Friday, March 20, 2009

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?


Anonymous said...

Thought provoking as always. In this case I am thinking about your final question - "is this solution really any better than what we now have?" I don't know the answer to that, but I think we should also consider whether that is the right question in this case. Is it possible that our current situation is one that warrants the alternate question - "is this solution really any worse than what we now have?"

Charles D said...

In the current situation (under both Bush and Obama), the government seems intent on funneling billions (trillions if you include the Federal Reserve's giveaways) into failing businesses with no control whatsoever on what they do with the money. The fear of seeming socialist is causing the waste of taxpayer dollars by the truckload and not helping the economy recover.

We have a scenario where the government has given certain corporations sums that are more than 10 times the value of every single share of stock currently on the market, yet the government doesn't attempt to exercise control. No businessman would be this stupid, why should our government?

Why not simply declare AIG, Citigroup, BofA and the rest bankrupt, take them over just as the FDIC would take over your local bank if it failed? Then the executives would get nothing except a pink slip, the shareholders would get nothing since they didn't do their job either, the creditors would get pennies on the dollar, and then the corporation could be broken up into pieces small enough to fail and sold back to the private sector.

There is no reason to permit a financial institution to get so large and so tightly integrated into the global financial system that its failure threatens our entire economy. We used to have laws against this sort of thing. We had a law that did not permit a single company to own a bank and an investment bank or an insurance company. We had laws requiring insurers and banks to have adequate capital reserves to meet their obligations. We had laws that would have prevented the marketing of exotica like collateralized debt obligations and credit default swaps. All those laws got repealed in the name of the "free market". Well it looks like the invisible hand is giving us the finger.

Scott Hinrichs said...

"No businessman would be this stupid, why should our government?"

Because nobody does stupid quite as well as the government. I know. I saw it first hand when I worked there. (I'm not saying that private business can't be stupid. But government consistently excels at it.)

"There is no reason to permit a financial institution to get so large and so tightly integrated into the global financial system that its failure threatens our entire economy."

Sure there is. When a business (or group of businesses) can lobby politicians to protect them from competition and repeal laws designed to promote competition, there are plenty of reasons — often denominated in greenbacks — to ensure that some companies become "too big do fail."

What is the definition of "too big to fail" anyway? It appears more and more that it simply a measure of how many powerful politicians you have on your payroll.

Charles D said...

You are absolutely correct. That is exactly why we are in this pickle and exactly why nothing will be done to get us out of it.

Actually from what I read earlier this evening, the house of cards may tumble quite a bit further. Apparently both China and the IMF are discussing replacing the dollar as the world's reserve currency. I would recommend buying a wheelbarrow now so you can fill it with dollars and push it to the market when you need another loaf of bread.