Another voice warning about the nationalization of AIG

I strongly recommend reading this, an explanation by a noted economist of why the nationalization of AIG was unnecessary — there were alternatives (which were legal, unlike the dubious course chosen by Paulson and Bernanke).  Printed in full, with permission of the author.

The transformation of the USA into the USSRA (United Socialist State Republic of America) continues at full speed with the nationalization of AIG“, Nouriel Roubini, posted at RGE Monitor, 17 September 2008 — Roubini is a professor of economics at NYU and former Treasury Department official (Wikipedia entry). Free registration required.  Headings added by me.

Last week we argued that, with the nationalization of Fannie and Freddie, comrades Bush, Paulson and Bernanke had started transforming the USA into the USSRA (United Socialist State Republic of America). This transformation of the USA into a country where there is socialism for the rich, the well connected and Wall Street (i.e. where profits are privatized and losses are socialized) continues today with the nationalization of AIG.

This latest action on AIG follows a variety of many other policy actions that imply a massive – and often flawed – government intervention in the financial markets and the economy:

  1. the bailout of the Bear Stearns creditors;
  2. the bailout of Fannie and Freddie;
  3. the use of the Fed balance sheet (hundreds of billions of safe US Treasuries swapped for junk toxic illiquid private securities);
  4. the use of the other GSEs (the Federal Home Loan Bank system) to provide hundreds of billions of dollars of “liquidity” to distressed, illiquid and insolvent mortgage lenders;
  5. the use of the SEC to manipulate the stock market (restrictions on short sales);
  6. the use of the US Treasury to manipulate the mortgage market (Treasury will now for the first time outright buy agency MBS to manipulate and prop up this market);
  7. the creation of a whole host of new bailout facilities (TAF, TSLF, PDCF) to prop and rescue banks and,
  8. for the first time since the Great Depression, to bail out non-bank financial institutions;
  9. the recent extension of the collateral available for the TSLF and PDCF facilities to a much wider range of toxic securities including equities and thus allowing the Fed to effectively manipulate even the stock market;
  10. and a whole range of other executive and legislative actions (including the recent bill to provide a public guarantee to mortgages for banks willing to reduce their face value).

So, with the nationalization today of AIG, comrades Bush, Paulson and Bernanke welcome you again to the USSRA. At least in the case of Fannie and Freddie these two institutions were semi-public to begin with as they were Government Sponsored Enterprises (GSEs). Now we get instead the first pure case of a fully private company, actually the largest insurance company in the world, being nationalized. So the US government is now the largerst insurance company in the world. So the transformation of the USA into the USSRA goes a step further.

Let me now flesh out in more detail my arguments on why this government AIG takeover is reckless, flawed and should have and could have been avoided. There were other ways to deal with the potential systemic effects of collapse of AIG.

Moral Hazard

First, note that the Fed and the Treasury claimed to draw a line in the sand on moral hazard with their decision not to bail out Lehman ; but two days later the financial tsunami of the century wiped out that line and led to the continuation of the mother of all moral hazard bailouts with the nationalization of AIG.

It is likely that AIG’s shareholders (both preferred and common) may be substantially wiped out; but then why does the government take only a 80% equity share in AIG? Why not 100% as it should? So, if by miracle, AIG is not liquidated, such private shareholders instead of being fully wiped out get any upside benefit from this government action.

Compared to the Fannie and Freddie bailout the risk taken by the government in the AIG case seems more limited: then, the preferred shares of the government were senior to common shares and other preferred shares but junior to the unsecured subordinated and senior debt of the agencies. In the case of AIG it appears that the US “loan” has as collateral all of the assets of AIG; if this were to be the case (a point to be clarified as the Fed statement was not clear about the seniority of a loan that has equity-like characteristics) the creditors of AIG would not be scot free as the government claim would have priority over any other secured and unsecured creditors of AIG, including possibly the insurance policy holders of AIG.

If this is truly the case (and I say “if” because the Fed has not been fully clear on the nature of its claims in the pecking order of the capital structure of AIG) the objective of the Fed in its intervention on AIG (i.e. avoiding the systemic effects of a collapse of a large and too big to fail institution) may not be achieved: i.e. if the claims of the government are senior to those of all creditors of AIG then AIG bondholders and also other creditors of AIG get whacked if AIG is insolvent (i.e. if in the effective liquidation of AIG the assets of the firm are lower than its liabilities).

Bankruptcy vs. nationalization

But if the action of the Fed are aimed at facilitating an orderly selling of AIG’s assets how does the Fed ensure that its investment in AIG is safe? In a formal bankruptcy (Chapter 7 and 11) there is a stay on the claims of a firm’ creditors; thus a roll-off of their claims cannot occur. But in this government takeover of AIG how does one ensure that such roll-off of claims does not occur?

