AIG - Illiquid Or Insolvent? (Or Both?)

Carol Leonnig of the WaPo writes about the government bail-out of AIG and includes this bold and disparaging comment:

A number of financial experts now fear that the federal government's $143 billion attempt to rescue troubled insurance giant American International Group may not work, and some argue that company shareholders and taxpayers would have been better served by a bankruptcy filing.

...Echoing some other experts, Ann Rutledge, a credit derivatives expert and founding principal of R&R Consulting, said she is not sure how badly the financial system would have been rocked if the government had let AIG file for bankruptcy protection. But she fears that the government is papering over the problem with a quick fix that was not well planned.

I don't want to echo Knick coach Mike D'Antoni so I'll settle for "Kidding?".  The Lehman debacle spectacularly illustrated the law of unintended consequences - the Powers That Were persuaded themselves that a Lehman filing would be somewhat unsurprising to the market (it had been mooted since March) yet they ended up surprising themselves.  The idea that AIG could have gone gracefully into the night without prompting a credit seizure that would have made the Lehman / Reserve Management fallout look like a beach picnic strikes me as, well, implausible and not an experiment with an attractive risk/reward profile.

As to what went wrong at AIG, Seeking Alpha excerpts a useful WSJ article:

The WSJ shines a bit more light on  what went wrong at AIG today, with a story centering on the chap who designed its risk models, Gary Gorton. In a nutshell, anybody writing credit protection runs two risks: the default risk of the underlying security, on the one hand, and market risk, on the other. It seems that AIG only ever asked Gorton to worry about default risk; no one ever bothered to calculate the risk that CDS spreads would gap out, forcing AIG to take billions of dollars in mark-to-market losses and post many billions of dollars more in collateral.

...As far as AIG was concerned, it was one of the biggest companies in the world, more than capable of weathering any mark-to-market storm -- and therefore all it cared about was default risk, not market risk. But as a result, it took on much more market risk than it was really aware of -- and that market risk ended up forcing the entire company into the arms of the US government.

Hmm.  As of Sept 2007 the AIG balance sheet showed $1,072 billion of total assets and $968 billion of total liabilities, for a book equity of roughly $95 billion.  A twenty percent decline in assets values could have wiped out the equity without any help from the machinations at the AIG Financial Products division.  However, the solvency issue became a liquidity crisis when AIG needed to post collateral and could not raise the money.  Times coverage from last week and last month is interesting.  This is from September:

A frenzied effort to prop up the American International Group, the ailing insurance giant, had failed. The Fed had decided it had no choice but to do the unthinkable: bail out A.I.G. with an $85 billion loan or risk a potential financial catastrophe of unknown proportions.

Over the preceding five days, A.I.G., the world's largest insurance company, had exhausted every other option. The company had sought a lifeline from some of the nation's largest banks, as well as from big private investment funds on Wall Street, but no one dared come to the rescue. As potential saviors pored over A.I.G.'s books, the holes they discovered kept growing -- first from $20 billion, then to $40 billion, then to $80 billion, then even more. The sharpest minds on Wall Street could not fathom where the bottom was.

...

By Monday evening, A.I.G.'s credit ratings were cut. Within 72 hours, the amount of money A.I.G. need had grown from $20 billion to $85 billion. By one internal estimate, A.I.G. might need more than $100 billion.

''The threat of bankruptcy was a real threat,'' Mr. Dinallo said. The government began to fear that the collapse of A.I.G. would lead to devastating losses across the financial industry.

Comments

[peter]

You're not an idiot.

[steve sturm]

An AIG failure would have left holders of 'debt insurance' unable to collect if/when the underlying debts went south, but would that have been terrible, and as bad as Lehman failing?

As I understand them, credit default swaps were a fairly new vehicle, Wall Street had dealt with debt for years before CDSs. Why would we have not been justified in expecting the debt market to continue to function without them now (albeit at a higher price)?

[Charlie (Colorado)]

Steve, it's like jumping off the Empire State Building: isn't the change in altitude that gets you, it's the suddenness of the stop. As it was, this is having a chance to sort itself out; there will certainly be people with better hindsight than Paulson/Bernanke had foresight, but then they don't have the luxury of waiting.

