I quote a Wall Street Journal article dated November 11, 2008, "The U.S. government unveiled a plan Monday to scrap its $123 billion bailout of American International Group Inc. and replace it with a new package valued at about $150 billion."
A single company is getting $150 billion in funds from the government (including the Fed). One source puts the government’s annual subsidies to all of agriculture at $35 billion or so. The space program costs $20 billion a year. Medicaid is one of the largest government programs. It runs about $339 billion a year (slated to rise to $674 billion in 8 years). The size, suddenness, and manner of the government’s loan to AIG are all extraordinary.
Why did the Fed intervene? What is the nature of this intervention? Why did AIG agree to this? Why did it not seek protection under the bankruptcy code? How did the eventual course of action come about? Whom is the Fed helping? Whom is it harming? What has the Fed revealed about all of this? What has AIG revealed about this? What can we learn from press reports and leaks?
The entire matter is quite complex. One short article only begins to answer these questions, but it is important to address them so that we can understand the full meaning and implications of the Fed’s intervention. The Fed’s loan and equity stake are so large that they affect the risk of the Fed and thus the dollar. They place the taxpayers at risk. They shift wealth. They alter the incentives under which financial companies operate. The same can be said of the government’s TARP program of $700 billion and the absorption of Fannie Mae and Freddie Mac that raised the national debt by an order of magnitude. These events transform the Fed, the government, and the relations of the government to all of us. They are not business as usual.
These bailouts change the financial system and the entire business system in basic ways. They alter the relations of firms to government at a fundamental level. This is due both to the size of the moves, which are orders of magnitude larger than anything in the past, and to the exercise of power itself. The Fed and the government are extending their powers in ways that affect all of us. There are bound to be follow-on effects down the road. Practice makes precedent.
We do not have all the answers. From my window, the Fed should not have done this and should instead have watched from the sidelines as the AIG company sought court protection under bankruptcy.
Why? One ground for this is that the Fed is going well outside its already significant sphere of power when it begins dealing with specific companies. This means it must pick and choose those whom it aids. This process is arbitrary and dictatorial. It is open to enormous corruption because we the people do not control the Fed, and yet its direct interventions into the economy transform into gains for some of us and losses for others. What right does the Fed have to engineer these wealth transfers? At least when individual banks make loans, there is a semblance of market discipline in that the banks are beholden to shareholders and bondholders, and the banks can fail. Individual banks have at least some incentive to make decent loans. The Fed has no such controlling organizations in place and, because it is a power unto itself, its incentive to make good loans is not as strong as a member bank’s. The Fed even revels in being lender of last resort, which means that it views its mission at times as taking in bad loans in return for cash or good securities.
The Fed necessarily coordinates with the Treasury when it conducts open market operations. If the Treasury wrote checks to AIG that AIG deposited in its bank accounts in exchange for a loan from the Treasury, the effect would be almost the same as the Fed making the loan. In effect, the AIG company has tapped into the Treasury (via the Fed) without any approval of Congress or appropriation. This is a naked power expansion with no consent of the governed.
AIG looks to be a tar pit. Once in, getting out is very difficult. Although the terms of the Fed’s loans are very stringent, the current valuations for AIG suggest that the Fed and the government will have a hard time collecting. The taxpayers will lose.
We need to think about the policy holders of AIG. Are they better off with government intervention or with a bankruptcy? Experience in the S & L case in the 1980s suggests that government cleanup of loans is a slow process. The value of the company erodes over time. Bankruptcy is faster and preserves more value. A number of units of AIG are sound. There are established ways to transfer policies to other companies if need be. The toxic securities within AIG could have been segregated in a bankruptcy. This is not happening now. Instead, the whole company is under stress. It now has even more debt than it had before. Sharp security analysts are saying that the Fed is actually not bailing out AIG but destroying it, which harms policy holders. (Two articles by John Appel provide a detailed picture of the condition of AIG. See here and here.)
Last, the gainers from the Fed’s actions turn out to be certain counterparties to AIG debt contracts. They are collecting full value, which is more than what they would have gotten in a bankruptcy proceeding since they are not senior creditors. The Fed and Treasury are using their powers to bail out a select group while the risk of the loans falls upon the taxpayers and those whose dollars may depreciate. This is another abuse and expansion of power.