The only way to avoid such risk is to impose a stay – like in a formal Chapter 7 or 11 – on such claims. But if the objective of the government was to avoid a disorderly workout that a formal bankruptcy would have entailed how does one ensure – short of an effective stay on all creditors claims – that the public money provided to AIG (the $85 billion “loan”) is not used by the unsecured creditors of AIG to roll off their exposure and run out of AIG scot free? Short of such a stay the apparent seniority of the government claims implies that any short term creditor of AIG should cut off its exposure and run. And if instead (“if” because again the Fed has not given any details on this crucial issue) the government claims are ensured by an effective stay on such creditors’ roll off then why did the government intervene in AIG rather than letting it go into Chapter 7 or Chapter 11 bankruptcy court?

So this is the conundrum of the government intervention in AIG: it was made to avoid a disorderly collapse of AIG with the provision of short term liquidity; but in order to avoid short term creditors of AIG to run and be full on their claims you need to impose an effective stay on such claims; otherwise some creditors are bailed out (those with short term claims who can run) and some creditors are whacked even more (those with longer term claims that are junior to the government) and such short term creditors become effectively senior to the government. But if the government has to be truly senior relative to all of the creditors of AIG you need to impose a stay on all creditors. And if you impose such a stay you whack all creditors, you impose losses on all the AIG debt holders and you risk the systemic panic and disaster that you wanted to avoid in the first place.

If this is the case it would have been better to push formally AIG in Chapter 11 or 7 bankruptcy court and then provide the government financial support in the form of traditional debtor-in-possession (DIP) financing. If this had been done such DIP financing would be formally – as provision of new money – senior to all of the other claims on the firm. So the government decision to avoid formal Chapter 11 (or 7) is puzzling: either the government loan is truly senior to all of the claims of AIG – in which case you need a formal stay to avoid short term creditors to run away (but such stay will impose the same potential systemic risks of a formal bankruptcy) – or if such a stay is not imposed then the government claims are junior to those of the short term creditors of AIG and the objective of avoiding a run on the claims of AIG cannot be avoided.

In the case of IMF loans to distressed governments such loans have effective – but not de jure – seniority over the claims of other foreign creditors of the country but the objective of such loans – in cases of illiquidity not insolvency – is to allow the roll off of short term claims of a solvent but illiquid sovereign under the assumption that financing the capital flight will stabilize the problem and stop, at some point, the run (“Catalyticfinance”) (for more on this matter and issues of seniority of claims in sovereign debt crises see the book I wrote in 2004 with Brad Setser on “Bailouts versus Bailins: Responding to Financial Crises in Emerging Markets”). But in the case of AIG we have a problem of solvency and the need for an orderly wind down of AIG so as to prevent a global systemic crisis. So it is rational for short term claimants of AIG to run if their claims are junior to those of the government. And if instead those claims were not junior (i.e. a stay is formally imposed) the systemic effects of such a stay will cause massive losses to all of the creditors of AIG and will thus not prevent the systemic crisis that the government intervention was meant to avoid.

The reality is that it would have been more honest and clean and proper to take AIG to bankruptcy court and then provide the government support (the $85 billion loan) in the form of a formal debtor-in-possession (DIP) financing. Why was this solution not taken? It is not clear. Going to court may imply a credit event that triggers formal default and consequences for creditors and CDS holders and the guarantees made by AG on toxic fixed income securities. But what has happened is effectively a credit event and such triggers should be occurring regardless of whether AIG goes into formal bankruptcy court or not. The Fed and Treasury should immediately clarify on whether their intervention includes or not a formal stay on all the creditors of AIG including the holders of the short term claims against AIG.

Disadvantages and ambiguities of this “new way” bailout

Any fuzziness and lack of transparency on this matter would be severely destabilizing for markets and investors. To truly safeguard the government claims such a stay should be imposed; and it is not imposed the government action will allow short term creditors of AIG to run scot free with two consequences: the government claims will be at risk putting taxpayers’ money at risk; and the claims of longer term creditors of AIG will be whacked more down the line as short term creditors were allowed to be bailed out. But in that case why should different creditors of AIG be treated differently with some being bailed out and some not and with the consequence that the bailout of some implies much bigger losses to the longer term creditors of AIG? Again a formal bankruptcy court would have allowed a more fair process for allocating losses between shareholders and short term and long term creditors of the firm.

The Fed statement is also fuzzy on the claims of the insurance policy holders of AIG. Are these insurance contracts junior or senior to the government claims? You may think that holders of standard insurance (life, casualty, etc.) should be treated as senior (in the same way as small depositors of banks are insured from loss)? But should only such policy holders (individuals and non-financial firms) should be bailed out and be senior or should also the holders of AIG insurance of fixed income assets (hundreds of billions of dollars of such insurance) be bailed out? If all of such insurance contracts are safe and made whole by the government why should the government bail out investors that bought insurance of toxic products (MBS, CDOs, etc) from AIG? There is no rationale for that.

