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Not Just AIG, But the Entire Financial System
Seriously, this New York Times article on AIG, is a quick and layman accessible recounting of what went wrong there, and now that the Taxpayer is laying out another $30 to prop them up, with the approval of the ratings agencies who made this problem possible in the first place, it bears reading.
What we see is a metaphor for the entire rotten "Anglo-Saxon" system of unregulated hyper-capitalism.
AIG does not exist any more, what's there is a simulacrum of a going business, fueled by zombie juice amounting to over $150 billion of taxpayer dollars, with the promise of more federal support, but that's not the important part.
The important thing is are not just talking recklessness and incompetence here, we are talk real and deliberate crimes, and even now the authorities don't have the slightest inclination to prosecute.
What took AIG down was a division that wrote credit default swaps (CDS), lots of them, and then, when they came due, they were bankrupt.
A CDS is a piece of paper that allowed them to insure all sorts of dodgy documents, but lacked the regulation, and the reserve capital requirements, of real insurance.
They wrote them because people were willing to pay them to write them, and people were willing to pay them because it allowed them to "lease" AIG's AAA rating (see the ratings agencies linked above) for their financial instruments.
The result is that if AIG is allowed to die, instead of remaining in its undead state, everything blows up:
So, AIG is Sheriff Bart from Blazing Saddles, holding the gun to his own head, saying, "Hold it! Next man makes a move, the n***** gets it!"
Of course, this isn't criminality (though it should be), this is Republican economics, privatizing the profits while socializing the losses.
The criminality is further down in the article:
So they sold insurance, and never had any intention on paying off, because if they had, and remember that AIG is (was) at its core an insurance company, even absent regulatory demands, they would have put aside something in the way of capital reserves.
This is the same as selling phony stocks. AIG, or more at least its everyone in a position of responsibility in its financial practices unit in London, where the swaps were written and sold, and everyone involved in supervising these activities, up to and including the CEO, and probably the board of directors, knowingly sold a fraudulent product.
Cross posted from 40 Years in the Desert.
What we see is a metaphor for the entire rotten "Anglo-Saxon" system of unregulated hyper-capitalism.
AIG does not exist any more, what's there is a simulacrum of a going business, fueled by zombie juice amounting to over $150 billion of taxpayer dollars, with the promise of more federal support, but that's not the important part.
The important thing is are not just talking recklessness and incompetence here, we are talk real and deliberate crimes, and even now the authorities don't have the slightest inclination to prosecute.
What took AIG down was a division that wrote credit default swaps (CDS), lots of them, and then, when they came due, they were bankrupt.
A CDS is a piece of paper that allowed them to insure all sorts of dodgy documents, but lacked the regulation, and the reserve capital requirements, of real insurance.
They wrote them because people were willing to pay them to write them, and people were willing to pay them because it allowed them to "lease" AIG's AAA rating (see the ratings agencies linked above) for their financial instruments.
The result is that if AIG is allowed to die, instead of remaining in its undead state, everything blows up:
.... Yet the government feels it has no choice: because of A.I.G.'s dubious business practices during the housing bubble it pretty much has the world's financial system by the throat.They fail because if AIG fails, then their CDS contracts are worthless, and they have to account for their assets at their actual value, and overnight they become insolvent.
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.
I don't doubt this bit of conventional wisdom; after the calamity that followed the fall of Lehman Brothers, which was far less enmeshed in the global financial system than A.I.G., who would dare allow the world's biggest insurer to fail? Who would want to take that risk? But that doesn't mean we should feel resigned about what is happening at A.I.G. In fact, we should be furious. More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin.
"They were the worst of them all," said Frank Partnoy, a law professor at the University of San Diego and a derivatives expert. Mr. Vickrey of Gradient Analytics said, "It was extreme hubris, fueled by greed." Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet -- and this is the part that should make your blood boil -- the company is being kept alive precisely because it behaved so badly.
So, AIG is Sheriff Bart from Blazing Saddles, holding the gun to his own head, saying, "Hold it! Next man makes a move, the n***** gets it!"
Of course, this isn't criminality (though it should be), this is Republican economics, privatizing the profits while socializing the losses.
The criminality is further down in the article:
....A.I.G. didn't specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.(emphasis mine)
....But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets -- housing -- could only go up in price.
That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That's why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn't have to put anything aside for losses. And it didn't. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.
So they sold insurance, and never had any intention on paying off, because if they had, and remember that AIG is (was) at its core an insurance company, even absent regulatory demands, they would have put aside something in the way of capital reserves.
This is the same as selling phony stocks. AIG, or more at least its everyone in a position of responsibility in its financial practices unit in London, where the swaps were written and sold, and everyone involved in supervising these activities, up to and including the CEO, and probably the board of directors, knowingly sold a fraudulent product.
