I believe that the FDIC essentially acts as a trustee in bankruptcy for a failed bank, in the process either moving deposits to another bank, or paying them off up to $100K. The concern is that liquidating a bank like Citibank would overtax the FDIC’s resources. And that the seizure would reverberate through other financial institutions.
Yes, but Geithner is bringing the FDIC into this process as well. I’m just wondering if a solution couldn’t have been found that leverages the current bankruptcy regime, with its established principles and rules. For example, perhaps FDIC limits could have been waived, and the federal government could simply have made good the debt repayment to creditors up to whatever percentages were assigned in bankruptcy.
The current system seems to be pretty unbalanced and haphazard. For example, you could have made the claim that AIG should have defaulted to Goldman Sachs, and then Goldman would have had to apply for relief under TARP. Instead, despite AIG essentially being broke, Goldman got paid out 100% of what it was owed by federal bailout money, without technically being bailed out. So Goldman is not operating under the restrictions of TARP (it recently handed out million dollar bonuses with nary a peep from the feds or the public). Had AIG been allowed to go into bankruptcy, Goldman Sachs would be one of many creditors, and would have been paid out whatever was available in proportion to other investors. Then Goldman Sachs could have applied for TARP relief for the difference, and the whole process would have been more transparent and even-handed.
To be honest, the high-finance aspects of this are getting out of my comfort zone, so I don’t want to make any categorical statements about the right or wrong thing to do when it comes to the fine details. But from a macroeconomic perspective, the current plan is chock full of moral hazards and relies on assumptions about the nature of the assets that I don’t think anyone has proven.
The problem is all of this is codified in law. You can’t just apply FDIC principles to things that aren’t banks without passing legislation. And how much funding do these changes need? You’re talking about months and months of legal wrangling for a problem that needs a quick solution.
The problem with liquidating AIG to pay off creditors is that there are very good, profitable and conservative parts of AIG. You’re talking about destroying a mostly successful and prudent company to repay the mistakes of the Financial Products division - to pay off the people who all bellied up to the casino table with the Financial Products division.
Well, yes, but does “liquidate” necessarily mean “annihilate”? Can’t those divisions be sold off as whole chunks, with the underlying securities intact? Heck, if they are viable and the employees honest and knowledgeable, its seems much more likely that a responsible buyer will be forthcoming. And if temporarily nationalized, we would have at least the prospect of eventual privatization, no? A prospect not easily envisioned for Toxic Sludge International.
There is a simple (well relatively simple) way to handle this. AIGs insurance business (as opposed to the I Can’t Believe it’s Not Insurance FP business) are in nice self contained state-by-state insurance companies, thans to the state regulation of insurance. You could package them as an asset and sell them out of bankruptcy very quickly if they really are a valid ongoing business. Of course the AIG holding company wouldn’t be running it, but you would have a hard time convincing anyone that they have earned the “right” to keep running them either. The rest of AIG is the holding company and the FP division. The stockholders, bondholders and counterparties of those entities get to fight over the proceeds from the sale of the “good AIG”.
It happens in bankruptcies all the time. An asset doesn’t have to be a building or a bank account, or even a security. It can be an entire line of business.
Doesn’t mean that this is the right way to do it, but AIG having healty lines of business is not a reason not to force them into bankruptcy. In fact now that we know that the foxes are guarding the chicken coop, the prudent thing to do is to get the chickens (the real insurance companies) out of the coop, before funny things start happening there.
This is one of the best summaries I have read about the current situation. One of the big problems is that there ARE solid assets under these garbage loans.
A bank may have lent more than what it was worth, but there is still a valuable house and piece of land under that mortgage. With the uncertainty, there is zero chance of the market responding to find exactly what that value is.
A house that I bought three years ago for $265,000 is worth what now? $150k? $200k? $180k? Nobody knows; and since nobody knows, banks don’t want to modify a loan, write a new loan or a buyer won’t want to buy it.
But that doesn’t change the fact that the government doesn’t have the legal authority to take control of AIG. Or any other insurance company for that matter. If you want pieces of AIG restructured or sold off, it has to be through bankruptcy. And in bankruptcy, what happens to their depositors and annuity holders? Their creditors get first crack at the liquidated pie.
Regarding the concept of “reflating the bubble” I don’t think that is what is being proposed here. Let’s suppose an asset has a proper value of 100 but during the bubble it trades at an inflated value of 150. After the bubble the price won’t go back to 100; typically it will overshoot in the other direction and go down to ,say 60. If the government manages to find a way of pushing the price up to 90 it isn’t “reflating the bubble”.