If we start bailing out those creditors of AIG (holders of bond insurance policies) we may as well nationalize also all of the other private monoline insurers. And we treat differently different bond insurers (we make whole those who bought bond insurance from a too big to fail AIG and we let go bust those who bought the same protections for a non-systemically important bond insurer) we exacerbate moral hazard as in the future no one will buy bond insurance protection from truly private and smaller bond insurers and everyone will buy it from large too-big-to-fail institutions such as AIG where such bond insurance comes now with the additional protection of an implicit government guarantee of insurance. So the US government may become – on top of the biggest insurer in the world with its takeover of AIG – also the biggest re-insurer in the world.

And how will the government decision to protect fully the small insured claimants of AIG (those who hold life and casualty insurance) affect the competition in the insurance business? If the government makes such policy holders senior to the government large and too big to fail private insurer have a massive competitive advantage relative to smaller insurance companies where the claims of the policy holders are at greater risk if the insurance company goes bust?

And, as in the case of banks involved in mortgages, where were the insurance regulators that were asleep at the wheel while AIG was using the policy holders premia not to invest into safe long term bonds but rather to insure toxic MBS and CDOs and other junk? Why were they asleep at the wheel while AIG was conducting the scam of the century getting involved into a business – bond insurance – that was toxic and caused its demise? Why was AIG allowed to become too-big-to-fail but letting it get into a business – bond insurance – where it should have not been in the first place and that caused its current bankruptcy?

Questions (probably nobody yet has answers)

So there are tons of questions that remain to be answered and the pathetic Fed statement of the Fed on the takeover of AIG does not answer creating much greater uncertainty and confusion. AIG should have been allowed to go into bankruptcy court and any government financial help to avoid systemic risk should have occurred in the form of a formal debtor-in-possession (DIP) financing. Bankruptcy court have laws and a judicial history of how claims of an insolvent firm are treated and they provide clarity to the pecking order of such claims while avoiding – via a stay – some creditors running and be made whole while others are inflicted – because of such a run – even greater losses. So instead of doing the right thing – pushing AIG into bankruptcy court and providing government DIP financing – the Fed and Treasury have formally nationalized AIG and they have created a legal mess where there will be endless confusion and lack of transparency of the government claims relative to junior and senior creditors of AIG, short term creditors and long term creditors, insurance policy holders of a traditional sort and of a non-traditional sort (life and casualty holders versus bond insurance holders).

And by nationalizing AIG the government that two days ago drew a line in the sand on no more bailout with its decision to let Lehman to go bust has now opened again the floodgates of moral hazard and of private firms’ demands to be bailed out. Already Ford and GM are requesting loans guarantees and Congress is considering them. Next will be airlines and lots of other non-financial corporate who expect now the government to bail them out. The argument of the supplicants will be: “If we are bailing out Wall Street firms such as Bear, Fannie and Freddie, AIG and soon enough banks why shouldn’t we bail out Main Street firm such as Ford and GM that are also systemic ally important? After all Bear was employing only 20 thousands or so folks while Ford and GM have hundreds of thousands of employees.”

The United Socialist State Republic of America (USSRA)

So soon enough the transformation the USA into the USSRA (United Socialist State Republic of America) will be complete: we have defeated the USSRR to create a communist economy in the most advanced free market economy in the world. And calling it socialism (even socialism for the rich, the well connected and Wall Street) is giving a bad name even to a failed experiment like socialism; this is more akin to the creation of a corporatist state (like the Italian fascism or the Germany Third Reich) where private sector interest are protected (gains privatized and losses socialized) where the government is taken over by corrupt and reckless private interests.

The paradox is that this this whole mess was creaete by a bunch of zealot fanatics who believed in the laissez faire ideology of free markets unbound by propers rules, regulation and supervision. As I wrote after the nationalization of Fannie and Freddie:

This biggest bailout and nationalization in human history [Fannie and Freddie] comes from the most fanatically and ideologically zealot free-market laissez-faire administration in US history. These are the folks who for years spewed the rhetoric of free markets and cutting down government intervention in economic affairs. But they were so fanatically ideological about free markets that they did not realize that financial and other markets without proper rules, supervision and regulation are like a jungle where greed – untempered by fear of loss or of punishment – leads to credit bubbles and asset bubbles and manias and eventual bust and panics.

