That didn’t last long

by John Quiggin on September 17, 2008

Two days after the US authorities made much of standing firm against calls for a bailout of Lehman, the Fed has announced an $85 billion rescue of insurance company (and large-scale counterparty in all kinds of derivative markets) AIG. There’s none of the ambiguity surrounding Fannie and Freddie in this deal. AIG is not a federally regulated entity, and the insurance subsidiaries are regulated at the state level to ensure their ability to pay out on claims. This is, purely and simply, a case of a speculative financial enterprise that’s too big to fail.

Having reached this point, it’s hard to see how the US can turn back from a massive extension of financial regulation, starting with the derivative markets where AIG got into so much trouble, notably those for credit default swaps (CDS). Along with winding up the affairs of AIG, Lehman and others, the authorities will need to oversee an orderly unwinding of the transactions in these markets which they are now effectively guaranteeing. More generally, it’s time for a partial or complete reversal of the financialisation of the economy that took place after the breakdown of the Bretton Woods system back in the 1970s.

BTW, if you have cash parked in a money market fund, you might want to read this. (Insert disclaimer about financial advice)

UpdateBrad Setser has the same reaction.

{ 39 comments }

1

Walt 09.17.08 at 2:06 am

I have been thinking that CDSes need to be moved to exchanges or at the very least require them to be handled by specialized clearinghouses, but now I wonder if CDSes are one of those markets that can’t really exist, and we’re just learning it the hard way. In a textbook world, someone who needs to hold a lot of bonds (a pension fund) could use CDSes to insure against bad luck. The effect of CDSes have not been as insurance, but instead to allow systematic risk to be concentrated in big market players, which means a systematic credit event imperils the whole system.

2

HH 09.17.08 at 2:14 am

Come one, come all! Get your bailout billions! Next will be GM and Ford, then perhaps Citicorp and Wal-Mart, and why not Halliburton and Blackwater? There is plenty of National Socialism for everyone. Plutocrats take the executive salaries and profits, and taxpayers take the losses.

3

Rich Puchalsky 09.17.08 at 2:16 am

“Having reached this point, it’s hard to see how the US can turn back from a massive extension of financial regulation […]”

Even if McCain wins? Really? I don’t see why they can’t just keep privatizing profits, socializing losses, and printing as much money as they need to do so. Why not just guarantee, say, a 20% instant return for anyone who can raise the cash to buy a $100K bond? One per customer per year, please. That would quickly inflate the dollar while giving the rich proportionately more of them. Perfect.

4

Another Damned Medievalist 09.17.08 at 2:56 am

Just one question, John … ‘cos I’m not an economist, just an historian. And you know, I’m not sure that bailing AIG out is a bad idea. But I am kinda wondering: where does the money come from?

5

Markup 09.17.08 at 3:23 am

“massive extension of financial regulation”

Perhaps why it seems some of JMc’s base are turning on him; they know they look funny in lipstick and want the other team handling the pigskin for a while. But at least JMc will have a 9/11 style comission to get to the bottom of it all somewhere around 2011. I’m sure Phil Gramm will get to the bottom of it and recommend the new regulation be less regulation. I think he prefers Bourjois Effet 3D Lipgloss Cell Phone Charm in Les Nude – Rose Mythic 20 in anyone was wondering. Buy soon, it’s imported.

“where does the money come from?”

Infrastructure, edumacation, your children’s children. Though perhaps they could arrage a few more sales of bunker buster’s and fighter jets and take a higher commission fee.

6

Thomas 09.17.08 at 3:39 am

I don’t think it’s a case of too big to fail, but of uncertainty about the effect of failure. The AIG balance sheet isn’t significantly bigger than Lehman’s, but the Fed had a clearer understanding of Lehman’s position because they’ve been camped out there since Bear Stearns went down.

It should be noted that AIG wrote its derivative contracts in London.

7

mpowell 09.17.08 at 4:21 am

That money market fund news is not good. But they’re talking about paying 96 or 97 cents on the dollar. Obviously disappointing, but we’re not talking about a serious hit to anyone’s savings. It’s only these highly leveraged bastards who suffer substantially from those types of losses.

