Policy rhetoric is now taking a turn to the ludicrous. I feel like real life is approaching the stories reported in the Onion. Yesterday, Bernanke is suddenly “angry” at the AIG bailout. “AIG exploited a huge gap in the regulatory system, there was no oversight of the financial-products division, this was a hedge fund basically that was attached to a large and stable insurance company.” REALLY!?!? The company “made huge numbers of irresponsible bets, took huge losses, there was no regulatory oversight because there was a gap in the system.” AMAZING!
Suddenly we are shocked to learn that the first $150 billion – granted with virtually no controls over an insolvent firm – was inadequate to turn the firm around. Even more shockingly, AIG officials were reluctant to sell off portions of the firm, which would have substantially reduced the value of their holdings and put them out of their jobs. SHOCKING! Managers acting in their own self-interest? ABSOLUTELY SHOCKING!
When AIG modeled their operations after hedge funds, they leveraged their off-balance sheet operations to create massive unfunded counterparty exposures that made the firm “systemically important.” Reports suggest that there remain some $300 billion in net notional exposures that must be resolved. Hence, I think the magic number for government infusions here is $300 billion, because the bleeding won’t stop until Treasury commits at least that much if they want to “reduce the systemic importance.” More than $300 billion will be required if any direct investors are to be rescued. At the end of the road, however, there are few tangible assets to support any substantial going concern value. Critics including former AIG Chief Executive Officer Maurice “Hank” Greenberg said the strategy of breaking apart the insurer and selling units wouldn’t reap enough to repay AIG loans.
The fallacy lies in acting as if the result is somehow unprecedented. We have seen this all before. AIG’s business was spread across 130 countries and 400 regulators. None of those regulators apparently caught the hedge fund play and resolved the “systemic importance” issue. Remember the BCCI scandal? Before BCCI failed in 1991, it built up a corporate structure so complex that it could operate virtually unregulated all over the world. BCCI used more than 400 shell companies, offshore banks, branches, and subsidiaries, and unregulated accounts in the Cayman Islands and elsewhere to hide crooked operations with fictitious transactions.
Like AIG, BCCI based its operations in countries where regulation was weakest. If BCCI encountered a legal impediment, it would often be able to circumvent the problem by creating a new affiliate or acting through one of its myriad existing entities. For further reading, see the December 1992 Report to the United States Senate Committee on Foreign Relations at http://www.fas.org/irp/congress/1992_rpt/bcci/. The international context of AIG makes BCCI look puny.
In the meantime, the public policy rhetoric is attempting to sell taxpayers a bill that is not theirs to pay. Bernanke said the revised bailout gives taxpayers “the best chance” of eventually recovering “most or all of the investments” the public has. Such specious statements are translatable as “AIG has us up against the wall so we have to throw good money after bad.” Otherwise, the threat is that AIG won’t be able to support their counterparty relationships with “the banks.”
Which banks, in particular? Apparently it is those banks that… well, also modeled their operations after hedge funds and are also, therefore, “systemically important,” by the Federal Reserve and Treasury’s accounts. Banks’ total assets as of December 31, 2008 were just over $13.853 trillion, with total industry equity capital of $1.302 trillion. But bank notional derivatives exposures as of December 31, 2008 were $201 trillion, sitting on top of another $7.166 trillion in commitments to lend, $2.028 trillion in securitized assets, and $1.005 trillion in standby letters of credit and foreign office guarantees, for a total exposure of $225.149 trillion, or a leverage ratio of about 173:1 on total industry capital.
Of course, today’s situation is primarily focused on large banks. Looking only at the 86 U.S. banks with assets larger than $10 billion, there are still notional derivatives exposures as of December 31, 2008 of $201 trillion, sitting on top of another $5.570 trillion in commitments to lend, $1.991 trillion in securitized assets, and $0.950 trillion in standby letters of credit and foreign office guarantees, for a total exposure of $219.418 trillion, or a leverage ratio of more than 241:1 on large-bank capital of $909 billion.
According to Timothy Geithner, “AIG is a huge, complex, global insurance company attached to a very complicated investment bank, hedge fund that was allowed to build up without any adult supervision.” The adults not only supervise the play, however, they also help choose good playmates. The question begs to be asked, therefore, who allowed the large banks to enter counterparty relationships with AIG in the first place? That would be the bank regulators – the same ones now threatened with the large banks’ leverage of 241:1.
I disagree with Geithner’s assertion that because of “the risks AIG poses to the economy, …the most effective thing to do is to make sure the firm can be restructured over time.” There is no core at AIG to restructure. As the Wall Street saying goes, with a failed business model and all the assets hypothecated elsewhere, the only asset of value is the copy machine toner. More capital and liquidity to others in the industry help, either, since many other firm assets are also hypothecated to cover similar off-balance sheet commitments.
The way out of this situation, therefore, is not further support for the unstable and opaque counterparty relationships that are causing the “systemic importance” but revealing those relationships and unwinding the exposures. It is a large task, but one that is not optional. Will policymakers continue to fiddle while our financial markets and economies burn?