The ideologue “regulators” who literally held a chain saw at a public event to smash “unnecessary regulations” are now communists nationalizing private firms and socializing their losses: the bailout of the Bear Stearns creditors, the bailout of Fannie and Freddie, the use of the Fed balance sheet (hundreds of billions of safe US Treasuries swapped for junk toxic illiquid private securities), the use of the other GSEs (the Federal Home Loan Bank system) to provide hundreds of billions of dollars of “liquidity” to distressed, illiquid and insolvent mortgage lenders, the use of the SEC to manipulate the stock market (restrictions on short sales), the use of the US Treasury to manipulate the mortgage market (Treasury will now for the first time outright buy agency MBS to manipulate and prop up this market), the creation of a whole host of new bailout facilities (TAF, TSLF, PDCF) to prop and rescue banks and, for the first time since the Great Depression, to bail out non-bank financial institutions, and a whole range of other executive and legislative actions (including the recent bill to provide a public guarantee to mortgage for banks willing to reduce their face value).

This is the biggest and most socialist government intervention in economic affairs since the formation of the Soviet Union and Communist China. So foreign investors are now welcome to the USSRA (the United Socialist State Republic of America) where they can earn fat spreads relative to Treasuries on agency debt and never face any credit risks (not even the subordinated debt holders who made a fortune yesterday as those claims were also made whole).

Like scores of evangelists and hypocrites and moralists who spew and praise family values and pretend to be holier than thou and are then regularly caught cheating or cross dressing or found to be perverts these Bush hypocrites who spewed for years the glory of unfettered wild west laissez faire jungle capitalism (and never believed in any sensible and appropriate regulation and supervision of financial markets) allowed the biggest debt bubble ever to fester without any control, have caused the biggest financial crisis since the Great Depression and are now forced to perform the biggest government intervention and nationalizations in the recent history of humanity, all for the benefit of the rich and the well connected. So Comrades Bush and Paulson and Bernanke will rightly pass to the history books as a troika of Bolsheviks who turned the USA into the USSRA. Fanatic zealots of any religion are always pests that cause havoc and destruction with their inflexible fanaticism; but they usually don’t run the biggest economy in the world. But these laissez faire voodoo-economics zealots in charge of the USA have now caused the biggest financial crisis since the Great Depression and the nastiest economic crisis in decades. So let them be shamed in public for their hypocrisy and zealotry that has caused so much financial and economic damage.

{end of Prof. Roubini’s article)

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

Key Treasury Department documents

We cannot plead the “we didn’t know the details in the fine print” excuse. The important details about this massive nationalization have been clearly spelled out for us.  See this page for a current list of Treasury Department documents.

Some FM posts about the current crisis

For a full listing see the FM reference page about the Financial crisis – what’s happening? how will this end?.

A few of the most important posts warning about this crisis

This crisis has long been forecast by many, including in articles on this site.  Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results.  Here are some of those posts.

  1. A brief note on the US Dollar. Is this like August 1914?, 8 November 2007 — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
  2. The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  3. We have been warned. Death of the post-WWII geopolitical regime, Chapter II, 28 November 2007 — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
  4. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
  5. Geopolitical implications of the current economic downturn, 24 January 2008, – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
  6. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
  7. What will America look like after this recession?, 18 March 208  — The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
  8. The most important story in this week’s newspapers , 22 May 2008 — How solvent is the US government? They report the facts to us every year.
  9. The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.

To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime.

21 thoughts on “Another voice warning about the nationalization of AIG

  1. Tom Grey

    I commented on prior post that I’d have preferred to let AIG go bankrupt — I’m pretty sure the reasons to do the 80% include: a) more cash to the lousy top execs (perhaps not the CEO), b) more flexibility (and possible corruption) for the new folk to operate, which might make it c) more likely for them to sell assets in an orderly way. Or a crony capitalist way (like Putin & Yeltsin did!).

    Prof Roubini, while having some good points, certainly sounds like an anti-Free Market fanatic. With respect to Fannie Mae, any true Free Market advocate would always have been in favor of closing it before.

    His critique of the flawed choices chosen is notably short on what should be done now, or even as of the last year. In particular, I think #10 for the gov’t guaranteeing mortgages at a true, much lower, 90% of recent foreclosure auction price (per sq foot) would be a reasonable, cheap way to stabilize the housing market prices fast. That’s the key to solving the bubble pop mess. Reaching a stable bottom so the assets have ‘some’ value, even if it’s only 50%.

    And the primary purpose of the gov’t is to defend ‘the land’. (Too bad there isn’t a Henry George land tax, which would have reduced the bubble hugely).


  2. Anthony J. Alfidi

    Prof. Roubini has been right on target for many months. His lurid comparison of lasseiz faire ideologues to hypocritical moralists is especially welcome and accurate. Nominate this man to be Chairman of the Federal Reserve!


  3. Nicholas Weaver

    I must disagree.