[steve sturm]

I get the analogy Charlie, but I still don't get it. So AIG can't cover the insurance it sold (I think we agree a CDS is insurance). This shifts a bit more burden to the firm that thought it had bought protection, but it doesn't change the fundamentals of the underlying debt security (not having insurance on an asset doesn't make it worthless, you're just at risk if the value drops). So AIG goes under, and firms across the world take a little bit of a hit (determined as the the decreased value of their asset, whatever that is, less the amount of insurance they thought they had). Not the end of the world, not the end of debt instruments (pricing goes up because of the lack of 'insurance'), while Lehman's failure sure could (and did) cause all sorts of trouble in run of the mill trading.

[Forbes]

There is a great deal of irony (and it's not "ha, ha" funny irony) that the ratings agencies that got the mortgage/CDO ratings so badly wrong, are the same agencies that down-graded AIG into the collateral call, thus creating AIG's liquidity/solvency mess.

Which time did the ratings agencies get it right? When they gave investment grade ratings to junk, or when they down-graded AIG?

And how do we know?

I watching a presentation two weeks ago, and it seems that the ratings agencies were using the prices of CDSs to confirm or question the validity of existing ratings, or the use such prices as am indicator when rating a comparable, but new rating. Sounds like circular reasoning to me: the market relies on the rating, while the rating relies on the market.

[Sarah Joseph Ballard]

Steve,

You're correct about the underlying security but that wasn't the problem. Prior to the credit rating cut AIG did not have to post collateral at all, after the cut they had to come up with $20 billion to $100 billion immediately. They became both illiquid and insolvent in the twinkling of an eye - that's the point of the post. I would strongly argue insolvent as well as illiquid because they lost access to the asset as well as having to post at least a portion of the change as a liability charge.

They busted their insurance reserve requirements (I think) and really could have been shut down by insurance regulators as soon as they posted the collateral.

It wouldn't have been a "little bit of a hit" because AIG going under would have triggered counterparty events that would have made Lehman's collapse look like a neighbor hood candy store going under.

[steveaz]

Suddenly, in less than six months, America's entire meritocracy has been shaken to its roots.

Our citizenship, our dollar, even our university credentials are now of dubious worth.

Was this by design - because of big city politics and Fannie Mac?

And, what'll happen to the Constitution if this gang wins? I'm voting straight "R" tomorrow...

[Patrick R. Sullivan]

James Lileks has two days to save America:

If you are opposed to higher taxes on the rich – well, let’s back up. If you start out by questioning the definition of “rich,” you’re one of them. “Rich” is like “racist” – the surest sign of the guilty is the failure to admit your problem. If there are a lot of people who make less money than you do, you’re rich, and it doesn’t matter how you got where you are, or whether that poor fellow over there who works for Wal-Mart – and don’t worry, we’ll belittle him as a three-toothed inbred cousin-marrying NASCAR Oxycontin-popping gun-nut in just a minute – made some life choices that may have affected his earning potential; the existence of disparity is sufficient to prove that something is wrong. Or at least suggest that something must be done. As a wise man said: half the people in the country live below the median income level. Half. In this day and age.

[stevesturm]

Sarah: although CDSs act like insurance, I don't believe they're regulated as insurance, and I don't know what, if any, capital requirements someone selling CDSs must have (none statutorily? just whatever the firms buying the protection want?) or what authority, if any, insurance commissioners would have had to step in. And, unlike Lehman, what counterparty events were there? (AIG sells Goldman insurance, collects a premium, stands by to pay off if Goldman can't collect on the debt instrument being insured. no counter party as in the Lehman model).

Hypothetically, what would have happened had AIG refused to hand over collateral and said they would only pay upon actual loss from default from the underlying debt and not merely on the trading loss taken on the security? Firms like Goldman would have been p***ed, but what would the ripples have been on that? AIG wouldn't have lost collateral (assets), they wouldn't have taken a write down or recorded losses on the CDS (loss only taken if and when paid to CDS holder), thus they wouldn't have needed the bailout.

I've long wondered (being the cynical paranoid type. there, I've admitted it) the extent to which Paulson was looking to bail out his former colleagues (either consciously or not, I don't know, and he certainly portrayed the bailout as of 'Main Street'). In its most simple structure, isnt' the AIG bailout a bailout of Goldman and the other firms which were demanding collateral and, without the AIG bailout, in danger of not getting it? To what extent has the AIG bailout funds gone to Goldman et. al. as collateral for the CDSs?