Who are these counterparties that are getting the largest benefits and windfalls from the Fed? They include Swiss Reinsurance (about $179 million), Aegon, Merrill Lynch, other banks and insurers, Hartford Financial Services Group, six large Canadian banks (about $1 billion worth). The amounts and firms are spread quite far and wide, suggesting that an AIG bankruptcy could have been handled without any financial meltdown. But Goldman Sachs is the largest beneficiary at $20 billion worth of exposure to AIG. (Goldman claims to have hedged that risk, but with whom?) Treasury Secretary Paulson was chairman and chief executive officer of Goldman. News reports tie Paulson into backroom machinations to get the Fed to save Goldman via lending to AIG. The AIG bailout is a Goldman Sachs bailout. The stock of Goldman Sachs rallied 20 points, from 110 to 130 on the news. This added almost $10 billion to its market value.
The institutions who bought AIG’s debt insurance knew there was counterparty risk, and they should have been the ones to face any losses from the insurer’s failure to pay off. The financial world does not topple because of defaults like these. All that happens is that the financial institutions are forced to value their holdings at realistic or actual values, which helps to get trade going again, something the Fed claims that it wants. The Fed acted on the false theory that there would be a financial meltdown if AIG failed leading to an endless depression. It has been acting on that theory for some time, with the result that it keeps inflating and re-inflating unrealistic price bubbles. This is making a shambles out of the financial and economic system and leading to the endless depression that they are trying to avoid.
Apart from bailing out Wall Street friends, the government is intent on an attempt to maintain values of securities at unrealistically high levels while supplying enough money so that people will borrow even more to hold these securities. This is futile if the cash flows that these securities generate are insufficient to support these high prices. Furthermore, what good will it do to increase the burdens of debt when many sectors are straining to maintain interest payments and pay off principal with their current debt levels? Market economies run on credit. Credit is a promise to pay. These promises have no credibility when prices of securities are manipulated, hidden, or thought to be inflated. Credit then dries up. A financial meltdown is nothing more than a marking to market of asset prices, and this is precisely what is called for in order to restore truth in pricing and encourage the formation of new and sound credit.
What sort of company is the object of the government’s tender mercies? It is not the sort of company whose reporting can be trusted, as the following review will show.
AIG is a very large insurance company. In 2007, its assets exceeded one trillion dollars. It writes many different kinds of insurance worldwide. In the fall of 2008, it could not come up with obligatory payments on some contracts that it had entered into. This meant that the company was going bankrupt. The company never filed for bankruptcy, however. Instead, the federal government and the Fed intervened. They supplied AIG with funds to keep it going. They supplied these funds under stringent terms that are compelling AIG to sell off assets in order to repay the funds. Hence, AIG is being restructured under these new contracts they have with the federal government and the Fed.
The stockholders of AIG lost most of their investment in the company. The stock is now about $1.50 a share. Earlier in 2008, it was as high as $60. It lost value steadily as the year progressed. At the end of the year 2000, the AIG stock reached almost $105. It fell to $45 in the general market decline of 2001—2002. Its movements were more or less in sympathy with the market until late 2007. The stock held up rather well considering the bad news about it to be mentioned shortly. It held up too well. In my opinion, investors did not adequately take into account the full meaning of the bad news that they were receiving about this company.
During 2006 and 2007, company insiders sold AIG stock heavily. Insider transactions are made public very shortly after they occur. These sales seem to have been ignored by the market. Between September 25, 2007 and October 17, 2007, interests controlled by the former chairman of the company, Maurice u2018Hank’ Greenberg sold 9 million shares of stock at prices between $66.50 and $69.35. It was all downhill from there.
The insider sales were bad news, but they are not the bad news I mentioned earlier. The other bad news about AIG occurred between 2000 and 2006. The company engaged in a number of different frauds. They led to the resignation of Greenberg in June of 2005. These frauds led to both civil and criminal prosecutions and convictions of officers of the company. Greenberg was not among them. We know that he made one telephone call to his CEO that instigated the operation that led to one fraud. He was named an unindicted co-conspirator.
Greenberg exercised his Fifth Amendment rights before investigators from the SEC and New York Attorney General Eliot Spitzer’s office shortly before he resigned. Spitzer made Greenberg a target; he was persuaded that the company was engaged in many kinds of questionable activities. The downfall of both these men has about ended that conflict. Greenberg was the guiding force behind the company for many years and still makes public comments about what should be done about AIG. He is rumored to be interested in regaining control. However, he sold most of his stock recently. Greenberg has solid establishment credentials and interesting connections. At one time, he held the highest posts at the New York Federal Reserve Bank. He is on both the Council on Foreign Relations and the Trilateral Commission. He was offered the post of Deputy Director of the CIA (he turned it down).
