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Moral Hazard: The AIG Bailout

The AIG bailout will go down as one of the most wasteful use of taxpayer dollars and the largest representation of moral hazard in government interventionist history.  Despite the seemingly strong recovery from the financial brink of doom, the silent risk that was introduced into the economic gears was the absolute financial backing and bailouts.  Moral hazard describes the way firms act differently under the knowledge that when they get in trouble, daddy (the taxpayer) will step in to save the day.  Imagine how you would gamble your life savings in Vegas if you knew that if you lost every dime, someone would step in and give you back your money?

The question with AIG is how did it happen?  With all of the corporate governance and the nearly 100 year history of selling insurance, how did the global behemoth succumb so quickly to the financial crisis?  If you read my introduction to the insurance business, you know that insurance is nothing more than a spread-based business.  The insurance company pays out interest that is less than the interest earned on its investments.  As long as they underwrite the insurance risks well enough and invest their money wisely, it is tough to take down an insurance company.  Those are two big “ifs” though.    Although highly regulated, insurance companies do become insolvent (Conseco, AIG, First Capital Life of California, Mutual Benefit of New Jersey, Executive Life,  Fidelity Bankers Life, etc.)  Usually they are seized by state regulators and unwound over time, sometimes they are sold off to other insurance companies and sometimes (AIG) the federal government backstops them.

AIG set a very poor precedent.  Like many insurance companies, AIG got in trouble on the asset side of the balance sheet.  In trying to increase the investment yield of their portfolio they reached out into more exotic and risky realms of investments.  When lower quality mortgage backed securities did not provide enough juice, they turned to CDO’s.  When CDO’s did not have enough juice, they turned to the credit derivatives market.  That is where the AIG Financial Products Unit comes into play.

AIG Financial Products Corporation was started in 1987 with its primary focus being the interest rate swap market.  In issuing debt or managing interest rate exposure in assets and liabilities, interest rate swaps are the key tools.  The unit later became the biggest pioneer in commodities as an investment (DJ-AIG Index).  In the 90’s AIGFP became a bigger player in the structured mortgage market, including CMO’s.  It took AIGFP until 1998 to enter into its first credit default swap, over 10 years after the unit was born.  From then on, it seemed that writing insurance on corporate bonds would become AIGFP’s bread and butter business.    Like all bonus incentivized businesses, the profits were never enough.  When spreads on corporate bonds were tight, the unit insured against losses on CDO’s, CMO’s, and CDO^2’s to increase the investment yield.  If you cannot earn enough with a once leveraged product, leverage it twice, three times or more.

The selling strategy for AIGFP to AIG corporate was simple: in the insurance products that AIG sold to policy holders they were borrowing money from policyholders and investing in credit-risky bonds thereby earning the “credit spread“.  If instead they bypassed the policy-holder and invested in bonds directly, they found that they could earn a greater spread with none of the costs associated with managing the actual insurance aspect of the product….  Now that is how genius is born.  They could make more money more easily and more quickly by borrowing from the financial markets and investing in credit risk rather than going through the traditional route of selling insurance products.  The employees at AIGFP with large bonuses loved it and the executives at AIG loved it.  Unfortunately, greed got the best of them.

It is my belief that AIGFP had a good business model going.  They were utilizing the strong credit rating of their parent company to borrow from the financial markets cheaply.  They went wrong when they got greedy.  Selling protection on credit default swaps is much akin to selling equity options.  When markets are calm, you collect a small premium and you are happy.  When markets get very turbulent you can lose a year’s worth of premium or more.  In AIG’s case, they didn’t just sell equity options or insurance on corporate credit, they sold insurance on leveraged products.  The slightest disturbances in the markets can make leveraged product prices change drastically.  On top of that, they sold credit insurance on products that were themselves illiquid.  So when the sub-prime mess hit, the value of the underlying securities went far below their fundamental value because no one wanted to own them.

So the situation looks like this:

  1. AIGFP has a lot of clout at AIG because they have been a very profitable derivatives/trading unit
  2. In 1998 they find the holy grail of profit generation in the form of selling credit risk protection via credit default swaps
  3. The further success of the unit gives them more power and management asks if they can generate even more in revenues
  4. Success brings hubris.  AIGFP starts selling protection on all sorts of leveraged products

The question that immediately came to my mind was: “why did all of the banks allow themselves to gain so much exposure to AIG as a single counterparty?”  Looking at the “who’s who” list below, that’s a big question.

Goldman Sachs and Societe Generale were the biggest suckers

Goldman Sachs and Societe Generale were the biggest suckers

Further delving into this question – why did the banks allow this to happen even after they got burned so badly by Long Term Capital in 1998?  The funny thing is that banks argue that they are the best at managing their own exposures yet it seems that they repeat their same mistakes.  Is it because they are just greedy and stupid?  I actually hope so, because if instead they believe that they do not have to worry about a large single exposure because the government will bail them out under tail events, then that’s the largest problem (moral-hazard) of all.

