Moral Hazard: The AIG Bailout

The AIG bailout will go down as one of the most wasteful use of taxpayer dollars and the largest representation of moral hazard in government interventionist history. Despite the seemingly strong recovery from the financial brink of doom, the silent risk that was introduced into the economic gears was the absolute financial backing and bailouts. Moral hazard describes the way firms act differently under the knowledge that when they get in trouble, daddy (the taxpayer) will step in to save the day. Imagine how you would gamble your life savings in Vegas if you knew that if you lost every dime, someone would step in and give you back your money?

The question with AIG is how did it happen? With all of the corporate governance and the nearly 100 year history of selling insurance, how did the global behemoth succumb so quickly to the financial crisis? Insurance is nothing more than a spread-based business and the insurance company pays out interest that is less than the interest earned on its investments. As long as they underwrite the insurance risks well enough and invest their money wisely, it is tough to take down an insurance company. Those are two big "ifs" though. Although highly regulated, insurance companies do become insolvent (Conseco, AIG, First Capital Life of California, Mutual Benefit of New Jersey, Executive Life, Fidelity Bankers Life, etc.) Usually they are seized by state regulators and unwound over time, sometimes they are sold off to other insurance companies and sometimes (AIG) the federal government backstops them.

AIG set a very poor precedent. Like many insurance companies, AIG got in trouble on the asset side of the balance sheet. In trying to increase the investment yield of their portfolio they reached out into more exotic and risky realms of investments. When lower quality mortgage backed securities did not provide enough juice, they turned to CDO's. When CDO's did not have enough juice, they turned to the credit derivatives market. That is where the AIG Financial Products Unit comes into play.

AIG Financial Products Corporation was started in 1987 with its primary focus being the interest rate swap market. In issuing debt or managing interest rate exposure in assets and liabilities, interest rate swaps are the key tools. The unit later became the biggest pioneer in commodities as an investment (DJ-AIG Index). In the 90's AIGFP became a bigger player in the structured mortgage market, including CMO's. It took AIGFP until 1998 to enter into its first credit default swap, over 10 years after the unit was born. From then on, it seemed that writing insurance on corporate bonds would become AIGFP's bread and butter business. Like all bonus incentivized businesses, the profits were never enough. When spreads on corporate bonds were tight, the unit insured against losses on CDO's, CMO's, and CDO^2's to increase the investment yield. If you cannot earn enough with a once leveraged product, leverage it twice, three times or more.

The selling strategy for AIGFP to AIG corporate was simple: in the insurance products that AIG sold to policy holders they were borrowing money from policyholders and investing in credit-risky bonds thereby earning the "credit spread". If instead they bypassed the policy-holder and invested in bonds directly, they found that they could earn a greater spread with none of the costs associated with managing the actual insurance aspect of the product.... Now that is how genius is born. They could make more money more easily and more quickly by borrowing from the financial markets and investing in credit risk rather than going through the traditional route of selling insurance products. The employees at AIGFP with large bonuses loved it and the executives at AIG loved it. Unfortunately, greed got the best of them.

It is my belief that AIGFP had a good business model going. They were utilizing the strong credit rating of their parent company to borrow from the financial markets cheaply. They went wrong when they got greedy. Selling protection on credit default swaps is much akin to selling equity options. When markets are calm, you collect a small premium and you are happy. When markets get very turbulent you can lose a year's worth of premium or more. In AIG's case, they didn't just sell equity options or insurance on corporate credit, they sold insurance on leveraged products. The slightest disturbances in the markets can make leveraged product prices change drastically. On top of that, they sold credit insurance on products that were themselves illiquid. So when the sub-prime mess hit, the value of the underlying securities went far below their fundamental value because no one wanted to own them.

So the situation looks like this:

1. AIGFP has a lot of clout at AIG because they have been a very profitable derivatives/trading unit
2. In 1998 they find the holy grail of profit generation in the form of selling credit risk protection via credit default swaps
3. The further success of the unit gives them more power and management asks if they can generate even more in revenues
4. Success brings hubris. AIGFP starts selling protection on all sorts of leveraged products

The question that immediately came to my mind was: "why did all of the banks allow themselves to gain so much exposure to AIG as a single counterparty?" Looking at the "who's who" list below, that's a big question.

Further delving into this question - why did the banks allow this to happen even after they got burned so badly by Long Term Capital in 1998? The funny thing is that banks argue that they are the best at managing their own exposures yet it seems that they repeat their same mistakes. Is it because they are just greedy and stupid? I actually hope so, because if instead they believe that they do not have to worry about a large single exposure because the government will bail them out under tail events, then that's the largest problem (moral-hazard) of all.

The argument that the banks used in the bailout of Bear Stearns, Merrill (yes, that was a bailout), and AIG goes something like this: if one of these counterparties goes under, who knows what the consequences will be? If AIG goes under then they might take out Goldman Sachs and Societe Generale. If those two go under, they might take out 6 more, if those 6 go under....

If you are asking why Lehman went under...you have probably watched a few hostage movies right? Usually one is killed to show the repercussions of inaction...

We cannot afford to let the domino argument prevail. If we do, then it just gives the behemoth financial institutions a free reign to pillage those who do not understand the truth - that the banks want this counterparty web of risk to exist because it is akin to a terrorist strapped in a bomb. "If you take me out, I will take you all out with me."