    Actually DECLARING Chapter 11 is THE major precipitating event, which would cause the problems feared if those fears are realistic. But this “bailout” is really Chapter 11 without being Chapter 11, with the US Government as de-facto debtor in posession financer and an instant change of management.

    If AIG’s problem is liquidity, the company gets spun apart, the bad books wound down, and the Fed makes a huge profit at Libor + 6.5% on whatever portion of the credit line is used over the next two years, the rest of the bondholders are made whole, and all is happy.

    If AIG’s problem is solvency, the company gets spun apart and the normal long-term bondholders can get reamed, because unlike most bailouts, the US government is FIRST in line to be paid back because the credit line is all collatoralized by profitable subsidiaries.

    Remember, the US government has a veto over AIG major activities, and is COLLATERALIZED against 80% of the company, but doesn’t actually own AIG if I understand what’s going on. Thus the AIG bailout looks like what Roubini wants in practice, a 2 year Chapter 11 restructuring, but without the systemic shock of a chapter 11 filing.

    This is in sharp contrast to both the Bear Stearns and Fannie/Freddie bailouts, where the government takes the FIRST hit, not the last.
    Fabius Maximus replies: Who knew that government intervention in the private economy was so easy!

    One of the great oddities of history is how often these games look so simple, success guaranteed — yet have such terrible records in the history books. The history of nationalized industries is horrible, with profitable enterprises often reduced to valueless hulks in a generation. American urban renewal programs are stars by comparison, often just a 100% waste of money but doing little harm (some of course are successful, some destructive as wars).

    One minor detail: if this is so obvious and easy, why did all those experienced private investors turn down this fine opportunity?

    One of the great perils of socialism is that it encourages folks to draw up plans for government economic action without actually knowing anything about the subject. Let’s hope that the nationalization of health care (IMO almost certain over the next decade) will not lead to well-intended amateurs doing surgery. At least not on me.


  4. Pete

    I am not economist enough to tell if the AIG bailoout is the demarkation line between the new “USSRA” and what came before, but I am in complete agreement that the privatization of profit paired with the socialization of debt/loss is a recipe for disaster. The essence of the free-enterprise system lies in balancing risk and reward. Negative behavior, leading to adverse consequences – debt, lost business, falling profits, etc. – is supposed to be punished by the markets, just as positive, adaptive behavior is rewarded by the markets.

    That’s the theory, anyway. Good-and-bad business decisions must be allowed to feed back into the economy, as painful as they may be in the short term for those who calculate wrongly. However, shielding from consequences those who err, who mismanage assets, who make poor decisions, disrupts the system, and creates a corporate welfare system. It is hard to argue we have anything else now…


  5. Seerov

    Besides the move to nationalize industry, I’m wondering what social policy changes will come with the new socialist America? One thing I think we can definitely count on is the loss of free speech. Socialist America will be a multi ethnic state. Both “sides” agree that America must accept millions of people who have no desire at all to become “Americans.”. The elites don’t care becuase they don’t have to live next to these new “Americans” nor do they have to send their kids to school with them. The right needs cheap labor, and the left needs more poor people to “take care of.”

    Many people are fed up with seeing their hospitals close, schools become overcrowded, and crime rates rise in their towns. Because people are starting to complain, it will be necessary to pass “hate-speech” laws to shut them up. Beside loss of speech, who knows what other horrors await us in this next “New Deal?” I’m not using the term “New Deal” jokingly. Today on NPR the commentator was joyfully predicting “an even bigger New Deal” than the last one. I think we’ll see all sorts of little “odds and ends” getting thrown into the mix of the socialist cake that will choke America for good.


  6. OldSkeptic

    Seerov, I thought many of those things had already happened .. and that was in the ‘good’ times. Anyway the precedent had long been set, with the MIC (Military Industrial Complex) being a corporate ‘socialist’ paradise for what, decades now, ask KBR and all the others. As for free speech, as an outsider looking at the US MSM, you’d never guess that it existed. NYT the new Pravda?

    I’m not trying to take cheap shots, just to demonstrate that these (and coming) problems have been brewing for years, even decades. They have also been warned about by a small number of people, nearly all ignored or even laughed at. If I was (taking one example) Steve Keen (google him, a great real economist) I would not be able to resist saying “I told you so” (actually I think he did recently).

    Equally it will take years, perhaps decades, to fix the whole mess and an awful amount of hard work.

    You are alos in good company, we in a lot of other countries are going through the exact same thing to a greater or lesser extent. Will one or more of the developed democratic countries fall into totalitarianism? Maybe. Personally I’m betting on one country falling (hint: it is not the US, but it does start with a ‘U’).


  7. Al L.

    I’m going to suggest something that’s not exactly on topic for this article but I think it relates to the big picture. And I’m going to try to simplify it enough for 250 words.

