March 10, 2009
Moral hazard and AIG
We are now suffering the consequences of one of the most spectacular financial miscalculations in history, after investors around the world discovered that trillions of dollars invested in securities derived from U.S. home mortgages were far riskier than they had originally believed.
Part of this miscalculation can be attributed to misguided quantitative models that were used to assess those risks. The key inputs for those models were assumptions about underlying default rates and their correlations across different borrowers. Default rates and correlations were quite low up until 2005, because rising home prices made default a decidedly inferior option to refinancing for even the least credit-worthy borrower. But the rising home prices were themselves caused by the huge flow of capital for lending to this market, sucked in by the illusion of safety. When the flow of credit stopped and house prices began to fall, the same forces operated impressively in reverse, now leading otherwise credit-worthy borrowers to default in increasing numbers.
But I would argue that another factor contributing to the illusion of safety was severe distortions in the markets for derivative contracts based on those underlying mortgage-backed securities. The seller of a credit default swap promises to make a payment to the buyer in the event that the security against which the contract is written goes into default. From the perspective of the buyer, a CDS is like an insurance policy against default. Some institutions might be interested in buying such contracts even if they did not have long positions in the securities against which the CDS was written, as a hedge against risks of other related investments.
And who would want to be on the sell side of these contracts? Insurance giant AIG was one big player. At first blush, you might think this could be a reasonable role for such an institution, since from the point of view of the buyer a CDS could function much like an insurance policy. But from the point of view of the seller, this is a very different product from conventional insurance. Selling more fire insurance policies helps the insurer to diversify, because fires across different communities have little correlation. But there is a common risk factor at the core of recent housing market developments. By selling a bigger volume of CDS, AIG was simply taking a bigger lopsided position on a single one-sided bet. And AIG lacked the financial resources to make good on those contracts in the event that the housing downturn became as severe as it has now proved to be.
But that raises a separate question. Could it make any sense for AIG to sell and someone else to buy a promise on which AIG in fact could not deliver? From the point of view of AIG-- at least the specific players within AIG running these operations-- one could argue that the answer is yes. In selling the CDS, they were receiving huge payments. As Forbes reported last September:
A big part of the reason was most likely that AIG's financial products unit, run by Cassano since 1988, was a veritable money machine, pouring $6 billion of riches into AIG's coffers from 1988 until 2005.... According to The Times, compensation ranged from $423 million to $616 million for Cassano's group. That would be about 20% of the unit's revenue, meaning Cassano was being paid like a hedge fund manager.
This understanding of AIG's incentives may have been what prompted Federal Reserve Chair Ben Bernanke to sound off last week:
if there's a single episode in this entire 18 months that has made me more angry, I can't think of one, than AIG.... AIG exploited a huge gap in the regulatory system.... There was no oversight of the Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets-- took huge losses. There was no regulatory oversight because there was a gap in the system.
So let's grant that Cassano and his cohorts may have had ample incentive to sell the product. But who would buy? Though he may not have been thinking of AIG and its counterparties in particular, Bernanke aptly described one potential answer in his remarks today on financial reform to address systemic risk:
In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy. However, the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm.
Could AIG's counterparties have been thinking that their payments would come not from AIG but from the Federal Reserve and taxpayers? If that's what they thought, some of them at least would appear to have been correct. Gretchen Morgenson reported this weekend:
When A.I.G. couldn't meet the wave of obligations it owed on the swaps last fall as Wall Street went into a tailspin, the Federal Reserve stepped in with an $85 billion loan to keep the hobbled insurer from going bankrupt; over all, the government has pledged a total of $160 billion to A.I.G. to help it meet its obligations and restructure operations....
Edward M. Liddy, the chief executive of A.I.G., explained to investors last week that "the vast majority" of taxpayer funds "have passed through A.I.G. to other financial institutions" as the company unwound deals with its customers....
On Wall Street, those customers are known as "counterparties," and Mr. Liddy wouldn't provide details on who the counterparties were or how much they received. But a person briefed on the deals said A.I.G.'s former customers include Goldman Sachs, Merrill Lynch and two large French banks, Societe Generale and Calyon....
How much money has gone to counterparties since the company's collapse? The person briefed on the deals put the figure at around $50 billion.
