AIG Was Broke by David Merkel, CFA of AlephBlog

There’s a significant problem when you are a supremely big and connected financial institution: your failure will have an impact on the financial system as a whole.  Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve.  You are Too Big To Fail [TBTF].

Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities.  They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.

In such a time, it does no good to say, “Just give us time.  This is a liquidity problem; this is not a solvency problem.”  Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly.  The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.

That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG.  If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed.  Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis.  Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well.  This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.

Buffett was asked to bail out AIG, and he wouldn’t touch it.  Running a large insurer, he knew the complexity of AIG.  Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products.  He also likely knew that AIG’s P&C reserves were understated.

For more on this, look at my book review of The AIG Story, the book that tells Greenberg’s side of the story.

To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent American International Group Inc (NYSE:AIG) as if it were a simple thing for them to be solvent through the crisis.  It was no simple thing, because only the government could have provided the credit, amid a cascade of failures.  (That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)


Spot the failure