    I think the initial discussions and actions on this housing/mortgage crisis have focused mostly on the impacts of the effect of restricted credit on the sale of houses and the impact of people who have bad mortgage structures. But I think some of the wise heads who have to deal with this problem are starting to realize we’re in a fix that goes much deeper than that.

    It all goes back to the house. Yes we have way too much supply of housing units, but there’s more to it than that. We also likely have way too many square feet of housing, with way too many unmaintainable features, built in way too many hard to insure places with way too many infrastructure requirements.

    Just one street level example of how this problem may just keep knocking back the economy as fast as we work out of it: When one buys a condo one agrees to collective maintainance fees. Those fees are typically the least they’ll ever be the day you buy the condo. A lot of folks have used credit to fund those obligations. Easy to do when you think future value will pay for current costs. But cutting the mortage rate does nothing to help someone overcome the other future costs of ownership that are beyond their means. Only more credit and/or increasing income will do that. Once they fall into this trap in say a year or 2 they may have to sell their home cheap to get out of the trap. Its this cycle that may keep us down for along time. If you add to this the uncertainties created by an AIG bankruptcy and the work-through time it would involve and the number of ways this insurer/reinsurer affects many types of asset and equity backed credit structures you get the potential for a downward spiral that goes way beyond just fixing “mortgages” Nationalizing AIG is a terrible move. But the guys in Treas. and Fed may be scared to death by what they’ve found out since they took over F&F, opened their books and got to run some analysis of the total shape of the housing market.
    Fabius Maximus replies: No question, this is a complex set of problems. This post was already too long to discuss this, but your point about oversupply of living area (square feet) is also an important aspect of the problem. This means that the price of housing expressed in price/area ($ per sq foot) will drop. Esp in areas with net out-migration or other adverse factors (e.g., suburbs distant from the jobs, where increased fuel costs make them less economic).


  8. Nicholas Weaver

    Its not easy. It should have NEVER happened: lax regulation and lack of transparency brought us to this position. Regulation is dangerous but necessary to at least attempt to prevent cases like this.

    And the other bailouts I agree are ridiculous disasters: Fannie/Freddie puts the US on the hook to guarentee their debt, and they should have never been privatized in the first place or should have been much better regulated.

    And Bear/Stearns is a more dangerous precident which at least for the MOMENT hasn’t been followed: it puts the US in the position of “first loser”, as the US is on the hook for the first 30B in losses incurred in the buyout as its a loan with no penalty for nonpayment beyond the bad junk at bear stearns as collateral.

    It just must be understood that the AIG “bailout” is different. It is not a government privatization, and it is not even really a bailout.

    There is long been a school of thought that, in a crisis, the fed should be the lender of last resort at punative interest rates: You CAN get liquidity from the fed in an emergency. Just rather than being cheap, it should be really expensive. And it is for AIG, in sharp contrast to the discount window games the Fed has been playing, where the Fed is willing to give almost free liquidity.

    And by appearing to be a De-facto chapter 11, it doesn’t just wipe out the shareholders, but it also means that the LONG term debtholders (>2 years to maturity) don’t seem to have a guarentee either (and the guarentee doesn’t matter if AIG is a liquidity, not a solvency problem). Thus it does not appear to be a bailout.

    It also removes the need for the DISASTEROUS decision by the NY State government (AIG’s primary regulator) to allow the insolvent/illiquid parent to borrow from solvent regulated subsidiaries, which would have the action of increasing risk.

    Actually declaring Chapter 11 on AIG’s part would have been a major shock. Now we have 2 years to price it in and detangle things. But just because it isn’t technically Chapter 11 doesn’t mean its not effectively Chapter 11.

    I think when the history books are written, most of this financial mess will be a major fiasco: there are probably shoes left to drop, the treasury rate is now 0% in the flight to safety, and worry Worry WORRY about money-market funds and bond funds for the next month. Fannie/Freddie are fiascos and will probably remain thought of as fiascos. Bear/Stearns was a looting of the public purse.

    But I believe that, 20 years from now, the AIG rescue package will be thought of as the best possible decision in a bad possible position.


  9. hsarvell

    This is silly, I’ve grown up in socialist Sweden which has been successfully managed by socialists for almost a hundred years. We are one of the richest countries in the world. State run schools, hospitals and universities are not bad, not bad at all. The feeling of security is underestimated, it’s a great boost for a country. This is something the US needs more of. I will concede though that this system might not work in a country the size of the US, however if it works it won’t make your lives worse, but better. Time will tell.
    Fabius Maximus replies: Thank you for making this important point, which I will discuss in a future post!

    Consider how things might look when the dust settles. (guessing) We will have nationalized or tightly regulated the financial system and largely nationalized the health care system (likely under either Obama or McCain). Bernanke goes to meeting in Europe. How will they euro-leaders react to these changes? “Good show; now America looks just like us.”