Obviously no one is sure what the “correct value” for these assets is and when it comes to risk assets, greater risk-aversion will reduce the fundamental value itself. But again there is a tendency to overshoot, if risk-aversion is too low during a bubble it will invariably be too high after the bubble and this will adversely affect lending, investment and economic activity in general. Prodding investors and banks to indulge in somewhat greater risk-taking is part of what the government has to do to fight recessions.
Also when it comes to highly illiquid markets there are substantial externalities when it comes to price discovery and liquidity. IOW if the government can create incentives for these hedge funds to trade these assets, this will improve their pricing as well increase liquidity which will prompt other investors to enter the market which will further increase liquidity and so on. Furthermore higher prices for these assets will improve the balance sheets of banks which will mean more more lending and economic activity which means fewer mortgage defaults which further helps asset prices etc.Here’s something else I don’t understand about this plan:
Let’s a bank has an asset on the books, valued at 80 cents on the dollar. The market price is 20 cents on the dollar. The bank thinks the real value is higher, but unknown. So it won’t sell the asset. That’s essentially the situation we’re in now. And buyers won’t buy at 80, because they don’t know what the real value is. Essentially we have an informational problem which is preventing assets from moving.
So now the government comes in, and says it will essentially guarantee the downside risk for buyers, so they can pay the 80 cents. So the buyers buy up the assets, and they move. But what information has been gained? How do we know anything more about the true value of these assets? How does this fix the underlying problem? Without the government being a permanent underwriter of risk, how do we get back to the point where these assets are freely traded? What’s the exit strategy for government here?
If there isn’t one, then this amounts to a permanent subsidy on the worst kinds of risky bets, which would carry a huge moral hazard.
Ultimately, I don’t see a permanent solution to this which doesn’t involve someone taking real losses, because it’s the prospect of real loss which will allow the market to price these assets accurately, which in the long run is the only thing that’s going to get them moving.
That analysis is based on the assumption that these assets are worth closer to 100 than 60. If the market knew that that was the case, they’d be moving already at some price above 60. The problem is that no one knows what the downside to these things are. There’s a fundamental informational problem at work here. I don’t see that government’s guess is any better than the market’s.
How does this improve their pricing? That’s the part I’m not getting. The government is removing downside risk, because it’s the downside risk that’s the big unknown. Once government stops protecting them, aren’t we going to be right back in the same situation?
I don’t think they’re removing it… They’re incentivizing it. People still have to bet their own cash (and can still lose 100% of what they front) - they just get to leverage it like it’s worth more. We’re still talking about large sums of money up front.
Unless a lot of people don’t know what they are talking about, including the insurance commissioners, annuity holders and policy holders are customers of the “good AIG” state regulated insurance companies, not the “bad AIG” holding company that is on the hook for the results of the FP division’s foolishness or recklessness.
The policy holders are protected up to $300,000 by the funds organized by stated to backstop insurance companies. The state insurance commissioners regulate the investments of the insurance subsidiaries because the states are on the hook if the fund goes bust, and the states can’t just create money out of thin air. Apparently, New Jersey is not too big to fail.
There are many people who hold policies over $300k with the same company. This is like having a million dollar 20-year CD in a bank, with a 100% penalty for early withdrawal. It is risky because you can pay 20 years of premiums and if the insurer goes bust, your beneficiaries collect something less than the face value.
The people who are exposed to the failure of AIG are its non-insurance customers, who purchased the non-insurance products. You now know who they are, Goldman, Duetsche, Soc Gen, etc. Bailing out AIG is actually bailing out these companies, with the added benefit of not being able to impose any conditions on them in exchange for the bailout. I guess we didn’t place any conditions on AIG either, so what am I crying about. Free money, free money, free money. Show me your losses, and collect your free money. Or don’t show me your losses, just hint that you might have losses, and collect your free money.
This isn’t necessarily true particularly because of risk aversion. Suppose you believe that there is a 50% chance an asset is worth 150 and a 50% chance it’s worth 50. How much would you be willing to pay for it. A risk-neutral investor would pay 100 but the more risk-averse you are the less you would be willing to pay. However risk-aversion isn’t set in stone and typically after a bubble it will be much higher than normal which drives down the prices of risk asset much below their normal value. If the government can find ways of reducing risk-aversion it will get prices back up without reflating the bubble. The government doesn’t need to know what the correct value of each asset is; it just needs to decide whether prices are being driven abnormally low because of market conditions and psychology. When it comes to sub-prime securities that would seem a reasonable assumption.
The hedge funds will provide greater liquidity and increase the number of informed participants in the market. This will help price discovery. And while the plan does reduce their downside it certainly doesn’t eliminate it ; they still have 30 billion dollars of equity to worry about.
Not in bankruptcy! In bankruptcy, these creditors are first in line to collect 100% of their obligations. Credit derivatives are exempt from bankruptcy codes.