8

Lex 09.17.08 at 7:30 am

@4, 5: my impression was that most of the money has been coming from China lately. Whether it will continue to do so is, of course, the elephant in the room. Let’s hope no-one digs up GWB’s “they’re only IOUs” moment again.

9

abb1 09.17.08 at 7:56 am

What Rich said in #3; of course the US can turn back from a massive extension of financial regulation.

The assumption here seems to be that somehow the politicians made a honest mistake, it now became obvious, and therefore they will have to change their ways.

In fact, politicians only do what their constituency (large corporations, mostly) wants them to do, and they will continue doing it. This is how ‘representative democracy’ operates.

Will their constituency demand “massive extension of financial regulation”? Seems unlikely.

10

John Quiggin 09.17.08 at 8:26 am

The constituency is not just Wall Street. The rest of the business sector has never exactly loved the finance guys and aren’t at all happy seeing them being bailed out while manufacturing has been left to the mercies of the market. And, while it’s mostly safe to ignore the voters, ignoring the low-probability high consequence case of a backlash is exactly the kind of thinking that got Wall Street into this mess.

11

Daragh McDowell 09.17.08 at 8:27 am

I think the bigger question is whether ‘strong regulation’ will become an accepted normative value in US politics going forward in the same way that ‘de-regulation’ was in the Reagan/post-Reagan era. Remember Al Gore smashing an ash-tray on Letterman, and boasting about the number of pages he and Clinton were gonna cut from the federal regulations? At the time it seemed obvious that getting rid of any rule was, objectively, a good thing. Perhaps now we’ll see the reverse (‘we need regs to protect your savings.’)

Personally I’m somewhat hopeful about this. Even McCain is talking about getting rid of ‘patchwork regulation’ the implication being he’ll replace it with something simpler, but stronger.

12

abb1 09.17.08 at 9:13 am

Well, it’s seems likely that the Democrats will have a significant majority in congress and possibly the presidency. That means that financial companies will have the upper hand.

13

stuart 09.17.08 at 9:31 am

The US Treasury doesn’t seem to think China are lending them much more money recently:

Major Foreign Holders of Treasury Securities

14

Lex 09.17.08 at 10:03 am

@13: are you surprised, look what they do with it. If I were China, I wouldn’t give them any more… Which was my point.

15

Chris E 09.17.08 at 10:09 am

I’m suprised that anyone would think that this might lead average American to eschew laissez faire economics in favour of regulation.

The financial sector have had great success in selling the idea that regulation equals socialism, and has great success pushing for policies that are against the best interests of the working man (a la Tom Franks).

16

scott m 09.17.08 at 11:28 am

I predict no backlash and no serious regulation – certainly not any that is simple and strongly enforced. Might see a very little something if the dems get the white house, but we will see nothing if McCain wins. Don’t hold your breath on changing the dialog.

17

PersonFromPorlock 09.17.08 at 11:39 am

It isn’t necessarily true that government buggers things up but when it does there’s no escaping it and it doesn’t go away. So increased regulation of business may do some good, or it may do some harm, and it’ll probably be captured by the regulated interests almost at once, anyway. In other words, not a panacea and maybe not even a good idea.

I will say that if government’s going to continue bailing businesses out it needs to save the business, not the businessman: otherwise it just reinforces poor management.

18

Rich Puchalsky 09.17.08 at 11:41 am

“The rest of the business sector has never exactly loved the finance guys and aren’t at all happy seeing them being bailed out while manufacturing has been left to the mercies of the market.”

I think that this idea was empirically tested in the great Clinton universal health care failure. A good deal of support was expected to come from car makers and other manufacturers whose long term survival was really in question because of their outstanding health care commitments. It never showed.

Nor was this entirely irrational. The manufacturers aren’t just “left to the mercies of the market”, they are given tax breaks and protected from stronger unionization and environmental laws. The same administration that would re-regulate the financial industry would re-regulate them.