  10. Nicholas Weaver

    Tight regulation is necessary for a sound financial system. These systems are based on corporate trust. Without corporate trust, they fail: Its a new-old-fashoned bank run. And given that people will buy short-term treasuries at 0% (because the fed will give the money back), we are in the midst of a good new-old-fashoned bank run.

    If you beileve that bank-runs are bad (and it is hard to argue that they aren’t), you MUST have regulation of banks to enforce trust and provide mechanisms to prevent lack of trust. FSLIC had huge costs, and the FDIC has potentially huge costs, but the net benefit of having an orderly S&L collapse in the 80s rather than a crisis like the 30s was arguably worth it.

    The problem is, we allowed the creation of huge bank-like institutions (hedge funds, AIG’s CDS business, CDOs, etc) without creating bank-like regulation. And the regulations need to be put in place well before the crisis occurs.


  11. Yours Truly

    Oldskeptic : I’m so sad that people living in other lands will have to experience the same sort of c@#$ totalitarian lifestyle I experienced whilst growing up…

    hsarvell : you’re lucky, the leaders of north Europe are enlightened ones.


  12. tdaxp

    It is likely that AIG’s shareholders (both preferred and common) may be substantially wiped out; but then why does the government take only a 80% equity share in AIG? Why not 100% as it should? So, if by miracle, AIG is not liquidated, such private shareholders instead of being fully wiped out get any upside benefit from this government action.

    You answer your own question. The 80% question means that even if AIG fully recovers, whether or not AIG pays out anything to shareholders is up to the government, and most of what would be paid out would be paid to the government. A 90% share would have been better. A 70% share would have been worse.


  13. Dave Schuler

    The central assumption of Dr. Roubini’s article, that any U. S. government could have stood by without intervening while the financial system collapsed, is incorrect. The failings, history, and motives of the present administration are irrelevant.

    If Dr. Roubini’s assertion is that FNMA, FHLMC, and AIG could have been allowed to collapse without taking the rest of the financial system with them, he has failed to meet his burden of proof.
    Fabius Maximus replies: Roubini discusses at some length the alternatives to the bailouts, specifically to AIG. I do not understand how you can have read his article and make this comment.


  14. Nicholas Weaver

    IIRC, the government isn’t necessarily taking 80% of AIG. Its that the 80% profitable, regulated subsidiaries are collatoral on the line of credit.
    Fabius Maximus replies: I have read only the Fed statement, not any detailed agreements (if they have been released). But the Fed document does not seem to match your summary.

    NW: “Its that the 80% profitable, regulated subsidiaries are collatoral on the line of credit.”

    From the summary: The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries.”
    {That is, almost all of AIG is collatoral.}

    NW: “the government isn’t necessarily taking 80% of AIG.”

    From the summary: “The U.S. government will receive a 79.9% equity interest in AIG.”


  15. Erasmus

    79.99% was a legal maximum. I can’t remember why, but in any case that’s why they took less than 80%.

    The Fed’s original mandate is to prevent systemic crashes like what happened in 1930’s. They are fulfilling their stated function. If AIG had been allowed to declare bankruptcy, literally hundreds if not thousands of banks would soon follow since they are the leader in the Credit Default Swaps derivatives used to bundle together/insure hundreds of billions of dollars of mortgages in a fashion that most experts agree they cannot really understand themselves. So the rescue of AIG was simply to prevent a run on the banks not to save the company per se.

    {snip — healthcare is not relevant to this post. I have repeatedly warned about staying on topic.}
    Fabius Maximus replies: Professor Roubini is a world-famous economist and former Treasury official, who has written almost 4,000 words explaining why there were alternatives to the nationalization of AIG. Your comment just contradict him without the slightest effort reference to his article. Why bother posting something like this?


  16. Erasmus

    A little about the swaps, which are essentially futures contracts on real estate using borrowed money to pay a monthly percentage akin to an insurance premium. Something like that.

    This is why the shortfall in the housing market can cause about a 40 trillion dollar collapse if we are not careful. The value of the derivatives dwarfs the underlying asset class especially since this has been an unregulated market. According to some analysts, there is in excess of 60 trillion out there that could have to be liquidated. That is a staggering amount. I hope they can find a way to muddle through, and clearly they are trying, but it is quite possible that we will have to restart the entire monetary system.
    Fabius Maximus replies: Little of this is correct. Credit default swaps are nothing like futures contracts; The are a form of insurnace, and secure many types of obligations. No, they do not secure “contracts on RE” — I believe you are thinking of mortgages and mortgage-related securities. The BIS estimate of outstanding CDS contracts is aprox $70 trillion (the Q2 number will be published soon); but the net (cash) value is under $3 trillion. The “shortfall in the housing market” is most relevant to CDS to the degree it causes bank failures, which creates counterparty risk.

