by Jerry Gordon & John Haldi
The Dow Jones index plummeted by another 4% in trading on September 17th reflecting near panic in investor and trading markets around the globe. The stunning developments these past two weeks started with the government seizure of Freddie Mac and Fannie Mae, followed by the bankruptcy of Lehman Brothers, the dramatic weekend deal by Bank of America to acquire Merrill Lynch and culminated in the $85 billion bridge loan by the Federal Reserve to bail out AIG giving it a 79.9% ownership stake in the insurance giant. AIG had huge exposure to the toxic collateralized debt obligations and unregulated credit default swaps market threatening its liquidity. For a comprehensive analysis of the government’s takeover of AIG read this engrossing Wall Street Journal article, here.
These stunning events have raised serious questions about risk management and financial de-regulation of the Depression era Glass Steagall Act that ended with its repeal in 1999 with the Gramm Leach Bliley Act. What were five independent investment banks at the start of the year - Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs - have been reduced to two, Morgan Stanley and Goldman Sachs. Trading in the securities and debt of both remaining independent investment banks has been pounded in the equity and debt markets, with risk premiums over benchmark US Treasuries reaching towering 800 basis points for their bonds. The market realities are that they and troubled commercial banks like Washington Mutual and Wachovia are in a perilous credit crunch and forced de-leveraging condition as a result of exposure to the housing bubble and subprime mortgage debacle. It is ironic that Morgan Stanley and Wachovia are in discussions about a possible merger or acquisition, notwithstanding the latter’s exposure to the subprime mortgage debacle with misguided acquisitions.
AIG, the world’s largest insurer, is a special case in that its bankruptcy under US and state insurance laws would have had globally significant effects on hundreds of banks, thousands of insurance companies and millions of policy holders. While Presidential contenders, Sens. McCain and Obama change their views overnight about such government bailouts, Senate and House Finance Committee chairmen suggest the possible need to create a new form of the Resolution Trust Corporation (RTC) used in the 1980’s and 1990’s to recycle commercial real estate assets from failed S&L’s. The problem with that is that the complex collateralized debt obligations and credit default swaps that might be re-cycled via these latest versions of the RTC would be composed of exotic and complicated instruments not easily valued and having doubtful remaining tangible assets. The government may be forced to acquire defaulted mortgages, which is somewhat ironic as it had liberalized underwriting standards in the late 1990’s and increased liquidity, as well.
While the Federal Reserve bridge loan to AIG has been criticized as a taxpayer bailout, the reality is that the terms of the deal protect taxpayer interests given the loan’s priority in bankruptcy above the company’s existing debt while payback will be derived from forced asset sales. The upside is that the Federal Reserve will earn a high interest rate of 11.5% plus a possible equity return given the issuance of stock warrants.
However, AIG will have to shed some of its good assets. Witness these comments from a former Wall Streeter:
The concept that keeps coming up is what was done with CIGNA years ago -- splitting the firm into a good bank and a bad bank. The good bank is all the insurance operations, International Lease Finance Corporation (ILFC), and the asset management operations. The bad bank is United Guaranty Mortgage and the Financial Services operations plus some other pieces with the toxic subprime exposure. The only problem with this solution is that nobody wants the bad bank. At least when CIGNA was split there was Warren Buffet and Ace, Ltd. willing to take on the asbestos risk. Right now there are no buyers at all for subprime mortgages.
What AIG will end up doing is selling off the good assets, and there will be plenty of buyers for its insurance and ILFC units. What is puzzling is why AIG turned down a bid from German insurance giant Allianz to take over the company one day before the Fed stepped in. The entire Board should be thrown out along with members of management who created this mess.
To understand the regulatory problems roiling the financial markets in the wake of the government’s bailout of AIG, the following is a colloquy on these issues with economic consultant John Haldi.
Haldi: My first response is focused narrowly on AIG, and it is a question to which you might have some insight. Namely, to what extent did AIG get up to its armpits in credit swaps and other derivatives while Hank Greenberg was running the company? Was it primarily he who led them down that primrose path, or his successors?
Gordon: Purchase of supposedly 'safe' senior tranches of collateralized debt and trading in derivatives began in the late 1980’s under Hank Greenberg’s regime at AIG. However, the big exposure to toxic collateralized debt and credit default swaps rose after his departure. Hank Greenberg’s successors became obsessed yield junkies. AIG’s credit default swap book was huge, over $446 billion, dramatically impacting the company’s liquidity. AIG’s board and management are now being asked to exit by the government as a result of the company accepting the $85 billion bridge loan. Hank Greenberg and Eli Broad may attempt to regain control via a proxy fight as they both had criticized what AIG was doing. However, Greenberg in a Charlie Rose interview called the government bailout a “disaster.” The good news is that the government asked Ed Liddy, former CEO of Allstate, to replace Willumsted as CEO at AIG. Liddy has a good track record as a sound and responsible manager having guided Allstate through the problems occasioned by Hurricane Andrew and Katrina. Hapless Willumsted, a former Citigroup banker, had been CEO for less than three months when this denouement occurred on his watch. Nonetheless, Liddy has to clear out the tainted senior management at AIG and sell assets to repay the Federal Reserve bridge loan. The government bridge loan amounts to senior secured debt having priority over existing AIG indebtedness.