[RichatUF]

Steve-

I've long wondered (being the cynical paranoid type. there, I've admitted it) the extent to which Paulson was looking to bail out his former colleagues (either consciously or not, I don't know, and he certainly portrayed the bailout as of 'Main Street').

I could buy that if the economic crisis weren't global. BRIC is off some 50%-60%, with all those markets closing because the sell offs were getting so bad and Russia has the very real probability of another debt default and currency crisis. SK is in a worse meltdown than the US-they have a banking crisis and currency crisis. Euro zone banks and insurance companies have also collapsed. The entire financial infrastructure in Iceland has collapsed.

AIG was a global problem and its problem division was located in London with trades being cleared in France-for US Treasury and the Federal Reserve credibility alone they had to take the least worse of a bunch of bad options.

[stevesturm]

I understand the global nature of the crisis (whatever the crisis was, it was certainly international in scope), but I remain unconvinced why AIG needed to be fed a hundred billion dollars. They didn't need the money to pay off actual losses on the debt (as, I believe, very few of these debts were actually in default). The money was used to replace the collateral they paid out and/or to pay the collateral they hadn't yet paid out.

A (possibly poor?) analogy: what would happen if there was no such thing as property insurance? The pricing on property debt would be different (higher) and it would probably take some time to shake out, but there still would be people willing to loan, there would still be property, people would still buy and sell it and build on it and live on it. In other words, the world would not come to an end. And the world wouldn't come to an end if there was no such thing as a credit default swap.

[Charlie (Colorado)]

Steve, honestly, I think the issue is that you don't want to get it. But let's try again: the issue, under everything, was that a well-respected firm turned out to have so much exposure that not only they, but the entire financial system, became too risky to deal with. A bankruptcy would have not only rendered them unable to operate, it would have meant a probable years-long fight over the remaining assets. That would have precipitated a cascade of other failures, and the credit crisis we had would very probably been hundreds of times worse. Paulson and Bernanke had to decide what to do, and they had about 48 hours in which to do it.

Maybe they should have just let AIG fail; maybe the precipitated crisis wouldn't have happened, or maybe they could have staunched the bleeding and saved the patient some other way. But as Tom put it very correctly, the risk/benefit tradeoff didn't look very favorable.

So if you have a better idea now, it's a good time to explain it, but I'd also like to see you explain how B&P could have gotten there, and what your Plan B would be if the cascading crisis had happened.

[sylvia]

"some argue that company shareholders and taxpayers would have been better served by a bankruptcy filing. "

I told you all. You all laughed when I asked why couldn't a bank get bankruptcy protection like other companies to get time to solve their cash flow problems, instead of the bailout. Y'all said it couldn't be done. Well we see that it can be done, and it maybe would have been better.

[stevesturm]

No no matter how many times you repeat the chant that AIG's problems placed the entire financial system at risk, it doesn't make it so. Yes, I understand that AIG was at risk, not having enough collateral to satisfy all the demands from those who wanted it, but I remain unconvinced how this failure to provide collateral placed everybody else at risk. Rather than blame the student for not seeing the wisdom of your arguments, perhaps you could try explaining it a different way.

If you're up to the challenge, were the demands on AIG collateral triggered because the debt holders were suffering actual losses (not getting the cash flow promised by the debt) or because of the mark-to-market driven drop in the carrying value of the debt? If the former, then giving AIG $100 billion to in effect pass along to the Goldmans would only alleviate the problems to the extent of the bailout; if there were $200 billion of demands for collateral, then financial firms were going to be out $100 billion, why wouldn't that trigger the collapse? And cynical it is, but if the AIG money was to go to the firms seeking collateral, wouldn't it have been more efficient to let AIG go under and pass the money directly to the holders of the debt?

And if the latter, why was it so necessary for AIG to pass out collateral?

[Garth]

y'all ready for....

President

Barack

Hussein

Obama......?

[Garth]

the question isn't really who AIG put at risk, but who cares if they go under because they voluntarily exchanged their cold hard cash for worthless pieces of paper.

if it's a crime... sentence'em

if it's legal... vote the republicans out

[sylvia]

"Hypothetically, what would have happened had AIG refused to hand over collateral and said they would only pay upon actual loss from default from the underlying debt and not merely on the trading loss taken on the security?"

