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

1. Treasury Secretary Paulson leads us across the Rubicon, 9 September 2008
2. High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
3. Say good-bye to the old America. Welcome to our new socialist paradise!, 17 September 2008
4. Another voice warning about the nationalization of AIG, 18 September 2008
5. A vital but widely misunderstood aspect of our financial crisis, 18 September 2008
6. A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
7. Another step away from our Constitutional system, with applause, 19 September 2008
8. What do we know about the financial crisis? What are the key questions?, 20 September 2008
9. Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
America appoints a Magister Populi to deal with the financial crisis, 21 September 2008
Legal experts discuss if the Paulson Plan is legal, 21 September 2008

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. Prof Nouriel Roubini describes “The Decline of the American Empire” ,18 August 2008
10. The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.
11. “The changing balance of global financial power”, by Brad Setser, 22 August 2008
12. “The Coming US Consumption Bust”, by Nouriel Roubini, 6 September 2008

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