Haldi: Moving on to broader policy issues, I have three comments.
First, if taxpayers have to bail out credit swaps gone bad in order to forestall systemic risk/failure ("contagion"), then it seems to me that there must be considerably more regulation of that market, regardless of what Alan Greenspan says about leaving markets unregulated so as to foster creativity by the cowboys in Wall Street and other financial markets.
Gordon: Again, with an unregulated $62 trillion dollar credit default swap market pivoting on less than 10% equity, we were bound to have excesses of the type we saw with AIG, Lehman and Freddie Mac. Realize there is no central clearing house facility for these exotic instruments that AIG and the major investment banks had created. The International Swaps and Derivative Association, Inc. (ISDA) lobbyists may have made political contributions to a number of key Senators to leave the derivatives market untouched, despite criticism by bond market traders like billionaire Bill Gross of PIMCO. Gross, it should be pointed out, bulked up on Freddie Mac and Fannie Mae bonds on a hugely profitable bet that they would be secured in a government bailout. As you know the very same investment banks that created these exotic products saw this as a global trading opportunity in the equity, debt and commodities markets. One suspects that Wall Street lobbyists tried to keep this alleged profit niche away from US securities and commodity trading regulators with disastrous results. Members of Congress didn’t become concerned until the debacle of these past several weeks. Both Sens. McCain and Obama, by the way, had major contributions from Fannie Mae and Freddie Mac.
Haldi: Second, I suspect that the government "takeover" of AIG marks the effective end of the Reagan era obeisance to unregulated free markets as the end-all and be-all for promoting economic stability and welfare. Only ultra-Libertarian voices (read "Cato Institute") will continue to voice the party line.
Gordon: It does say that the Cato Institute and Ayn Rand School of laizee faire economics constitute a ‘fool's paradise’ and that investors were not protected from the invincibly arrogant actions of management lacking oversight and risk management controls. The issue is what system of regulation would work best with a strategic light touch to mitigate these situations? Certainly, the enactment by Congress of the Sarbanes Oxley Act of 2002 hasn't done anything except make CPA and consulting firms rich by creating complicated systems endeavoring to make corporate accounting more transparent and responsive to investors. Ultimately, one has to question whether the current financial debacle isn’t a byproduct of financial deregulation when the commercial banking community lobbied for the removal of the barriers to ownership by bank holding companies of investment banks and insurance companies. The barrier established by the Glass Steagall Act of 1933, was repealed in 1999 by the Gramm-Leach-Bliley Act (GLBA).The current financial turmoil brings into serious question the hope of GLBA that diversity of services would mitigate risks. Witness this benighted view from Investopedia:
Many argued that allowing banks to diversify in moderation offers the banking industry the potential to reduce risk, so the restrictions of the GSA could have actually had an adverse effect, making the banking industry riskier rather than safer. Furthermore, big banks of the post-Enron market are likely to be more transparent, lessening the possibility of assuming too much risk or masking unsound investment decisions. As such, reputation has come to mean everything in today's market, and that could be enough to motivate banks to regulate themselves.
Haldi: Third, it would appear fairly obvious that the NYS Insurance Commissioner was totally incapable of coming to the rescue of a worldwide giant such as AIG. And that raises some questions. For instance, how long do we rely on state insurance commissioners to be the sole regulators of such insurance giants? Even the "strongest" state regulators are essentially feeble when dealing with a worldwide giant such as AIG. Also, to what extent can state insurance regulators restrict or regulate trading in credit swaps and other financial derivatives? If they cannot do so, then what good is all the regulation of traditional insurance lines when the unregulated part of the business brings collapse of the entire firm? Suppose AIG had gone under, with huge losses in its credit swap portfolio. Would the NYS Insurance Department have imposed an assessment on other insurers (and ratepayers) in NYS to pay off the losses?
Gordon: As you know from both your own research and my experience as an insurance regulator the state regulatory regimes don't have the talent or the authorities to control such investment vehicle innovations, except after the fact. I doubt whether the central National Association of Insurance Commissioners (NAIC) Security Valuation Office in Manhattan had the technical firepower to even value these complex instruments, let alone establish an effective monitoring system. I suspect that in AIG's case the credit default portfolio valued at over $446 billion and underwritten out of the holding company had minimal regulatory oversight from state insurance departments like New York. Thus, it would have been impossible for the New York Insurance Department receiver to marshal resources to pay off any of the CDS counter party obligations. Its first priority would be paying off policyholder claims. I am also a believer in bi-chartering of giant insurance holding companies like AIG at the federal level akin to the Comptroller of the Currency system for federal and state chartered major banks.
It would appear that this latest financial crisis may have been the result of a moral hazard caused by liberalizing mortgage underwriting rules by the federal government beginning in the late 1990’s. This was exploited by the investment banking community and hedge funds, including AIG, operating on extended leverage. The federal government bailout of AIG was a direct result of these developments. While the direct cost may not impact taxpayers, the credit crisis created is affecting the economy and main street.
 Jerry Gordon is a contributing editor to the New English Review and John Haldi is an economic consultant based in New York City.
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