I work at the hedge fund end of Wall Street. I want to explain to people who do not work in finance the pros and cons of a taxpayer bailout for AIG because people need to understand exactly how and why their government is using their money before they vote on November 4. In all fairness, there are good arguments for doing something and for doing nothing. What is indisputable, however, is that taxpayers are screwed either way. On November 4, voters will have a choice between saying "Please Sir, may I have another?" and voting for John McCain, or "No Mas!" and voting for Barack Obama.
AIG is a large global insurance company based in New York City. You have probably seen their advertisements on television. Over the past weekend they let it be known that they needed about $40 billion in capital to remain viable. By the end of the day on Monday, that need had grown to $75 billion. By the time the government finally intervened, that number had grown to $85 billion.
Before I explain why they need this money in a hurry, let me put it in perspective by pointing out that $85 billion is more than the budgets of all but two states in the US, California and New York. Last week, when Rick Wagoner, Chairman of General Motors, went to Washington to ask for help, he asked Congress to lend the auto industry $25 billion. Doing that would at least create jobs. Giving AIG $85 billion will create not a single new job, although it will preserve some very well paid ones.
So now let me explain why AIG needs $85 billion. As an insurance company, The insurance policies that it sells are its liabilities. AIG must have offsetting assets at all times to pay claims that it receives on the policies that it has sold. To raise those assets, AIG collects insurance premiums from consumers like you and me and from businesses like yours and mine. Traditionally they take those premiums and invest them in bonds and other interest bearing loans so that they appreciate in value at a faster rate than their claims go up.
Many insurance companies stick to a pretty simple model like the one I have just described. Some take more risk, however, in order to increase the profitability of their firms. AIG is probably the leading risk taker among large US-based insurance companies. For many years, in addition to buying financial assets to fund their liabilities, they have taken a very active role in the exotic frontiers of financial markets, especially those that involve fixed income derivatives. I cannot explain derivatives in detail here, but you may think of them as sophisticated wagers on the outcomes of different financial events. For example, one might make a bet that interest rates will go up, or that a particular company will default on its bonds.
AIG has made a lot of bets in the past few years that have not panned out, including many related to residential and commercial mortgages. As a result, they are currently in a position in which they cannot afford to pay off on all their bad bets and still honor their commitments to their policy holders. If AIG goes out of business, then all of those policy holders will need to find new insurance. This is not the big problem for property and casualty policy holders, but it can be disastrous for holders of life insurance policies. Even if their cash values are protected, they will pay much higher prices to buy new policies than they are currently paying AIG.
The problem is that the parties who are on the winning sides of the bets that they made with AIG want to be able to collect on their bets. Those parties are primarily banks like JP Morgan Chase and Goldman Sachs, hedge funds, and private equity funds. If AIG fails, then those parties who won their bets with AIG, will have no way of collecting their winnings. Although cloaked in sophisticated financial terminology, it is no different than someone holding a winning ticket at a race track being unable to collect on the bet.
AIG wants US taxpayers to lend them money so they can pay off their losing bets and not go out of business. Their argument for this is that the parties to whom they owe money will be in trouble as well if AIG does not pay them because they have been counting on getting paid off. This is what people mean when they talk about financial "contagion". AIG is correct. People who cannot collect money they are owed may indeed be unable to pay money they owe to someone else. You can see how this could spread in a bad way. What this analysis leaves out, however, is the idea that people who make wagers have some responsibility to assess the ability of their counterparty, the person with whom they have placed the bet, to pay. I can bet $1000 on a football game with my teenage son, but I will not be collecting anything even if I win so I should probably not plan to pay next month's mortgage with the money I hope to take off him.
So if we had not used taxpayer money to help out AIG, what would have happened? Well, let's assume that AIG had followed Lehman's example and filed for bankruptcy protection. Then their shareholders would have been wiped out. In addition, anyone owning bonds issued by AIG might not have received 100% of their money back. AIG might have been unable to honor insurance claims that it has received. And the parties with whom AIG has placed losing wagers would been unable to collect some or all of their winnings. None of this is pleasant to contemplate, but in a capitalist system, everyone is supposed to assess the risk inherent in their financial transactions.
To the extent that it is difficult to make such an assessment because information required to do so is unavailable, we need to be able to rely on regulatory authorities and rating agencies to help us. As an insurance company, however, AIG is regulated not by the federal government but by the various states in which it operates. In the lax regulatory climate of the past few decades, however, regulators have fallen far behind the ability of sophisticated financial firms to do clever things with other people's money. It is well documented elsewhere that the rating agencies (Moody's, S&P and Fitch IBCA) have been asleep at the switch throughout the expansion of the credit bubble. And then there is Bubbles Greenspan but that is a story unto itself.
Going down the list of victims of an AIG bankruptcy, it is pretty easy to write off the shareholders and bondholders. AIG's problems have been well publicized for the past year or more and any of them could have sold their shares or bonds easily until the past few weeks. Counterparties, i.e. other financial professionals with whom AIG has transacted business, are primarily banks, other insurance companies, and hedge funds and other private investment vehicles. In short, they are the most sophisticated investors in the world. They should have known better.
Finally, what are the pros and cons of using taxpayer money to bail out AIG. Well, the principal argument in favor is that it prevents AIG's problems from spreading further, at least for a while. If they were to spread, other innocent people, e.g. policy holders and employees of businesses hurt by AIG's demise, would be hurt as well. So why not use taxpayer money to stabilize the situation? AIG might recover and be able to pay the money back with interest. Now that the government has acquired its 79.9% interest in AIG in exchange for $85 billion, we will actually see if that happens in a few years. Even if it does end up costing nothing, it is still a terrible and unnecessary idea.
Here is why. Every dollar spent today propping up a financial institution that took more risk than it could bear, is a dollar not spent today to fix America's infrastructure, to improve its schools, to deal with its healthcare and energy crises. Every dollar spent to help the financial services industry is a dollar that supports real estate prices in the Hamptons but pushes them lower in Ohio. Taxpayers might get paid back, or they might not; but in the short run, financial professionals can rest assured that they can still take the family to Barbados for the holidays while the rest of the country takes second and third jobs to afford $4/gallon gasoline. if you think the price of gas is unrelated to the problems of our financial sector, think again. A primary reason why gasoline costs $4/gallon is the devaluation of the dollar caused by our massive overseas borrowing. To fund the bailouts of FNMA, FHLMC, and now AIG, we will be borrowing hundreds of billions more dollars from the Chinese, the Koreans, and even the Russians - the ones President Palin wants to fight.
Taxpayer-funded bailouts of financial institutions erode the confidence of the American people in their government further, and reward irresponsible behavior. The only way to stop them, frankly, is to stop them. The way to prevent them in the future, is to have more regulation. It is too late to reel in the current crop of miscreants. It will be up to the next administration to rebuild our regulatory infrastructure to protect taxpayers from the consequences of risky behavior by financial professionals.
Today both candidates want you to understand that they see the problem, but only one of them will even attempt to do anything about it. If people want to stop seeing their money taken from them and given to Wall Street, they need to get behind Barack Obama and the Democrats immediately. Otherwise, I'll be counting on you to bail me out when my bets go wrong.