The argument that the banks used in the bailout of Bear Stearns, Merrill (yes, that was a bailout), and AIG goes something like this: if one of these counterparties goes under, who knows what the consequences will be?  If AIG goes under then they might take out Goldman Sachs and Societe Generale.  If those two go under, they might take out 6 more, if those 6 go under….

If you are asking why Lehman went under…you have probably watched a few hostage movies right?  Usually one is killed to show the repercussions of inaction…

We cannot afford to let the domino argument prevail.  If we do, then it just gives the behemoth financial institutions a free reign to pillage those who do not understand the truth – that the banks want this counterparty web of risk to exist because it is akin to a terrorist strapped in a bomb.  “If you take me out, I will take you all out with me.


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14 Responses

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  1. Stingy Saver says

    I’d be curious, reading the above, on your thoughts on how the dominoes laid out across the economy might fall (or cemented in place) with TARP, TALF, and the rest of AIG moral hazard compardres (i.e. GMAC, GM/Chrysler, Fannie, & Freddie…) Especially since many of them seem to be getting an extension to their tax payer credit line, including GMAC today according to the WSJ.

  2. jb says

    If the CDS trades were established through an exchange there would have been no domino situation. AIG would have been stopped out way early due to margin calls and trades would have been unwound at relatively better rates as compared to the depth of the crisis.

  3. jb says

    What is irritating is that its the same as LTCM. If all the LTCM trades were against an exchange they would not have had huge counterparty risk (as per one of their top employees – Rosenfeld). Regulators don’t learn, don’t want to learn.

    Also, in the case of LTCM, the counterparties (banks) pooled in money to save LTCM. That was a better deal. Neither was that lesson learnt?! In fact we go one step worse. Sigh!

  4. SurlyTrader says

    That is a great point and I was planning on covering that for tomorrow’s follow-up article. I have harped on the opacity of OTC markets for a while. I understand the OTC market’s place with certain trades as I often transact in that form, but there is no reason that vanilla interest rate swaps and standardized CDS on large names should be traded on the OTC market.

  5. SurlyTrader says

    GMAC should never have become a bank and the recent $3.5B is a slap in the face to every tax-payer. The current risk out there is sovereign risk. The backing of private institutions by the public sector has created a very large strain on many governments and the stress will only increase. Greece might seem like a small economic risk, but if they default the guns might turn to Ireland, Spain and even Japan. Sovereign default risk could be the next wave of contagion.

    With regards to private instituions – ignoring the possibility of any other disturbances, the same game will be played. Loose monetary policy promotes poor investments. Poor investments create bubbles. Bubbles create crashes…

  6. Travis Robinson says

    Would you go so far as to say they should regulate loss reserving on written derivatives to be on-par with that of insurance companies? Or are the ‘heavy tails’ (extreme contingencies) still too debatable from a probability standpoint?

  7. Travis Robinson says

    In your response to your comment above regarding sovereign risk, what currency would you suspect the sellers of that “troubled debt” to exchange into?

  8. SurlyTrader says

    A sovereign default in Greece, Ireland, and even Japan would most likely feed a rally in the dollar. The safest currencies right now over the long haul are probably the Norwegian Kroner, Danish Krone, & Australian Dollar. If you have any relatives in China, I would highly suggest putting some money in the Renminbi.

  9. SurlyTrader says

    A written credit default is a lot like a put that is written far out of the money, but with more of a binary payout. There is no reason that margin requirements like those required on options at the CBOE would not work for credit default swaps. Put it on an exchange and have true transparency.

Continuing the Discussion

  1. Counterparty Risk: Reform is Overdue | SurlyTrader linked to this post on December 31, 2009

    […] article in a series that covers the perverse government bailout of AIG.  The first piece covered how the insurance industry operates and where problems can arise, the second dove into the moral hazard of the AIG bailout in particular and this third piece will […]

  2. Counterparty Risk: Reform is Overdue | Reaction Radio linked to this post on January 1, 2010

    […] article in a series that covers the perverse government bailout of AIG. The first piece covered how the insurance industry operates and where problems can arise, the second dove into the moral hazard of the AIG bailout, and this third piece will address not […]

  3. Counterparty Risk: Reform is Overdue | Stocks and Sectors linked to this post on January 2, 2010

    […] article in a series that covers the perverse government bailout of AIG. The first piece covered how the insurance industry operates and where problems can arise, the second dove into the moral hazard of the AIG bailout, and this third piece will address not […]

  4. Why Not Walk Away From our Mortgage? | SurlyTrader linked to this post on January 12, 2010

    […] us the largest imbalances in global trade ever experienced in the industrialized world.  I have talked extensively about the moral hazard inherent in bailing out financial institutions and corporations in general.  I have laid out how the actions of the government and the federal […]

  5. Mortgage Principal Paydowns Possible? | SurlyTrader linked to this post on February 26, 2010

    […] paying principals down as well.  I am not for the idea of paying down mortgages, you know clearly my views on moral hazard, but from the economics of the situation it sometimes makes sense for the lenders.  After a […]

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