The kinds of frauds that were committed had to be known by Greenberg and AIG’s upper management, and the public record clearly suggests this, although Greenberg was never indicted. The working culture and ethos of the company had to be such as to encourage or tolerate such frauds. Furthermore, once there had occurred more than one of these frauds, investors should have been alert to the possibility of more hidden business practices that, if uncovered, presented serious risks to an investor. And they should have been alert to the possibility that factors such as high growth and profits might have been the result of cooking the books. This is Monday morning quarterbacking, I concede, but the fact is that the frauds were public information. Furthermore, there is a history of financial company frauds with certain earmarks that goes back to the failures of many large S & Ls in the 1980s. Once frauds were turned up at AIG, some of which depended on accounting manipulations, investors should have very carefully scrutinized AIG’s use of offshore subsidiaries, its entry into many and diverse insurance lines, and its high growth by acquisitions. These run precisely parallel to the kinds of things that high growth S & Ls did before they failed in the midst of frauds.
In other words, it is just possible that some of the large losses booked by AIG in 2008 that have dropped the stock price so drastically have arisen from some things other than the credit default swap contracts that went sour.
In 1997, AIG began to market an "insurance" product that allowed companies buying it to smooth their reported income. It was an unconventional retroactive insurance by which a company with losses or earnings shortfalls might "insure" against them, report higher earnings, and later on, when premiums were due, take the losses into income at a time when they would be offset by higher income (hopefully). This accounting manipulation was, in essence, fraudulent, since the company using the technique was deceiving investors as to the true condition of the company’s operations. It amounted to a kind of loan that is taken into income and later repaid. There is no transfer of risk as there would be in real insurance.
The SEC brought charges against AIG in two instances of this product. By the end of 2004, the civil cases were settled and AIG paid out $126 million.
In 2004, in a separate matter, two employees of one of AIG’s units pled guilty to bid-rigging felonies.
In early 2005, a new investigation began. This case was about AIG manipulating its own loss reserves by buying an insurance product from General Reinsurance, which is a unit of Berkshire Hathaway. This case eventually led to the conviction of four General Re executives and one AIG executive. The fines came to $1.6 billion.
In March of 2005, on this matter, AIG announced that it would delay filing its 10-k statement, that its accounting for reserves had been improper, and that some of its other accounting might also have to be revised.
William Wilt, who was an analyst for Morgan Stanley, wrote: "Some investors may take comfort that details are beginning to emerge, however, we are inclined to focus on the depth and breadth of the apparent accounting deceptions.” This remark should be understood in the context that security analysts usually are not bearish.
AIG in May of 2005 said that “certain former members of senior management” were able “to circumvent internal controls.” A Wall Street Journal article said: "The [AIG] statement added that accounting entries that boosted AIG’s net worth by about $100 million since 2000 u2018appear to have been made at the direction of certain former members of senior management without appropriate support.’ The statement didn’t name the former executives, but people familiar with AIG’s continuing review by two outside law firms said the references included Mr. Greenberg and Howard I. Smith, AIG’s chief financial officer until the company ousted him in March for refusing to cooperate with investigators. Government regulators also have documents and testimony suggesting the two former executives were behind financial moves that smoothed or boosted the company’s earnings in recent years, people familiar with the matter said." These moves included deals (that were not at arms-length) with offshore reinsurance subsidiaries in Barbados and Bermuda. In addition, top-level moves managed to increase reported earnings by classifying capital gains income as investment income. Press reports appeared that the outside auditor had found "material weakness" in AIG’s financial controls
As a footnote, on April 22, 2002, AIG asked the New York Stock Exchange and the SEC to look into short-selling in its stock. The short interest in the stock had ticked up between February and April, but was still at a low level of less than 1 percent of the shares outstanding. The stock had dipped that day from $70.79 to $67.50 before closing at $69.76. The stock had dipped far more in two days in January when it dropped from $78 to $66. The company evidently was anxious to discourage short sellers and keep its price up. In a related incident in 2005, Greenberg reportedly called AIG’s trading desk and instructed it to buy AIG shares prior to his resignation. This smacked of price manipulation.
