Friday, October 1, 2010

Exit of AIG. Model for Govt Rescue Programs?

This article from the NYTimes reports the impending exit of AIG from TARP (the $700 mil U.S. Government's Trouble Asset Relief Program). By the government's account, TARP prevented the meltdown of the U.S. financial system, caused by lousy bets on credit default insurance and loose financial management controls in the nations largest banks and insurers, of which AIG was the poster child.  The problem with this view is two fold. The 'exit' strategy does not actually put money back in the hands of the taxpayers.  The proposal consists of a package consisting of debt for equity swaps, senior to common equity swaps, and a proposed IPO of the AIA (AIG's Asian Unit) business.  The entire package depends on only one thing - the state of the capital markets, and hence, the eventual ability of the government to unload its positions without riling the markets. Regardless, there will still be policymakers and activists that point to AIG as the model child for government rescues.  This is a concern because AIG was unique and its lessons are not broadly applicable to other industries or circumstances.

AIG was kept alive because it was seen as a lynchpin to the entire financial system. They owned a vast majority of the credit insurance obligations that underpinned the mortgages and mortgage derived instruments held by governments and institutions. Having said this, it is not clear to me still why allowing the contracts to collapse, while wiping out billions of dollars in value and sending a lot of people to the poor house, would necessarily lead to the end of the global financial system.  The system will simply adjust to a new, slower growth state.  We will never know.  In any case, even if we accepted the argument, very few institutions have the status of an AIG at the time of the crisis (LTCM is probably the closest analog - during the Asian Currency Crisis - except that LTCM was rescued by industry, not government).

AIG, as a company, had many parts that were sound, in particular their Asian and European units.  The industry in which they competed, notable China, is still in high growth state.  Hence, the restructuring that occured in the post-rescue period had a good chance of success, so that the there was some implied collateral backing the loans from the Fed.  If, for example, the deal between Prudential and AIA had gone through, the resulting cash infusion would have allowed AIG to exit TARP last year.  This is not the case with the automobile or airline industries.  The sick companies in those industries have either hived off their crown jewels (e.g., the leasing companies of the automakers) or do not have much assets that can back a proper restructuring. Moreover, with reference to a prior point, the criticality of the survival of those companies are not the same as AIG.  If any company in those industries failed, there would still be many competitors to produce the same, if not superior, products and re-employ the workers.

In sum, because the final chapter on AIG is not yet written - the U.S. government will still continue to be its largest shareholder for many years to come, and because AIG was unique, we should not allow ourselves to be persuaded by arguments on the 'success' of the rescue as justification for future 'too big to fail' rescue operations.

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