happens to the people who bought these insurance policies when they discover that maybe the insurnace isn't worth what they though it was worth, in other words when they discover that bad stuff is happening that AIG may not be able to protect them against?  Naturally, they will go out and liquidate the other side of the bet to protect themselves.  Equally naturally, the forced liquidation of this other side will actually cause that very bad stuff to happen.  Very quickly.  Because the guys who bought this insurance were also leveraged.  Let's say Goldman had $5 to play with and it wanted to be on good things happening.  It went out and paid AIG $5 to insure against a fire that would cause $100 in damages if it happened.  Paying that $5 made Goldman comfortable with the idea of going out and borrowing another $95 to bet on good stuff happening.  If that insurance goes away, even if there has been no fire, Goldman now has to go out and sell all $100 of good stuff, because even a very small $5 fire will wipe out all the money that they had to play with (which in any case they already paid to AIG as the premium on the insurance).  Selling $100 worth of good stuff makes the price of good stuff go down.  Especially if everyone made the same bet with the same insurance company and has to sell it all at the same time.  This is why stuff like this doesn't really make a lot of sense:

Every day, insurance companies sell policies to homeowners to cover the cost of damage in the case of fire. Why would those companies agree to pay out in full to a policyholder even if a fire had not occurred?

That is the type of question being asked about the federal government's bailout of American International Group in which the insurance company funneled $49.5 billion in taxpayer funds to financial institutions, including Deutsche Bank, Goldman Sachs and Merrill Lynch. The payments, which amount to almost 30 percent of the $170 billion in taxpayer commitments provided to A.I.G. since its near collapse last September, were disclosed by the company on Sunday.

Gretchen Morgenstern is usually more thoughtful than this.  I guess thoughful ain't selling papers at the moment.  Because there's no point in bailing out AIG at all, if you are not going to make good on the policies they wrote.  Paying out on those policies, in order to avoid having the policyholders liquidated the other side of the transaction in a hurry, was the whole reason for bailing them out in the first place.  So you can't really act surprised when this is what happens.  It wouldn't have been a bailout without this. In fact, rather than being surprised that 30% of the money went to this, I want to know what the fuck happened to the other 70%. 

You can certainly argue that there should have been no bailout of AIG.  What you cannot argue is that there should have been a bailout of AIG, but that these policies should have been cancelled.

I would argue that the bailout of AIG was necessary, because there literally would be no financial system if all the people who bought insurance from them had to protect themselves from that insurnace ceasing to exist at the same time.  Contrary to popular belief, the financial system not existing is not actually the end of the world.  The species is not going to die out.  In fact, the resultant death toll would probably be very limited.  However, abruptly eliminating money would cause a fair bit of chaos and suffering that it really kinda needless.  Hence I support the bailing out of AIG.  Hence I support these payouts, which was exactly what the bailout was supposed to do.

Of course, while I did and do support the bailout of AIG, I also am not stupid enough to think that all of this came as a surprise to Goldman, Morgan etc ...  These guys knew with 100% certainty that AIG was insovlent, and knew with 100% certainty that the government would bailout AIG when push came to shove.  I defend the bailout, the mechanism of which necessarily involves paying out on these cynically accepted policies.  You can ask why Goldman et al ... were not forced to take a haircut on these policies.  This is like asking why we shouldn't let the house burn down just a little to punish the guy who knowingly bought crap insurance and then sat in the bath tub doing coke off the top of his toaster.  If you could let just his house burn down just a little, this would be a splendid punsihment; unfortunately, you're bound to end up setting the whole neighborhood on fire.

The only thing you can do to solve this problem is to actually have the political sack to bail out the system and then go and lay blame for this directly at the doorstep of those who caused it in individual fashion.  In other words, the government should bailout Goldman in this fashion for the sake of systemic stability, and then it should fucking confiscate some portion of the company from current irresponsible shareholders.  You could do this through forcing them to issue shares, or through taxing them into oblivion.

This brings us to the second big point in the AIG debate -- the bonuses.  I don't really see any reason to pay the guys at AIG any bonuses at all.  None of the arguments I've heard holds even a minimal amount of water, not even when it comes from the pseudo-regretful mouth of the New York Times, rather than from the more defiant posturing of the Journal (who can expected to defend its own, and whose opinion pieces are at any rate incoherent -- I mean, these guys give Karl Rove a weekly space). 

The arguements I've heard have to do with not changing contracts, and with retaining talent.  These are silly.  The government rountinely changes the rules of the game.  They write the rules, and they can change the rules.  They do it all the time.  Ask anyone in healthcare, defense contracting, or pretty much any other industry that has anything to do with the government.  Crap like this is non-sensical:

If you think this economy is a mess now, imagine what it would look like if the business community started to worry that the government would start abrogating contracts left and right.

As much as we might want to void those A.I.G. pay contracts, Pearl Meyer, a compensation consultant at Steven Hall & Partners, says it would put American business on a worse slippery slope than it already is. Business agreements of other companies that have taken taxpayer money might fall into question. Even companies that have not turned to Washington might seize the opportunity to break inconvenient contracts.

If government officials were to break the contracts, they would be "breaking a bond," Ms. Meyer says. "They are raising a whole new question about the trust and commitment organizations have to their employees."
The other argument is about retaining "talent".  Um, no.  This "talent" is what put us here to being with,.  In addition, this "talent" has nowhere else to go.  Have these guys not seen the state of employment in the financial industry?  Nobody is going to hire these idiots now.  They should be glad that they even have a job and are not flipping burgers.  On top of that, this is simply the nature of working in finance and everyone should know it.  You don't make money by loosing money.  It's feast or famine here. 

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