AIG

AIG needs more tax payer money. While this seems a little like throwing good money after bad, what happens if we don’t? Here’s my lay-person’s take.

If AIG goes under, presumably it will not make good on its credit default swaps (CDS), the insurance-like products it sold to the banks. These CDSs were bought by the banks to protect the mortgage-backed securities they had written; in the event that the collateral (the properties against which the mortgages were written) turned out to be worth less than the mortgages themselves, their mortgage-backed securities (or collateralized debt obligations, CDOs) still had something behind them. If AIG doesn’t make good on its CDSs commitments, the banks’ CDOs are worth less than they currently and those banks will likely fail their ’stress tests’. Consequently, they will be forced into bankruptcy as well.

Some think this is a good idea (and perhaps in some ways they’re right), yet the cost to many could be horrendous. Without the banks to lend to business and consumers the economy will contract further, more people will loose their jobs, their houses, their 401k savings. Property prices will fall further, personal credit will be more difficult to obtain, consumption will decline, and the recession will deepen.

Of course, though keeping the banks alive may lessen the severity of the recession, we will have preserved the very system that was in no small measure to blame for getting us into the mess in the first place…

A question answered

A few weeks ago, I posed a question: how will the bailout plan simultaneously unfreeze the credit market and ensure that taxpayers are not left with the bill. I think I now have an answer. Nationalizing the banks (taking share in exchange for cash) fixes the weak balance sheets in a way that buying troubled assets at fair market value did not. And it appears that the terms are not that shabby; a guaranteed 5% return with greater upside potential if the banks' shares do well.

In other words, the plan, in its original form was never likely to work without the taxpayer taking a bath. This new approach looks a lot better.

A passing thought

Sometime early next year I imagine, AIG will hold its annual shareholder meeting. Someone will walk into that meeting holding a certificate for 80% of AIG’s shares. Will the name on the share certificate read “Secretary of the Treasury Henry Paulson”? If so, how will he cast his vote? Just a passing thought…

The Market for Lemons

Akerlof (1970) pointed out that when there is asymmetric information with the seller knowing more about the true quality of the product than the buyer, the only items up for sale will be lemons. The Treasury is likely to be in just this position when it offers to buy toxic assets from over-extended banks. Talk of ‘eventually making a profit’ from the purchase of such lemon-flavored assets thus seems, at best, overly optimistic.

Identification

Identification: a feeling of belonging to something larger than oneself.

When one group is treated differently from other groups, people might be forgiven for adjusting their frame of reference. The larger group to which they once thought they belonged - and owed some allegiance - may be replaced by a smaller more proximate group. The Wall Street bail-out risks creating such a shift. Small business owners may wonder why it is acceptable for them to fail but not for large Wall Street firms. Home owners struggling to pay mortgages, other who have lost their homes.

Arguments about vital interests and the like, while intellectually comprehensible, are hard to swallow in a culture that holds dear the notion that everyone has an equal shot - but by the same token faces the same risks. If care is not taken in how the Emergency Economic Stabilization Act is implemented, fissures may appear in the rather delicate fabric of our society (sorry Lady Thatcher - there is such a thing as society).

Moral Hazard

Allowing those investment banks that found themselves unable to meet their obligations to creditors not to fail creates a moral hazard problem that will haunt not only the financial services industry but all businesses in the US for a generation.

• We have signalled to outside directors that they need not exercise due diligence in oversight of the companies on whose boards they sit.


• We have signalled to managers agents that their risky behaviour has no downside and thus that there is not cost to risky behaviour in the future.


• And we have signalled to owners - shareholders - that they need pay no heed to the actions of those working on their behalf. Their investment is guaranteed.

Everyone - owners and managers alike - how has an incentive to take ever larger risks. If they win fine; if they loose, not a problem, someone will come to their aid. The problem is that those who are being asked to provide that aid is all of us, the US taxpayer. We have created an expectation, not just in the banking sector, but thought the business community that if you are large enough, no harm will be allowed to come to you, if you’re big enough. Small business owners may create half the wealth in this country but they are not equal recipients when it comes to a transfer of wealth from Main Street to Wall Street and beyond.