19

Joel Turnipseed 09.17.08 at 12:21 pm

Well, talk about getting bought at a premium! The Feds just effectively bought AIG for ~100B, or 10X valuation.

So, who’s to say whether the damage to the economy had AIG failed have been worse though? If AIGs crash had caused enough damage to the economy that it shrank by 3% the U.S. (and their taxpayers) would be out more than they just paid for AIG. I think (I’m doing number from memory, calculating as I type).

Still, you sort of wish that some pro-regulatory type at the Fed or Dept. of Treasury (not likely, right?!) spent at least a few hours saddlebagging (thank you, Tom Wolfe) the execs at each of these firms. Hell, that they continue to do so…

20

stuart 09.17.08 at 12:37 pm

Joel – the Feds haven’t bought AIG at all, they have extended it a line of credit. Currently the US public have lost nothing at all, they lose the money if AIG go under despite these loans, otherwise it gets paid back at some point – of course if they look likely to collapse despite the intervention it could well lead to the Fed extending even more credit to them, or some other intervention at least to avoid such a loss.

21

stuart 09.17.08 at 12:39 pm

Of course the other thing to note is that if these emergency loans are similar in structure to the ones the Bank of England makes, they are the first in line to get repaid before any other debtors, which allows the government/BoE to intervene in very risky situations without losing public money – as the risk is mostly pushed down onto other creditors of the at-risk company.

22

Slocum 09.17.08 at 12:54 pm

The rest of the business sector has never exactly loved the finance guys and aren’t at all happy seeing them being bailed out while manufacturing has been left to the mercies of the market.

But is ‘bail out’ really the right term given that equity in these firms is being wiped out?

I wonder, too, to what extent many of the complex financial innovations will disappear not because they’re regulated out of existence but because of a lack of buyers (hey, buddy, wanna buy a risk-free, AAA-rated senior tranche from my new CDO?)

I have more faith that buyers of securities will impose the necessary discipline going forward than in new regulation, given the long-standing cozy relationships between Wall Street and Washington. I suppose it might be one thing of one party was the ‘party of Wall Street’, but Wall Street has been giving more money to Democrats in recent years, and getting good value for the investment:

“These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

http://query.nytimes.com/gst/fullpage.html?res=9E06E3D6123BF932A2575AC0A9659C8B63&sec=&spon=&pagewanted=print

Damn that Bush administration for ignoring the problems so long…

23

Joel Turnipseed 09.17.08 at 1:09 pm

Stuart,

Well, OK. The Feds are only “buying” them if they can’t pay the debt–but the equity option is very favorably priced, right?

Which raises question: Why would you back up an $85B loan with an 80% equity option in a company worth $10B, when as a lender you have all the leverage in the world (saddlebags!)? I can think of a few answers (signaling strength to the market/creditors, at the top of the list), but curious to know if anyone out there has a, you know, smart one.

24

nnyhav 09.17.08 at 1:29 pm

Moral hazard insurance rates spiked up sharply Wednesday after AIG (ticker: AIG), in an industry on the verge of declaring moral backruptcy, was priced by the US (ticker: US) at 80% upfront and 8.5% running over 2 years. Rates for collusion insurance also increased to levels not seen since the government investiture of Chrysler (ticker: C [see also Citigroup]).

US has been active in the under-the-counter markets, having covered their Fannies (ticker: FNM) and, indded, their Freddies (ticker: FRE) just one week ago. Previous US involvement included entering a tri-party repo of Bear Stearns (ticker: BSC [now JPM]) last March; US declined a similar opportunity to participate in Lehman (ticker: LEH [now BCS, not BSC]). On the US decision to re-enter the market, it was remarked, “A single default is a tragedy. A trillion dollars is a statistic.”

25

Barry 09.17.08 at 1:53 pm

“UpdateBrad Setser has the same reaction.”

The link doesn’t work – it leads right back to a nonexistant CT post.

