Why Bail Out AIG’s Creditors?

Simon and I wrote on op-ed in the New York Times today, trying to debunk the idea that, as we put it, “A.I.G.’s traders are the people that we must depend on to save the United States economy.” The AIG bonus fiasco, as I’ve written earlier, has been particularly useful in raising the political cost of the administration’s current bailout strategy. But, as I said then, “$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another.” And as far as the cost to the taxpayer is concerned, the big bill is for bailing out AIG’s creditors. In his op-ed in the Wall Street Journal today, Lucian Bebchuk wants to know why.

Now, the government has not explicitly guaranteed AIG’s liabilities. But the main reason for bailing out AIG in the first place was the fear that an uncontrolled failure would have ripple effects that would take down many other financial institutions who were dependent in some way on AIG; most commonly, they had bought insurance, in the form of credit default swaps, from AIG and were counting on being paid. And a major usage of bailout money has been to make whole AIG’s counterparties holding those credit default swaps, primarily investment banks trading on their own account or on behalf of their hedge fund customers.

I still think it was a mistake to let Lehman fail, because of the sudden panic it created. But we are in a very different situation today. Many people now believe that the government may decide to let bank creditors lose some of their money. As Bebchuk says, instead of continually giving AIG taxpayer money that is effectively used to bail out other banks (many of which are in Europe, allowing European governments to free ride on the U.S.), the government could let AIG fail and bail out those other banks directly, thereby at least getting increased ownership stakes in return. Bebchuck also explains that AIG’s insurance subsidiaries would not become insolvent if the AIG holding company went bankrupt, because they have their own reserves. (Insurance operations are regulated on a state-by-state basis, and state regulators establish reserve requirements for insurers.)  Furthermore, he argues, failure is not an all-or-nothing proposition:

For example, the government could place AIG in Chapter 11, but commit to provide supplemental coverage that would make up any difference between the value that creditors would get from AIG’S reorganization and, say, an 80% recovery. Such an approach could allow setting different haircuts for different classes of creditors.

I think that the government could let AIG fail, if – and this is a big if – it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors (not to mention employees – bankruptcy would settle this whole question of whether the bonus contracts are legally binding once and for all).

There was clearly no time to do this between September 15 and September 16. But the government by now has had six months to study the books of AIG and its major domestic counterparties. People are no longer willing to take it on faith that the future of the free world depends on an implicit blanket guarantee for AIG. At least we want to see some evidence.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.

4 Responses to "Why Bail Out AIG’s Creditors?"

  1. Guest   March 20, 2009 at 5:22 pm

    It’s not the creditors, it’s the CDS counterparties that have been abd will continue to be bailed out. There are $55 trillion CDS still outstanding, the vast majority of which – exactly like AIG’s CDS – were sold only to collect premiums with neither intent nor capacity for payment in the event they were actually needed because of someone’s default. Not only did the U.S. pour $170 billion into AIG so that it’s CDS counterparties couldn’t demand payment (as automatically triggered if AIG’s fake “collateral” fell below a certain level), they poured it in because the whole global CDS party-counterparty network is a giant rube goldberg fraud machine waiting to collapse and take all the major financial players that exploited it with them. Once AIG (and other CDS “insurers”) are forced to cover their CDS payment obligations and fail, the CDS themselves (all $55 trillion) become worth less than they were before and this triggers another round of Lehman-like balance sheet crises at all the institutions with worthless loans they can claim are worth something because they are “hedged against default” by CDS. The unwind process is like a house of cards collapsing, or perhaps a nuclear chain reaction: the devaluing of the alleged worth of all the financial assets of the world’s large financial institutions (banks, investment houses, hedge funds, insurance companies, mutual funds, pension funds, etc) implodes so fast it’s virtually instantaneous and total. No, the Fed will not permit that implosion if it can help it and AIG is neither the only nor the last of the CDS “insurers” that the Fed and Treasury will be underwriting for years.

    • Mark   March 20, 2009 at 7:15 pm

      Mr. Kwak’s point, I believe, is that in supplying bailout money to prevent the potential bankruptcy of AIG’s counterparties, we are simultaneously supporting AIG’s creditors. He argues for a thorough accounting of AIG’s CDS holdings so that the Treasury could then be in a position to determine which counterparties would represent a “nuclear” risk if they weren’t paid, and which counterparties could absorb the loss without setting off a chain reaction. The higher risk counter parties could then be paid off directly by the government and the AIG holding company could then be allowed to go into Chapter 11 saving the taxpayers the cost of floating AIG’s creditors (along with all the low risk CDS counterparties). It’s a very rational approach. The problem is that the Fed and Treasury are suffering post-traumatic stress disorder triggered by the demise of Lehman. My guess is that they’ve decided that it’s safer, at least for the time being (and I fear permanently) to throw taxpayer money at the problem. And it’s easier, especially for the Fed.

  2. CHRIS DAVIS   March 22, 2009 at 12:11 am

    This is pathetic: the Fed and Treasury had more than enough quantitative analysts available to have demanded and thoroughly analyzed the entire outstanding net CDS book: about $5tn, NOT $55tn.Next step, call all players in a room(we can suppose 90% contracts owned by 5% participants) and threaten to 1)drastically raise the margin requirements for all CDS;and/or 2)abrogate all CDSs simultaneously because participants couldn’t meet new margin requirements.Moral analogy: a life insurance company that has sold thousands of “a-penny-gets-you-a-million” life insurance policies to seniors. Just because policies have been sold with a fraudulent intent creates no moral obligation for the authorities to honor them.