Can AIG Fail Softly? Should It?

An AIG failure can be safely managed without producing systemic collapse, says Lucian Bebchuk, a professor of law and economics at Harvard, in this WSJ article.

We have been told since last autumn that it was necessary to pump (apparently endless) billions of dollars into AIG to prevent the complete collapse of our national and worldwide financial industry. If the whole financial industry were to crumble, we would all be left to make do with only the assets currently in our possession.

Such a catastrophic failure is a seriously scary scenario. Look in your wallet. None of your plastic cards would work anymore. Your paper money would be worthless. ATM screens everywhere would go dark. What would you trade for your next tank of gas or loaf of bread? Is it any wonder that demand for gold has skyrocketed (driving its price up), or that retailers of emergency and home storage products are having trouble keeping up with demand?

To prevent such dire events, the government first dumped an $85 billion “loan” into AIG in exchange for preferred stock shares. Then every 90 days or so since then, we’ve chucked in another few tens of billions of dollars. And, whaddoyaknow, that has added up to a pretty large chunk of taxpayer money.

But at least we’re buying worldwide financial stability, right? Well, not quite, says Bebchuk. Some of AIG’s capital infusions to its customers are producing no value for taxpayers, he says. Many of these customer firms deserve to get what Bebchuck calls “a significant haircut.”

Bebchuk is not taking the hard libertarian line that the best course of action is to allow all of these firms to take their lumps even to the point of failure, regardless of the wreckage that would occur. (To be fair, many libertarians say that in the long run, this would produce the most humane outcome.)

Rather, Bebchuk says that Chapter 11 bankruptcy would be quite feasible, provided all of the various governments involved step up and deal directly with firms to which AIG has derivative obligations, and “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.” For this cushion, governments would get stock shares in these businesses, much as the U.S. government is now doing with AIG.

Why should U.S. taxpayers solely bear the burden of AIG’s obligations to international firms? AIG is a multinational firm with obligations in many nations. Not only should other governments deal with AIG problems within their own borders, many have actually demonstrated a willingness to work on today’s serious economic issues.

Bebchuk says his plan “could allow setting different haircuts for different classes of creditors.” It sounds intriguing. I like the idea of letting U.S. taxpayers off the hook for foreign obligations. However, I believe that government ownership of private business creates a moral hazard that should be avoided.

When government competes in the marketplace, it uses its exclusive coercive powers to crush competitors and to pick winners and losers, irrespective of what the market desires. It uses its power to change the rules of the game. It is like having a powerful sports team that owns the stadiums, writes the rules, and employs all of the referees. What other team could successfully compete?

I have to wonder what is worse: government owning shares in one big corporation, or government owning shares in many companies throughout the world.

I have long felt that the government’s midnight deal to prop up AIG was not the best way to have handled the situation. I believe that subsequent events have proven this out. It is nice to hear a proposition for letting AIG fail without destroying our financial system. But is this solution really any better than what we now have?