    Please do not post material about which you have little understanding. Negative information is the worst kind, the enemy of us all.


  17. Erasmus

    FM: just saw your comments. Sorry if my posting is irritating. My 79% submisssion was in response to the article above. The author was not aware of the law in this case apparently and had several theories going about why only 80%. Sorry, no link to where I read that.

    I disagree with you about whether or not they are futures in the sense that they use highly leveraged instruments to defer future risk in many cases needing no ‘margin’ at all the way these things are bundled. That is what happened to Lehman essentially, a 10% decline in asset values taking their net worth below 0 rapidly.

    You are right, I don’t understand it all. Is the idea here that only people who are experts in things the experts don’t seem to understand contribute? I shall re-read your guidelines and perhaps stop bugging you!

    I was not clear about why I was including info on CDS. It is simply because it is mainly that aspect of the AIG operation that was a systemic threat to the US and world economy. I suspect that most people don’t really know much about them – most experts say they don’t really understand them – nor how a shortfall of several million houses could actually pull down the world financial system. It is mainly because of these opaque, leveraged instruments that have run riot throughout the world banking system.
    Fabius Maximus replies: You appear to have overlooked the primary point of my comment — which is that you just contradict the post without providing a shred of evidence of logic to rebut it. Repeating your assertion tells us nothing of use.

    It would have been useful if you could have provided a link or specific evidence to the 80% limt. As it is, you tell us nothing of use about it.

    “I don’t understand it all. Is the idea here that only people who are experts in things the experts don’t seem to understand contribute?”

    This is just common courtesy, the sort of thing I previously have never had to spell out. Don’t try to explain things you do not understand. Providing a link or quotation to a relevant source is appropriate, if the information is topical.


  18. Yours Truly

    “The fundamental point is that Britain was undone as a great power not because of bad politics but because of bad economics. It had great global influence, but its economy was structurally weak. And it made matters worse by attempting ill – advised fixes — going off and on the gold standard, imposing imperial tariffs, running huge war debts. After World War II, it adopted a socialist economic program, the Beveridge Plan, which nationalized and tightly regulated large parts of the economy. This may have been understandable as a reaction to the country’s battered condition, but by the 1960s and the 1970s it had condemned Britain to stagnation.” : from The Post American World, by Fareed Zakaria

    Deja vu?


  19. Blackburn

    From “Why Have the Government Bailouts Involved Only a 79.9% Equity Position?“, Credit Slips, 18 September 2008 — Excerpt:

    “It turns out that the explanation is not related to 80% being the threshold before the Fed/USG would have to carry the entities on their own books. Federal Accounting Standards are silent on the issue, but the Congressional Budget Office is already treating Fannie/Freddie like USG assets/liabilities (consistent with GAAP).

    “Instead, the explanation is tax. Section 163 of the Internal Revenue Code generally provides that interest paid on debt is tax-deductible for federal income tax. But there’s an exception. If the interest is paid on a loan from an entity that controls 80% or more of the voting power and value of a corporations’ total shares, then the interest is not tax-deductible. Fannie and Freddie are generally tax-exempt. They are, however, subject to federal income tax. AIG, of course, has no tax-exempt status, whatsoever.

    “Because the bailout deals were structured so that the Fed or Treasury will make sizable loans to the nationalized entities, they had to be careful not to reach the 80% threshold, lest the nationalized entities (which still pay taxes) lose their tax deduction for the interest paid on the Fed/Treasury loans (LIBOR +850 on $85BN for AIG–that’s a lot of interest). ”
    Fabius Maximus replies: Thanks for posting this!

    Like so much of the speculation about these things this is just overly-confident guessing. The first reason they cite, the most common explanation, seems to me the most likely (the folks throwing this together in the middle of the night might not have been considering tax angles).

    The author does not accurately reflecting government policy about consolidating the GSE’s debt onto the government’s books (which was the major reason they were privatized in 1968. See this excerpt from “Fannie Mae, Freddie Mac to Be Kept Off Budget, White House Says“, Bloomberg, 12 September 2008:

    “White House Budget Director Jim Nussle said today that the companies, which were taken over last week by the Treasury Department, will be left out of the government’s budget and financial statements in part because of the ‘temporary nature of the arrangement.”

    … The decision means the costs of the government bailout will affect the federal deficit and debt while the companies’ business operations will remain off the books. That contradicts the planning of the nonpartisan Congressional Budget Office. CBO Director Peter Orszag, contending the budget ought to fully reflect government operations, said Sept. 9 that his agency will begin including these assets and liabilities as part of its budget estimates.”


  20. Pingback: Galen Slade’s Place » Blog Archive » Welcome to the USSRA, comrad !

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