Cross posted from 40 Years in the Desert.
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Seriously, if these companies are too big to fail, the senior executives are still small enough to send them to gaol for the rest of their lives.
March 2, 2009 12:32 AM | Reply | Permalink
Hi Matthew,
Can you tell me why we shouldn't incorporate/charter a few new large banks, capitalize them with the trillion or so in TARP funds thus generating ten trillion in immediately lendable funds, using the customary leverage ratio for sound banks. Why not let the chain letter of 60 trillion in CDS alchemy go down the tubes.
The new banks will have ample empty office space, with computers and cables and office furniture already in place right after the huge fire sale?
Why prop up B of A and Citi and all the hyenas?
March 2, 2009 5:08 PM | Reply | Permalink
See Martin Weiss, Beginning Now: The Panic Phase of the Collapse, he is predicting 500 on the S&P, and 900 on the NASDAQ.
March 2, 2009 9:36 PM | Reply | Permalink
Weiss also says what DH Williams says, why give free money to prop up crooks (at the Fed 'window"), while denying honest businesses loans at any rate.
March 2, 2009 9:38 PM | Reply | Permalink
I agree with all that you said. But, doesn't this lead to the conclusion that there no longer is a financial system in the world? And, if that is the case, why isn't there a big worldwide meeting of the "group of 12" for example, holding continuous sessions devising a financial system for tomorrow?
The world economy was largely based on the financial system, but the financial system is kaput! So, the world economy is also kaput. Nero needs to put down the fiddle.
March 2, 2009 12:45 PM | Reply | Permalink
That's why I've been suggesting that we amputate the existing financial industry for some time.
March 2, 2009 12:55 PM | Reply | Permalink
Our current travails can be traced to many things, but fundamentally it gets back to Nixon and Schultz killing Bretton Woods in '71 (OK, Viet Nam before that certainly didn't help). That set the trajectory for all neo-liberal experiments that followed: currency speculation post-Bretton Woods, deregulation in all its forms (trucking, airline, utilities, financial), union busting, creation of the oil spot market, Reagan's tax cutting, tariff cutting and deficit ramp up, Greenspan's creation of derivatives, repeal of Glass-Steagal, Dot Com bubble, Y2K bubble, rise of the Hedge Funds, Shrub's tax cuts and war spending, mortgage bubble and perhaps a few other things that are not coming to my 53 year old mind at the moment.
In other words, most of FDR's reforms, which had laid the basis for a long wave of economic growth, were jettisoned, and the wealth that had been built up from the mid 30's to the late 60's started being systematically looted.
So, from the broad outlines of how FDR did it, updated for today's situation, we can take the following actions to begin to turn things around (or failing that, see civilization itself unravel before our eyes). Start with a new Pecora Commission. Investigate and prosecute the treasonous pirates who caused the meltdown. Re-instate Glass-Steagal (put a wall between chartered banks and investment banks). Put a whole lot of banks into receivership; write off the bad assets (ALL of the derivatives - then outlaw them) and release the banks back into the wild. Temporarily freeze foreclosures during this process. Shut down the Fed, and/or subsume it under a new National Bank. As Hamilton did post-Revolutionary War with the State's debts, monetize our debt thru the Bank, creating credit targeted (only) for massive investments in needed infrastructure. Raise tariffs to historical norms to protect what little manufacturing capabilty we have left, and nurture it back - we will need huge amounts of steel, concrete, skilled and semi-skilled workers, engineers. We will have to have a lot of white collar folks switch to blue collars.
And more, but I'm out of time. It can be done. It must be done. Some very powerful people will fight it to the last (the grandsons and grand-daughters of FDR's "Economic Royalists"). But they must finally be entirely defeated or they will destroy the nation's institutions and usher in fascism.
March 2, 2009 3:50 PM | Reply | Permalink
It's all dirty paper now...
This is unreal. The ultimate scam, & all (by our laws) 100% legal???
Everyone wants to excercize the commonsense approach & say "let it tumble". The implications of allowing this Co. to tumble from my understanding may very well find the assetts of the USA divvied up among, Saudi Arabia, China, The EU, Great Brittain... So the fact that our government is scrambling to keep the little charade afloat should come as no surprise. At some point we're gonna have to reconcile the fact that it's really all just dirty paper in the end.
March 2, 2009 12:59 PM | Reply | Permalink
It may all be dirty paper, but dumping trillions of dollars into AIG isn't going to clean up either the paper or the system that produced the paper. And if the dumping of all of that money isn't accompanied by a sound plan for a clean financial system, we have just handed our treasury to a few obscenely wealthy individuals to play with.
This may be the time for reality to govern our actions, as hard as it will be accept that reality.
