There’s an uproar about whether the government should let AIG fail, a debate
re-energized by the latest revelation of bonus payments going to AIG’s
executives. In fact, there’s a good case to be made that AIG should fail,
and it has nothing to do with bonuses.
The rescue of AIG is warping the banking system and unnecessarily extending
the credit crisis. This misguided effort stems from a lack of transparency
and some basic misconceptions about AIG’s business.
Let’s take a moment to review how AIG made money and why it’s now losing so
much. Most of AIG’s losses have been attributed to its failing positions in
credit default swaps . Essentially, AIG is swapping cash flows with
other institutions: those banks pay AIG a small sum on a regular basis, and
then under certain conditions — like mass foreclosure or corporations’
defaulting on their loans — AIG pays out a large sum. In other words, AIG
sold insurance — its problem is that it is paying out too much.
Of course, it’s a bit more complicated than that due to the funky nature of
AIG’s insurance. Other types of insurance do not carry the same risks
because when one claim pays out, it does not snowball. AIG’s insurance on
foreclosures or other defaults is not like insurance for accidents or
disasters; while earthquakes in California are not correlated with
earthquakes in New York, foreclosures are spiraling out of control together,
fueled by a widespread recession.
Moreover, investors or banks holding credit default swaps do not necessarily
own the tranches of mortgages or bonds that the CDSs insure. AIG may have
even written multiple swaps over the same mortgages or bonds. It would be
like an insurance company selling earthquake insurance on one single house
to multiple investors. When the house falls, so does AIG.
But there’s a true insight into this mess if you just step back and consider
the bigger picture, not just AIG. Regardless of the details of the various
swap contracts, they all represent potential transfers of wealth between
financial institutions. If we consolidated the entire financial sector, all
these debts would effectively vanish.
Think again of the insured house. Many institutions hold insurance on the
house; on the other side are insurance companies and the like making an
opposite bet. If the house is destroyed, one group of institutions wins and
the other group loses. Considering all institutions together, no money was
truly lost — it’s what economists call a zero-sum game. In good times, risk
hungry banks loved this game, but now they have become risk averse, and the
game seems to have changed. So how can many of the banks simultaneously
claim enormous swap losses with no bank claiming significant profit
Here are two possibilities: either the vast majority of all swaps — not just
AIG’s — are held by investment banks, or a significant portion is held by
other financial institutions like hedge funds. Suppose all swaps are held
by banks. Since swaps are a zero-sum game, the banking industry as a whole
cannot lose money on swaps. Then there is no need for a bailout.
Alternatively, if hedge funds hold significant positions, then it is
possible for the banking industry as a whole to net a loss on swaps. That
loss would be the hedge funds’ gain. This means the bailout is ultimately
saving the hedge funds.
Whichever it is, if the number of institutions involved in swap trading
were limited to those trading with AIG, then no, AIG is probably not too big
to fail. We have to worry about chains of claims. Just because AIG only
dealt with banks does not mean that those banks did not rewrite similar
contracts with hedge funds.
The most direct solution to fix the swap problem is to settle all such
agreements and eliminate their uncertainty from the equation. If the
payments are reversed, or the payments are stopped, or they are settled once
and for all, the uncertainty will vanish.
The problem with keeping the swaps on the banks’ books is that their
potential payoff or loss is random, depending on the particular details of
the contract and various outcomes in the world. Moreover, banks today are
risk averse and often assume worst-case scenarios into current pricing.
Thus, they are far more likely to claim losses than profits on such
instruments.
At the very least, there should be full transparency. Any institution
receiving money from the government — and ultimately from American taxpayers
— should reveal its holdings. Even institutions that do not require a
bailout should be more closely tracked by regulators. The government can
and should monitor all transactions, even those over-the-counter.
We have focused too much on each individual bank, and its possibility for
failure. But the economy does not need every bank to survive; it needs
most. Right now, we need to know which ones. By propping up financial
institutions with unknown potential losses, the government is prolonging the
uncertainty about whether they will fail. This perpetuates the crisis of
confidence in which banks do not trust each other enough to loan money.
Read “AIG’s Distress: Are There Enough Fingers for This Dike”
See pictures of the global financial crisis
