Saturday, September 20, 2008

AIG, Ben Bernanke, and the Sympathies of a Free Market Capitalist

Did taxpayers REALLY just give AIG an $85 billion dollar bailout?

Turns out, not so much.
For those not in the know, American International Group (AIG) is one of the world’s largest insurance companies, and they insure, well…a lot of things. AIG’s primary and re-insurance policies cover everything from life insurance and annuities to financial securities. It is one part of this business—the part that insures a specific kind of financial security, mortgage-backed Collateralized Debt Obligations (CDOs)—that has them in so much hot water. It is not that the company is bad per se, and it is not even that the company is not profitable (it is). The problem is that the insurance on the mortgage-backed CDOs covered by AIG are in so much trouble that the credit ratings of the issuers are being negatively impacted. Well, in this sense, companies are just like individuals. If one’s credit rating heads South, then other people and banks that you use for loans will charge you a higher interest rate AND—very much to the point at hand—they will likely require you to put more down or have more equity at hand in case there is a problem. This is what is happening to AIG.

If you are a company with the reach and size of AIG and you pay just a little bit higher interest rate, then you end up with billions of dollars of increased costs and will be required to have tens of billions more in readily available capital assets overnight—corporate bonds, stocks, and real estate don’t count, they want you to have that in cash or US Treasury Notes. AIG has hundreds of billions of dollars in assets across the spectrum. It is, as they say, a balanced portfolio. To meet these newly minted capital requirements would require then to literally flood the market with sales of stocks, bonds, real estate, and even some of the businesses that they own within days. This fire sale would drive down prices on all those assets. Real estate and business units on this scale can take literally years to sell, so bonds and stocks would have to be the first to go.

Imagine the Unimaginable
In their current fragile state, imagine the impact of tens of billions of dollars in “sell at market” orders flying into the dimly-lit corridors of Wall Street. Ben Bernanke, Hank Paulson, and Christopher Cox imagined just this sort of thing.***

It must be stated that the patently extra-Constitutional (and therefore, in my book, atrocious) bailout of AIG comes in the form of a loan facility. A mustachioed and cloaked man did not show up at AIG headquarters with a handcuffed attaché' filled with blood diamonds while whispering, “Is it safe?” This is an important distinction. The much ballyhooed number of $85 billion is a loan secured by what amounts to a 79.9% “ownership” of AIG assets. They have to pay this loan back at an interest rate equal to 850 basis points over LIBOR (many readers will have home loans or credit card interest rates based on similar structures). If AIG does not pay the money back, the government gets the assets and the stockholders lose their investments (fair enough). This loan must be paid back in two years. Thought about in this way, this is a bailout of “time” rather than “money.” Two years will allow AIG to sell assets and cover obligations in an orderly way. Their other (very successful) businesses will continue to operate and earn a profit, assets and businesses will be sold over time at what they hope will be fair market values, the loan will be paid back with interest, and the impact to the overall economy will be minimized—though not eliminated. How much of the bill will taxpayers be on the hook for after all this washes out? No one knows, but—based upon estimated asset values—anywhere from a small net profit to a few tens of billions of dollars depending on how successful the overall economic recovery plan is.

The Empire Strikes Back
Do not get me wrong--I am structurally and philosophically against such government action. If we include Fannie Mae and Freddie Mac and the others out there, the Federal Government now has substantial control over about 50% of the nation’s mortgages and the insurance that covers them. This is terrible for free markets, capitalism, the republican form of government, and freedom in general. A few years hence one wonders if the almighty heroes of Washington DC will set the markets free again or cling jealously to their new empires (I shudder at the possibilities). However, to be fair, we must recognize that we were at serious risk of having trillions of dollars in assets suddenly become un-insured and un-insurable for the short term as AIG flirted with the idea of bankruptcy to buy time. That very real possibility, coupled with a likely asset sell-off-driven market disruption, is probably the best definition of "uncertainty" that one can find outside of Schrodinger’s Cat.**

Markets--as we all know--hate uncertainty. As such, the economy was at a very real risk and I suspect that Ben & company looked into the depths of AIG's business structure and saw a spaghetti nest of deals and re-insured assets that could not be untangled in the time allowed—in their opinion—and therefore took what they believed to be the lesser of two very distasteful evils.

Not a Golden Parachute, More Like and Emergency Rip Cord
Thomas Sowell—noted economist and a true lover of all free markets—once postulated that if one were to fall out of an airplane, the price you would be willing to pay for a parachute would quickly escalate to your entire net worth, but there is no way that the market could react fast enough to deliver one to you in time. To his way of thinking, these types of things occasionally occur in nations and should rightly be the only times when we accept drastic governmental actions that interfere with free markets. Perhaps we should allow a little charitable reflection on this concept when we deride Mr. Bernanke and the actions of his economic team.

Be well,

* Full Disclosure: I own about one hundred shares of AIG--now worth the equivalent of one high-quality steak dinner with cocktails.
** Yes, I know that Heisenberg is a better analogy to uncertainty, but the “alive/dead” paradox is far more prosaic under the circumstances.
*** Ben Bernanke is the head of the Federal Reserve Bank, Hank Paulson is the Treasury Secretary, and Christopher Cox leads the Securities and Exchange Commission (SEC).

More information can be found in the MarketWatch article.

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