AIG: a short post-mortem

The meltdown of the world’s largest insurer AIG (AIG) makes the stakes of this credit crisis plain to all.

In my view, the AIG situation and the subsequent turmoil in financial markets could have been avoided. The markets were clearly on edge at this time last week. However, Hank Paulson and Ben Bernanke, worried about moral hazard, simply let Lehman Brothers (LEH) fail.

This government ‘solution’ to the crisis surrounding Lehman Brothers only made matters worse – and unmasks the lurching, make-it-up-as-you-go approach to crisis management at Treasury and the Fed.

When Lehman Brothers was forced into bankruptcy I said the following:

Were Paulson and Bernanke correct? After some time to digest events, I must answer no. They were wrong.

They were wrong for three principal reasons:

1. The U.S. government has failed to provide a framework and process for dealing with failed institutions of this size and the impending wave of future bankruptcies it should expect.
2. Failure will lead to asset liquidation, depressing asset prices further and putting further pressure on the remaining solvent financial services firms to writedown asset values.
3. This will potentially result in a Great Depression-like chain of failures, credit contraction and asset liquidation.

Rather than learning from the Great Depression, we are likely to repeat it.

Subsequently, it does seem that my view of the situation was on target because any number of financial institutions have come under heavy selling pressure, risk premia are increasing in the credit default swap market, and investors are fleeing to the relative safety of U.S. treasurys and the safety of gold and silver.

When the Fed came out with it’s AIG solution, I was fairly happy with the results of the loan provision, saying at the time:

The line of credit, which is at a steep rate of LIBOR plus 850 basis points, is in accordance with Walter Bagehot‘s theory of central bankers as a lender of last resort: lend freely at a penalty rate.

This is exactly what the Federal Reserve should do. Ben Bernanke, in not raising rates and in providing liquidity to AIG at a penalty rate has done exactly what a Central Bank should do. I am impressed.

However, I am less impressed with the equity side of things. Why does the government need to own AIG? If so, why not 100% as opposed to 80%? Does the Federal Reserve think that AIG is a victim of lack of liquidity or an intrinsically bankrupt institution?

All of these questions come not as a result of the loan provision to AIG, but the poor decision to take an 80% ownership stake of AIG by the Federal Reserve. If AIG was the victim of faltering liquidity, as I believe, the Fed did its job in lending freely at a steep rate, securing its loans with AIG assets. However, that is all the Fed should have done. Taking over AIG gives AIG equity and debtholders a free ride which they don’t deserve. After all, if the Fed believed AIG to be fundamentally insolvent, it should have taken the firm into conservatorship or receivership and liquidated its assets. This half-pregnant middle ground is in reality a government subsidy for the shareholders and debtholders of AIG.

Given the extraordinary amounts of debt the Treasury has released to fund this operation — hundreds of billions of dollars — it is apparent to all that something has to change in the U.S. approach to crisis.