March 2, 2009 1:58 PM | Reply | Permalink
This is basically what I interpret Krugman as saying.
March 2, 2009 5:46 PM | Reply | Permalink
Actually, when an insurance company sells insurance with no intention of ever paying out, and this is what happened with AIG, it's fraud.
You can argue whether someone like Citi had the expertise to understand the instruments, but not an insurance company, but they set aside no capital reserves.
I would also note that the idea behind the CDS, that people do not have to have an interest in the continued existence the insured property, and that you only get paid for the actual loss, was recognized as toxic, and made illegal 263 years ago in the Marine Insurance Act of 1746.
This lesson isn't a depression era one, it's from before the US was a nation, and the past 15 years have been the only time that we have turned away from it.
March 2, 2009 2:48 PM | Reply | Permalink
"Actually, when an insurance company sells insurance with no intention of ever paying out, and this is what happened with AIG, it's fraud."
Not precisely. They never had an expectation of paying out. That's close, but not quite the same as having no intention of paying. And there was never a legal requirement that they capitalize to cover their potential losses. The worst part is that everyone was playing the same high-stakes game of bullshit, including the Bush administration, who actively encouraged all of it because it made them look good. And they all knew what they were doing, and it was all completely legal. As Nocera points out, AIG never tried to hide what they were doing. They openly referred to that part of the business as "regulatory capital".
There are a whole lot of people who should be sitting in a jail cell at this point, but for what's happening now--not for what happened then. I'd put Ed Liddy right near the top of the list.
March 2, 2009 5:58 PM | Reply | Permalink
By the way, Liddy is putting the whole thing squarely on the head of former AIG CEO Hank Greenberg:
http://www.bloomberg.com/apps/news?pid=20601087&sid=ad3MwV9Jaqbk&refer=home
March 2, 2009 6:06 PM | Reply | Permalink
Man, you're a brave rabbit kitty coming here and making that point. I was going to do it, but I smelled the boiling tar and saw 'em ripping up pillows and figured even so mild a correction was a risky proposition.
March 2, 2009 8:27 PM | Reply | Permalink
One point you touched on in a comment - the gambling aspect, buying insurance in which the buyer has no material interest. This is what John Paulson and I believe Steve Eisman and others did. Paulson got a 45:1 payout ($1B gross profit) on at least one deal.
This is a seldom noticed part of the problem. That's a theft from the taxpayers who are bailing out AIG. All such contracts should be declared null and void, and any such payments already made should be subject to enforced clawback. I also propose that this apply even to some of those who had material interest in some underlying insurable.
March 2, 2009 9:01 PM | Reply | Permalink
I keep asking why letting AIG and the big banks fail would be worse than what we are doing now. I haven't seen anyone with an answer other than our pension funds would disappear.
Maybe that would be preferable to the potential 4 trillion hole that AIG and Wall Street could end up costing us.
For anyone that believes that prosecutions will ever take place has missed the point of all the bailout money. We are using taxpayer funds to ensure that the Oligarchs recover their losses.
So once again, why bail out AIG and their Wall Street "partners" to ensure the Oligarchs get their money back?
March 2, 2009 10:49 PM | Reply | Permalink
FLA - I have been asking that myself. I did a lightweight search on the net and got to see some interesting things. The foreign investments - United Arab Emerits (sp?) and China may be a small factor but here is what I think is the problem. If the big banks fail then people panic and pull money out of all the banks and the government won't be able to get ALL the banks back together. Actually, I did my research based on why won't the Obama administration nationalize the banks, but same answers apply. I should say maybe partial answers. I am not an economist, I'm just repeating what I read.
March 2, 2009 11:12 PM | Reply | Permalink
FD - The basic reason given is that letting things go to hell in a handbasket would be irresponsible and create much worse damage.
That said, it's a false choice again. We don't have to sit by and let them fail chaotically. Also, if we did let them start to fail, the "oligarch" interests would step in to avert a total wipeout of their own interests, thus saving the system to some extent (JP Morgan did something like this, I think it was 1907). So we don't really need taxpayer money to do this.
But even better is that we don't have to let the whole thing try to fall apart, we COULD be doing a better job of separating the wheat from the chaff, saving the useful banking functions and taking assets from the holding companies to rehab those functions. Then let the market (oligarchs or not) gobble up what's left of Citi et al and start their old games over again.
There is a slim chance that Obama and Geithner are not just giving away the bank here, pardon the pun. That is, they may be smarter than their words and actions to date tell us.
But I'm with you on this: Indications are that what Bush started is not be stopped effectively so far. And sending government money to ANYONE via private firms rescues strikes me as unConstitutional, even if the recipients are not the gamblers and thieves which we know about already.
March 3, 2009 12:30 AM | Reply | Permalink