John Quiggin:
” The constituency is not just Wall Street. The rest of the business sector has never exactly loved the finance guys and aren’t at all happy seeing them being bailed out while manufacturing has been left to the mercies of the market. And, while it’s mostly safe to ignore the voters, ignoring the low-probability high consequence case of a backlash is exactly the kind of thinking that got Wall Street into this mess.”

To add on to what others have said – the reason that the financial community has gotten such good treatment (for the past 20-30 years, and now) is that they have serious political clout, clout which the manufacturing companies don’t seem to have since the 1970’s. Perhaps because the manufacturing companies’ clout works well in parallel with strong union voters in the middle and working classes, the people who’ve gotten f*cked for the past 30 years. With the eager help of those same manufacturing companies.

Meanwhile Wall Street corporate interests are nicely aligned with the interests of people pulling down $200K – $100M/year.

We might see real change, but any real change would be a very radical thing indeed, bucking the trend of a quarter century. I expect merely potemkin changes, with the only real change being that the Fed guarantee to Wall St firms is now explicit – but only if the firm is big enough to pull a Samson is now explicit.

I wonder about the incentive effects on firm mergers in the next decade – size is valuable, but mega-size carries that extra value of a Fed bailout backing you.

26

lemuel pitkin 09.17.08 at 3:08 pm

This piece from Ken Rogoff looks interesting:

Our examination of the longer historical record … finds stunning qualitative and quantitative parallels across a number of standard financial crisis indicators. To name a few, the run-up in U.S. equity and housing prices, [one of] the best leading indicators of crisis in countries experiencing large capital inflows, closely tracks the average of the previous eighteen post World War II banking crises in industrial countries. So, too, does the inverted v-shape of real growth in the years prior to the crisis. Despite widespread concern about the effects on national debt of the early 2000s tax cuts, the run-up in U.S. public debt is actually somewhat below the average of other
crisis episodes. In contrast, the pattern of United States current account deficits is markedly worse. …the refrain that “this time is different” has been repeated many times.

27

noen 09.17.08 at 3:16 pm

Welcome to the USSRA (United Socialist State Republic of America) comrades.

the Feds haven’t bought AIG at all, they have extended it a line of credit.

It’s a stealth bankruptcy. The FED loaned AIG money to stay in business long enough to liquefy it’s assets. The FED gets whatever is left. Next up — Washington Mutual.

But I am kinda wondering: where does the money come from?

The same place that all magical ponies come from.

28

Walt 09.17.08 at 3:18 pm

ADM: The Fed actually has assets of its own which it can sell to raise the money. It can also (de facto) just print new money to cover the cost of the loan.

Stuart: The Fed didn’t buy a stake in AIG, they were given a stake in AIG. The details aren’t completely clear, but the Fed now has a 79.9% ownership stake.

Joel: You have it backwards. If everything goes well for AIG, the Fed gets the loan paid back, plus 80% of any gains in the stock price from the bailout.

29

Joel Turnipseed 09.17.08 at 3:32 pm

Walt,

It wasn’t clear how the deal was structured from the NYT article–just that they received convertible warrants for 80% of the company in exchange for the $85B loan. So, yeah, now that I think about it more, if the warrants are priced at today’s stock market price and they have anti-dilution provisions, then: Feds did, in fact, give the AIG shareholders the saddlebags treatment (while also overpaying for the deal and preserving, potentially, 20% of the existing value for current shareholders).

30

Chris E 09.17.08 at 3:53 pm

just that they received convertible warrants for 80% of the company in exchange for the $85B loan.

It’s also unclear exactly what priority they would take in relation to other existing and future creditors.

The devil is truely in the details.

31

Markup 09.17.08 at 5:58 pm

“The devil is truely in the details.”

Trickle down at work. Something not really widely discussed yet is the increase in burden on the other governments, the state and local ones that bought in to these ‘innovative investments’ with dubious diligence based on a hyped marketing and with yawns from the regulators and ratings folk. The burden will be much greater than what those who have the option of printing money have bought US.

