Foregoing Valuable Options

Fri, 24 Oct 2008 15:33:52 +0000

The conduct of AIG in the wake of the government's loans to keep it afloat suggests a real problem with its bailout. At least with the bailout of banks, there is a presumption that "cash for trash" or preferred equity investments make funds available to allow them to do new lending and contribute to economic activity. There doesn't seem to be any presumption of this happening with AIG. In this Washington Post article, "AIG Has Used Much of Its $123 Billion Bailout Loan," we learn:

AIG has borrowed $90.3 billion from the Federal Reserve's credit line as of yesterday, the bulk of it to pay off bad bets the company made in guaranteeing other firms' risky mortgage investments. That's up from roughly $83 billion AIG had borrowed a week ago, and the $68 billion level it reached a week before that. The news comes as the company's new chief executive warned Wednesday that the government's financial lifeline may not be enough to keep AIG afloat.

What is the new economic activity we are supposed to get from these loans and ownership of AIG? What good thing will AIG now do in the real economy because these loans have occurred? Nothing.<!--break--> This part of AIG isn't going to go out there and start making money in the derivative markets again. It's just going to pack up and disappear after the rest of the company's subsidiaries have been sold.

These loans circumvent a bankruptcy process that would otherwise have to occur and that would occur without direct taxpayer financing. Equity is wiped out, creditors take over the firm, and assets are sold to pay off as much of their claims as possible. Some of those creditors now get paid off with taxpayer money. Why do this? AIG wasn't insured by the FDIC or any similar government entity.

Of course, we get the usual boilerplate answer in the next paragraph:

AIG began reporting unusual multimillion-dollar losses this spring as a result of its heavy exposure to risky mortgages, and the U.S. Treasury decided that its failure would probably bring down several other major investment firms and banks whose fortunes were tied to AIG.

This means that several major investment firms and banks would be among the group of creditors taking possession of AIG. And some of those entities are FDIC insured or have some potential to contribute tot he real economy. Doesn't that mean that we have to protect their balance sheets?

No, it doesn't. The major investment firms are not FDIC insured. They and their shareholders suffer for their investments gone bad, just as they would profit had the investments gone well. What of the banks that are FDIC insured? Some will be strong enough to withstand AIG's bankruptcy. Their shareholders should take the hit. Some will not be strong enough. Their shareholders will lose all of their investment and the depositors will make claims against the FDIC. Fair enough -- better to use the government money to directly compensate those who had government insurance than to prop up those who did not.

We have the option to deny absorbing AIG's debts and do it through the FDIC as needed by AIG's creditors. There are many places in AIG's balance sheet where that funding gets siphoned off to non-insured entities. That means taxpayers are contributing more than they are obliged to, because the government decided to forego the valuable option to contribute its funding later, rather than sooner.

The reduction in the balance sheet assets (or bankruptcy) of investment firms and other banks will cause there to be less financing for real economic activity. But as with AIG, if the government is going to commit funds, it would get a better return if it did so in banks that were not encumbered by sour investments made in the past. That's another valuable option foregone by letting its money get channeled on the basis of "who had the biggest relationship with AIG" rather than "who has the most to contribute to the economy going forward."