Send AIG to Chapter Eleven

There are two reasons to bail out a financial company.  The first is that it’s failure would lead to a run on liquidity at similar companies duewith those of to a lack of confidence.  The second is that it their promises are so interlaced with those of other companies that failure would cause many other companies to fail.

For the first reason, we have the FDIC and similar institutions for deposit-takers, and the insurance guarantee funds for the insurers.  For the second reason, the government should be minimalistic, and only guarantee the entities that threaten systemic risk.

For AIG, what should have happened back in September, and what should happen now, is that the government should have let the holding company fail, and guaranteed the obligations of AIG Financial Products in exchange for a senior loan that would subordinate all existing holding company debt.  [Essentially a DIP loan, because the holding company would be in Chapter 11.]

Aside from Financial Products, most AIG’s subsidiaries are probably fine, and don’t need any help.  Those that might fail don’t pose any systemic risks.

So, when I see AIG coming back to the government for more, I think of several things:

1) When Hartford Steam Boiler was sold for a cheap price, I commented that if that was the price for a good asset like HSB, then AIG common was worthless.

2) Why are we messing around with the holding companies as we do bailouts?  Regulated entities I understand.  There is no compelling interest for the US government to own AIG holding company stock.

3) Let the bondholders suffer a little.  AIG did not trade like a AAA credit, even in its glory days.  It traded more like single-A.  If you didn’t take the warning that the bond market was giving you as the leverage built up, then that is your fault.

4) Back to point 2 in a more general way.  If the government is going to intervene, let them inject money into the regulated subsidiaries, not holding companies, and then limit dividends and transfer payments to the holding company.

5) If large derivative counterparties are so critical to the financial infrastructure, then they need to be regulated as well.  Open the derivative books to the regulator, and let the new regulator set leverage/capital policy.  What?  They can’t do as much business?  Too bad.

6) As I commented regarding the automaker bailouts, the important thing is to get your foot in the door and get some money, so that the legislators/regulators feel they must protect their initial investment with more money later.  With AIG, that is in full force, as this could be the fourth bailout.  When does it dawn on a bureaucrat that you have been bamboozled?

7) The government was hoodwinked on the first few iterations of the bailout.  Shame on them, if they don’t realize that they are throwing good money after bad again.

AIG is a case in point of why I don’t like the way we are doing bailouts now.

  • We bail out the holding company, which is not in the public interest.
  • We accept the creeping costs of bailout rather than use better-understood bankruptcy process.
  • It’s obvious that the government does not understand what it is doing/buying.
  • We do incrementally bad deals, rather than squeezing the stakeholders, as a clever lender of last resort would.

If the US Government wants to prevent systemic risk, fine!  Guarantee the subsidiaries that pose that risk, but let the rest go into bankruptcy.