Frank Thomas: The Rescue of AIG in 2008 was the Right Decision
Part 3 of a multipart series, John will give his “NO” answer in Part 4. Part 2 can be found here
by Frank Thomas and John Lawrence
Up to the financial crisis in 2008, AIG’s very poor risk management and operational complexity overwhelmed prudent and strictly enforced risk controls. By year-end 2008, AIG had at least a $1.8 trillion exposure in derivative liabilities from 35,000 to 45,000 separate contracts.
As an insurer for 100,000 entities from retirement plans to major firms, AIG was drowning in mortgage-linked derivatives and gambling the entire house on a single pile of hedge fund-like casino debt. AIG was in effect insuring the banks against the default of their borrowers.
Thus, it was in essence using CDS derivatives to speculate on the value and credit risk of the underlying mortgaged assets.
Stockman says the government missed an opportunity to use its majority ownership to shrink AIG and eliminate its systemic risk to the financial system. This is utter nonsense as TABLES 1 and 2 confirm.Fed oversight of AIG’s winding down of toxic assets and return to core business has considerably improved the firm’s focus and risk profile. During 2008-11, AIG unwound over 35,000 CDS trades with a notional value exceeding $1.6 trillion. All but three core businesses were sold: property and casualty insurance, life and retirement insurance and services, and mortgage guaranty business.
TABLE 1 documents the four-year dwindling of AIG’s derivatives risk exposure from $1.8 trillion in 2008 to a tiny $127 billion in 2012.
TABLE 1: Legacy AIG Derivatives Book –
Net Notional Exposure FYE 2008, and 2012 – Dollars Shown in $Billions
Market Derivatives $1,450 $101 93%
Regulatory Capital CDS $245 $0 100%
Total Legacy Derivatives $1,800
Total Position Count 35,000 1,600 95%
SOURCE: U.S. Securities and Exchange Commission (SEC)
TABLE 2 shows how the focus on risk reduction and simplification, e.g., dismantling its Financial Products unit has considerably shrunk AIG’s financial debt. The firm has also been employing more common stock in its capital structure and has returned to profitable operations in 2012
TABLE 2: AIG’s Improved Balance Sheet and Profitability
Shareholder Equity as a % of 43.3% 79.5%
Financial Debt as a % of
Income From Continuing Operations –$99 Billion +$9.3 Billion
AIG returned $205 billion to the Treasury including a positive – although meager – return of $22.7 billion to taxpayers. This came with the stench of some obscenely immoral, “retention bonuses” for executives totaling $165 million – paid to very ones who made most of the deals that brought AIG to its knees. AIG argued they were necessary to retain key proprietary knowhow required to unwind the more dangerous derivative contracts. Others saw it as a financial extortion by a bunch of financial engineers.
Despite this odious action, the AIG bailout did stabilize the financial system, left no loss to the taxpayer, and forced AIG to divest of its risky derivative business … a firm that had rapaciously taken advantage of the tax regulatory system to turn itself into a titanic hedge fund that nearly sank the economy. I think Stockman would call this “Reformation” as opposed to “Deformation.”
I conclude the bailout of AIG was the right thing knowing the multiple concomitant financial and economic risks culminating in 2008. The timely and orderly turnaround of AIG was a success by all objective measures. While our nation’s financial markets have normalized, the question remains … for how long?
I do not favor taxpayer bailouts of financial institutions. AIG was a unique exception. Stockman is right that the BIG banks should be gradually broken up. At least “too big to fail” legislation (section 16 of Dodd-Frank Act) was passed. This bans taxpayer bailouts for a broad range of derivative dealing and swap activities. It should put the financial institutions on risk alert when using derivative products in a reckless, speculative manner and managing them well, particularly in bad times.
This is NOT good! When derivatives counterparties have super-priority status, the claims of all other parties are thus in jeopardy. Prof. Mark Row of Harvard says that repeal of this status will induce financial markets to better recognize the risks of counterparty financial failure. This in turn would lower the possibility of another AIG-Bear Stearns-Lehman style financial meltdown.
What’s Happening to Derivative Markets Now?
The derivative process of packaging many mortgage loans into one investment or collateralized debt obligation (CDO) is an efficient way to channel money to borrowers who might not otherwise get funds. But, as Stockman highlights, this proved dangerous during the 2003-2007 real estate boom because it encouraged banks,particularly at times of very low interest rates, to expand and give risky loans to people, many with weak credit; then bundle these loans into CDOs and sell them to investors; then insure them through AIG’s credit default swap contracts (CDSs).
When underlying assets supporting mortgage loans lost their value in the sub-prime mortgage bubble, this inflicted heavy unexpected losses on banks, investors, and AIG – forcing the latter to make substantial payments it couldn’t pay to its counterparties. AIG basically was insuring a speculative return to banks and investment institutions but didn’t reserve funds or properly manage and neutralize the aggregate risk in the event its CDSs went bad on a massive scale.
Are derivatives again becoming instruments of speculation where excesses creep in? When will the next blow-up occur? Or are banks taking steps to make the new generation of structured financial products safer?
There are signs we are again spewing derivatives in force. Banks are getting aggressive – especially in interest rate swap contracts, new securities issues backed by commercial mortgages for firms with “junk ratings,” and rising interest-only loans. Most of the large banks –JP Morgan Chase, Citibank, Bank of America, and Goldman Sachs – are reviving their derivative portfolios and bonus paychecks like there’s no tomorrow. This isn’t surprising as the same old players are still around pushing the boundaries of arcane structured financial risk products – helped by the dwindling effect of Dodd-Frank regulations and recent loosening of prudent underwriting standards.
Dodd-Frank regulations require financial institutions to take special steps when bundling loans for backing bonds bought by investors. But I agree with Stockman that that won’t stop this inherently greedy and risky process from getting out of hand again. The IMF is very concerned about the weak underlying collateral for derivatives. (AAA rated firms like AGI don’t have to put up any capital). But banks have undermined and delayed Basel III’s deleveraging policies to 2014. And they will delay them again so nothing happens.
Here are some unsettling figures from offices of U.S. Comptroller of the Currency.
TABLE 3: Total Derivative Notional Exposure as of 12/31/2012
JP Morgan Chase $69.0 trillion
Bank of America $42.4
Goldman Sachs $21.2 “
GRAND TOTAL $223.0 trillion = 14 years worth of GDP tied up in notional derivatives
SOURCE: “America’s Banks Are Knee-deep in Derivatives,” by G. Schultze, Forbes, 03/28/13
This Huge $223 trillion notional amount of derivative risk exposure now is greater than it was when the world almost financially collapsed in 2008!
Also disturbing is that 85% of this exposure is held by 4 firms, and 80% is tied to interest rate swap contracts to hedge interest rate risk. This could be a “financial weapon of mass destruction” (Warren Buffet’s definition of derivatives) when interest rates move higher. That is why downgrading of AIG’s “AAA” rating caused their CDS funding costs to soar … to the point that taking a huge loss and getting out of the trades was cheaper then funding them until maturity.
Bear in mind derivatives are a Zero-Sum game – for each party that makes money, another loses money. Given the $223 trillion in notional derivative bets now taking place, one can only imagine how much counterparties must be praying that nothing goes wrong in the near future. As one expert said in response to the complex, opaque, leverage-laden financial derivative pyramid creating a recurring risk of chaos in our financial system:
“This begs the question what’s the true value of hard assets in a world in which the only value created by financial innovation is layering derivatives upon derivatives, serving mainly to drive banker bonuses to all time highs?”