And what a marvelous little innovation that is, too! Its like those nifty rules that allow a credit card company to force you to sell a kidney if you make a late payment to NetFlix…
But, seriously, folks. Grimly.
Nobody knows. We can surmise that because people who we can fairly expect to be experts have wildly divergent views. There is no consensus to be relied upon, its not that the center cannot hold, its that there isn’t one!
Do the bankers favor a solution that makes them whole? Well, of course they do, and they have good. solid reasons, based on the clear and obvious fact that they are the backbone of the economy. Do consumers and mortgagees favor a solution that relieves them of onerous burdens? Also, good solid reasons, and they are the backbone of the economy.
When there is no agreed consensus for a solution, you should take that to mean there isn’t one, that any way you jump will entail enormous risk, and the best laid plans are still 50/50 at best to gang agley.
That being the case, its best to proceed soonest rather than later, its best to hope we’re doing the right think, and do it now! The Tinkerbelle Effect is important, we must clap, or she dies, and if she dies, then the better plan won’t help us any.
All in all, I’m with the Krugman/Sam Axis, I think the Timmeh! Plan is far too cozy and generous for bankers and financial types. But I don’t know, can’t be sure enough to make a fight worth the effort, so lets get on with it!
I voted for the guy because I trust his judgement, mostly. I even got over resenting him being smarter than me and having a smokin’ hot wife.
So, OK, go for it, Big Guy.
They are not obligations of the insurers. They are first in the queue for the proceeds from the sale of the insurance companies, not from the assets of the insurance companies themselves. Some of the insurance companies themselves have invested in some dodgy vehicles, but not the freaking insane ones, because the state insurance regulators are, well, actually regulating and have been all along. AIG purchased a savings and loan in 1999 specifically to escape state regulation at the holding company level.
Cite:
http://www.naic.org/Releases/2009_docs/correcting_aig_misinformation.htm
http://www.naic.org/index_aig_consumer_faq.htm
AIG did engage in a securities lending scheme with it’s insurance subsidiaries, which did in fact cause major losses for the insurers (or at least a liquidity crisis in the scheme). But this was bailed out by the first tranche of bailout funds in November. As long as the holding company still has control of the insurers assets, they are going to be tempted to loot them to prolong the life of the holding company. For the people managing the holding company, survival of the holding company has value, personally. They remain employed and as we have seen can even collect bonuses.
So what happens if you sell off the insurance company(ies), but still owe your creditors billions and can’t restructure the debt?
ETA: I am in way over my head here, but I think you’re creditors would have standing to sue to keep you from selling off the insurance companies if that sale would keep you from being able to pay them back. At that point wouldn’t they have to liquidate assets to pay back creditors? Or am I high?
The insurers are assets of AIG. But they still have to operate within the bounds of state laws. They cannot hand over their assets to the parent company. The state regulators would need to approve that, and now that they are on notice, you can bet they will be extremely vigilant.
The counterparties basically have two choices without a government bailout. Force a liquidation of the company or wait for their money. I think the only way they jump the queue is to force the company into bankruptcy in the first place. But even in bankruptcy they cannot touch the assets of the insurance subsidiaries directly. They can auction off the subsidiaries either as a whole or in part, but all they can get their hands on are the proceeds from the sale. The shareholders and creditors all get wiped out, and the counterparties consume the assets. But you cannot get blood from a stone.
I am only addressing the 71 US insurance companies that AIG owns. They also own 100+ overseas subsidiaries. I can only imagine that they are subject to regulation in those countries as well, which prevents them from taking assets held in trust to pay insurance claims and just handing them over to counterparties of the parent company’s non-insurance contracts.
The moral hazard in insurance is well known. We give companies premiums for claims to be paid in the future. They always have the motivation to gamble with the float. If they win, they take the profits, if they lose they go bust and move on to the form another insurance company. States and foreign companies know this, and naturally regulate them, particularly in terms of what they can invest in. Mortgage-backed securities are a big part of the investment portfolios of most insurance companies, so they are not immune from failure. Just hasn’t happened yet on a mass scale, because the holding are not large enough to result in a liquidity crisis. Could still happen.
I am in way over my head too. So I will shut up about this after this post.
Thanks for all your replies so far - it’s been a big help in my understanding. I know you said this was your last reply but… You’re talking about state regulators having a say in a bankruptcy proceeding that’d be handled by federal law (or is that not right?). Couldn’t this be a pretty sticky and unpredictable mess? And what about the event of of the AIG bankruptcy itself? Wouldn’t that be another ‘credit event’ that triggers more payouts from other firms on credit default swaps? Wouldn’t it cause more ripple effects than Lehman?
I think in the long term they shouldn’t let companies get this big in the first place. Fixing it in the meantime though… man…