S & P sums up some of this as follows: "Investigations by the New York Attorney General and the SEC into AIG’s use of non-traditional insurance products and certain assumed reinsurance transactions (sometimes referred to as finite reinsurance) culminated in a number of events, including a management shake-up that led to: the resignation of AIG’s long-time CEO, Maurice Greenberg; a write-down against earnings from 2000-2004 totaling nearly $4 billion; and a write-down of shareholders’ equity of $2.26 billion. During 2005, AIG also incurred after-tax charges totaling $1.15 billion to settle its numerous regulatory issues and $1.19 billion to boost loss reserves." This summary gives some idea of the amounts involved in these frauds.
Also: "Going forward, we believe there remains a high degree of execution risk as AIG seeks to sell enough assets to pay off the Federal Reserve loan. Auditors have also claimed AIG has a u2018material weakness’ in certain internal controls." This means there is a very good chance that AIG won’t be able to sell enough assets at a high enough price to pay off the Fed loan.
Further bad news was reported on December 10, 2008. "WSJ reports that AIG owes Wall Street’s biggest firms about $10 billion for speculative trades that have soured, according to people familiar with the matter, underscoring the challenges the insurer faces as it seeks to recover under a U.S. government rescue plan. The details of the trades go beyond what AIG has explained to investors about the nature of its risk-taking operations, which led to the firm’s near-collapse in September." This is another reason why S & P worries about other time bombs going off.
Honest reporting by insurance companies is exceedingly important. An insurance company sells promises to policy holders. It takes cash from them with the commitment to pay them in the event of certain contingencies occurring in the future. If it reneges or stonewalls on paying out claims, that is a type of fraud. Before paying claims, the company invests the cash. It has an obligation to report on these investments so that their safety can be gauged. If it misreports on these, that is another type of fraud. The company also sets aside reserves for the claims that will have to be paid. If it does not report these honestly, then it is misleading both investors and policy holders concerning the viability of its promises. That is a third kind of fraud. There are others. Between the promises and the cash payouts that may not occur for many years, the policy holders have to rely on reports about the company’s finances. If these are manipulated or doctored so as to deceive the policy holders, that is where fraud enters in.
None of the frauds described above have been shown to be the reason for AIG’s deterioration in 2008, at least not yet. They were signals that all was not right about this company, and that where there was one roach, there were probably more roaches. AIG’s big problems reportedly came from writing risky insurance-type contracts that it should never have been writing, and writing them with terms that made the risk to AIG far too high. AIG wrote credit-default swaps (CDS) to insure various debt securities such that when they lost value, AIG had to come up with many billions of dollars in a hurry. This happened in September of 2008. It could not come up with the collateral. That triggered an even worse provision that they had agreed to, which was that the swaps would be terminated and they’d have to come up with the full value of the debt that was insured.
It was at this point that the Fed prevented the bankruptcy of the company. Bankruptcy is not the end of the world. A company is actually protected under the U.S. bankruptcy laws. It continues to operate and creditors cannot seize assets. Instead, there are procedures to deal with the creditors in an orderly way.
Why did the Fed get involved with a company whose history of reporting gives its securities questionable worth? Although panic is the term used to describe markets that fall sharply, they usually fall for good reason when they fall sharply. They then often stabilize quickly at their new lower values. There is also such a thing as stabilizing speculation which, when one is committing large sums of money, is a sensible variety of speculation. It buys stocks that are below their value and sells stocks when they are above their value. I suspect that our authorities were more panicky and fearful than the markets, which were going about their business of discovering values. Their words reflect their own fears when they speak of market action.
Then too, it stands to reason that Paulson pushed for the AIG bailout to stabilize Goldman Sachs, a bellwether stock. Why did Bernanke support the move? The Fed’s official statement gives as its first reason the avoidance of "financial market fragility." In 1987, Bernanke co-authored a paper titled "Financial Fragility and Economic Performance." He introduced the idea of a fragility multiplier. Fragility became a popular recent topic in the literature of government regulators, along with systemic risk. I believe that Bernanke’s policies follow the blueprints of his academic papers. Whether or not there is even such a thing as financial fragility is questionable. A system such as ours in which the authorities help their friends and act upon their novel pet theories for which there is little basis is even more questionable.
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.