32

CJColucci 09.17.08 at 8:18 pm

The collapse of a large company like AIG would obviously be bad news, but why would the collapse of what is, after all, a single insurance company among many, be so much more devastating to the economy as a whole than the bankruptcy of, say, Boeing or Conoco Phillips or Pfizer?

33

anomalous 09.17.08 at 8:22 pm

A general request:
The big websites left and right TPM etc. are being swamped with visitors, mostly idiots who don’t know a damn thing and usually don’t care, who are now scared and looking for information. They’re the undecided and embarrassing it is to the human race, they are the one’s who will decide the election.
Stop chattering with your depressed friends. Go to Megan McArdle or Hot Air or Patterico or any wingnut blog with comments. You take a shower when you’re done.
It’s not for the regulars its for the clueless idiots searching for something to hold on to. Bring facts and figures and the ice cold will to punish

And with all do respect, don’t hang out here and wait for the election to be over. Obama may suck but he’s all we have.

34

Walt 09.17.08 at 8:51 pm

It could cause all of the other banks to collapse. See, where Boeing and Pfizer fucked up is that they didn’t make it so that if they went down they would take everyone else with them. That’s why financial people get the big bonuses.

35

Barry 09.17.08 at 9:06 pm

And that’s what I meant by saying that the incentive to get big has changed; it’s not sheer size, or diversification, it’s getting ‘Samson big’. Being able to take things down with you now carries as close to an explicit government guarantee as is possible under any likely US political system.

IMHO this also *should* mean that mergers are heavily scrutinized, with the bar for ‘too big’ being set at a very small percentage of *any* financially significant market (e.g., if a merger would produce a company which would be ‘too big’ in a single state, that merger should be blocked).

36

Barry 09.17.08 at 9:12 pm

What’s further interesting is that this can be expressed as there now being a stronger incentive to structure one’s business so that significant losses cause catastrophic damage to an influential target’s interests, so that they’ll bring political pressure to bear for a bail-out. Of course, influential targets don’t like this.

37

Markup 09.17.08 at 9:19 pm

See, where Boeing and Pfizer fucked up is that they didn’t make it so that if they went down they would take everyone else with them. That’s why financial people get the big bonuses.

I seem to recall Boeing as being a relatively well armed entity that more true Patriots would call ‘too big to fail’ than them money pushers on wall st. Could we really survive going forward without ABL’s? Pfizer, well one could bottle waste water and get their wares free for a while then do the mail order to Canada end run. Conoco Phillips, Hugo would buy them up in a heartbeat, though would face some stiff bidding from Ali al-Nuaimi. I guess what I’m getting at is some Hydra’s cut up easier; and taste better too! Maybe the AIG bail/buyout is the first step in the R’s secret plan to offer socialized life insurance. Think about it. After all those welfare payments they deserve to get something back when we pass.

38

Chris Williams 09.18.08 at 9:19 am

I think it’s time to dig up our Adam Smith and re-energise our various Monopolies and Mergers Commissions. The regulatory failure is in letting them get too big to fail in the first place: mandated split-ups, rather than rescue packages (Northern Rock), take0vers (Lloyds TSB) or sell-offs (BAA).

39

J Thomas 09.19.08 at 12:00 am

The regulatory failure is in letting them get too big to fail in the first place: mandated split-ups

That sounds good to me. Should they be split up on a case by case basis, or should every corporation that’s too large be split up?

Can we make a rule that applies everywhere or should some industries be allowed to have bigger corporations than other industries?

Should they be limited by number of employees? By cash flow? I’d be inclined to limit the number of employees. Make them split ibto smaller corporations that have contractual relations, renegotiated frequently.

That would help a variety of things, but would it help the current problem? I see it as gambler’s ruin. Lots of individual managers saw the chance to make good profits by taking small risks of giant losses. Any given year the risk paid off and they made their profits. Anybody who didn’t participate fell behind. Then there was a big shock and the risk hit everybody at once. What can help with that? If it had been hundreds of thousands of tiny companies taking the risks, they’d have still done it.

Unless you can quantify the risks, how can you say they’re a bad thing? Would it help to forbid any financial instruments that are hard to understand?

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