Yes I've wondered that myself. This mark to market rules sound good in theory, but in practice not so good in an acute situation like this. If the credit agencies suddenly downgrade a company like AIG, then under mark to market, AIG must come up with more hard assets or sell off debt to balance out their debt. But these MMR rules are standard operatiing procedures mainly good for insurance in case of any big disaster or run, so that all debts could be potentially be paid off by AIG.

But is that concept so holy that we have to put the country into debt for this? If the Feds make and enforce this rule, then why can't the Feds just relax the rule? What about telling a proportion of the customers, sorry your insurance coverage may not be guaranteed for the next 3 months. Chances are the worst case scenario would not happen and not all people would cash in at once. If too many did, we'd have to tell the last ones, sorry you can cash out next month. I mean, yeah, not the greatest way to run a business, but what alternatives do the customers have, now or in the future? Life would go on for most of them as usual, until the situation stabilized. Most wouldn't even notice. So the reputation of the company, and also by extension the US suffers of course, but then the companies can adjust and do better in the future, and build the rep back up. Much cheaper than a bailout anyway.

[sylvia]

You know I was talking to my dad about this earlier and he got me to thinking. I think this does all come down to the idea that we do need to tax the rich more now. Obama is right on that one. Don't forget, for all things there are a balance.

For instance, Repubs like to tell you that "oh if you raise the minimum wage, you'll lose more jobs". Yeah, true, but only to some extent. What they forget to tell you is that raising the min wage increases buying power, which increases sales which creates jobs. It works both ways. So it's not all about raising or lowering, it's about finding the right balance at the time.

The same with taxes. Keeping taxes low for the rich is good in that it does stimulate investment. Most rich people do not spend most of their money, so most of that money sits in banks, which can then be loaned out. Which is good mostly. However, if there is too much money sitting around in the banks, we get into crazy financial schemes like this where the investment bankers run hog wild and spend the money on foolishness that we then have to bail them out on. So there is a right balance.

I think we do need to put more money in the pockets of the middle class now to stimulate spending and cut down on investment for the moment, until the bubble passes.

[NK]

Sylvia-- you say:

"I think we do need to put more money in the pockets of the middle class now to stimulate spending and cut down on investment for the moment, until the bubble passes."

First clause, we can all agree give the broad middle more money, how? let them keep more by reducing the federal and atate tax burdens. Second clause, how does 'cutting down investment' help anyone? capital needs labor and consumers, labor needs capital even more. Please, there's a lot of informed economic thinking and comments here, don't mess it up with ignorant drivel.

[sylvia]

"First clause, we can all agree give the broad middle more money, how? let them keep more by reducing the federal and atate tax burdens."

I was talking about the wealthy there, you might want to read it again. Cut taxes or keep taxes low for the middle class, raise taxes for the rich.

"Second clause, how does 'cutting down investment' help anyone? capital needs labor and consumers, labor needs capital even more."

Because you can only invest as much as the labor market and current technology will absorb. If you do more than that and throw whatever you got at our economy, whether or not these extra funds actually results in capital improvements we need, it is likely to be a kind of over-investment. Then it becomes investment in wild schemes, such as more housing subdivisions that no one needs or wants to live in, or are poorly planned ideas, just to get rid of the money sitting around in the bank not otherwise being used. This is not a smart use of capital. Better to instead pay off the national debt and ensure more financial stability for the future.

I'm afraid your thinking is very one-dimensional NK, you can't see the forest through the trees.

[glasater]

TM--There was an interview of Hank Greenberg by Maria Bartaroma today on CNBC and I'm sure that conversation will be in the CNBC's video files soon. It is worth a look.

My takeaway on this complex subject is something like this:

The structure of the loan B&P lined up for AIG is unsustainable at fourteen per cent.

AIG had a liquidity problem not a collateral problem.

During Greenberg's time--CDS were hedged--after he left he doesn't know what was going on.

Greenberg hopes AIG can be kept intact and perhaps go into chapter 11 if nothing else.

I loved the line from the WSJ link of Buffett on Charlie Rose: "All I can say is, beware of geeks...bearing formulas." (from computer models)

Which does remind me of climate computer models....but I digress as usual.

[Angie Smith]

I would think if you kept taxes low for the wealthy that would be very good and most likely spur investment. When the wealthy leave their money in the banks, why do these idiot liberal illuminati bankers jump to take it out and spend that money on hare-brained investments? They act dumb-as-a-box and are like children--can't wait to spend it!

[sophy]

Welcome to our game world, my friend asks me to buy some 12sky gold .