To the extent that the buyer and seller of the CDS were making a bet for which the taxpayers were implicitly picking up the downside, the CDS market, rather than helping institutions effectively manage risk, would have been a factor directly aggravating systemic risk.
I raise this issue not to be yet another voice clucking that we need to get tougher on AIG or others in order to prevent moral hazard, though that is one reasonable inference to draw from the discussion above. But the issue for me has always been not to exact retribution or instill market discipline, but instead the very pragmatic question of how to use available resources to minimize collateral damage. I accept the argument that a complete failure of AIG would have unacceptable consequences. The relevant question then is, what combination of parties is going to absorb the loss?
The concern I wish to raise is that any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Societe Generale, and Calyon, to pick a few names at random, as major contributors to this particular collateral-damage-minimization relief fund. But if they are to contribute, the plan must be something other than doling out another $100 billion every few months to try to keep the operation going a little longer, but instead requires seizing this bull by the horns. Split AIG into a core business we want to protect-- with enough equity to be a viable operation, and a hefty fraction of the existing management team fired-- and a derivatives business that's going to be systematically liquidated in large part by abrogation of outstanding contracts.
Then there's the domino effect to consider. What do we do when this brings down the next player who can't continue operations without those payments AIG (or the taxpayers) were supposedly going to deliver? I say, we implement the parallel operation there.
That's my proposal for how to dismantle the derivatives house of cards. One trillion at a time.
Posted by James Hamilton at March 10, 2009 10:36 PMdigg this | reddit
Sorry, any haircut to Goldman just isn't on, you know. That's for little people without politicians in their pocket.
Posted by: Mogden at March 10, 2009 11:46 PM
There are two risks conflated under the heading "systemic risk"
(a) political consequences (as suggested in previous comment by Mogden) of unwinding a very small number of very large and powerful counterparties.
(b) The "computational (also legal and institutional) complexity" of unwinding a large number of relatively small counterparties.
We're being told by (b) is the problem: We need to suck it in for the greater good. Do we really believe this?
Posted by: CSTAR at March 10, 2009 11:56 PM
About moral hazard and AIG...Ä± thought that might be helpful for some of your lessons because you like give examples about moral hazard problem..=))
Posted by: Anonymous at March 10, 2009 11:59 PM
What I found interesting in the Forbes article is that apparently, at AIG "these complex contracts were hedged until former Chairman Hank Greenberg was ousted from his post in April 2005". According to another newspaper article from the IHT from 2006, that's about when things got hot at Citi too:
Weill’s strategy for building Citigroup had little to do with taking big trading risks, Maheras said. Instead, Weill drove up profit, and the stock price, by stripping the fat out of the companies he acquired and sticking to businesses that would generate safe, steady growth. Now Prince is under pressure to improve Citigroup’s revenue, profit and stock price. [...] Lifting revenue, at least in capital markets, sometimes means taking more chances. That is where Maheras comes in. [...] Prince promoted Maheras to head of capital markets in February 2004. Citigroup has spent more than $1 billion in the past three years to strengthen the bank’s equity and fixed-income units, which are Maheras’s bailiwick. The bank has also added more than 1,000 employees, partly to push further into fast-growing ventures like energy, commodities and credit and equity derivatives”
Perhaps the chain of events and decisions leading to this situation is not quite as involved and long as usually assumed in big policy discussions. People do have a bias to associate big events with big causes.
Posted by: Anonymous at March 11, 2009 12:38 AM
Does the fact that derivatives claims are not stayed in bankruptcy make your proposal unworkable?
Posted by: apvm at March 11, 2009 03:02 AM
The problem with the ring fencing the falling dominoes approach is that the credit markets will go into complete paralysis waiting for the next domino to fall. Think the post-Lehman environment, except far worse, since in the scheme of things Lehman was not a major player in the credit markets. A mass execution approach would be better I think - stress test the major commercial banks, then simultaneously nationalize those that are deemed too impaired to survive on their own. Whether Treasury has the politcal will to execute after the stress tests is an open question. If not, it turns out that Japan is the economic model for the 21st century after all.
Posted by: Turbo at March 11, 2009 05:42 AM
Other than the Citi based bounce yesterday, I think the federal government should do the nasty job of nationalizing Citi and BofA. Yes many people will lose money. But the last time I checked my prosepectus, it says that investments come with risk and may result in losses. If the government then sells off parts to healthy regional banks maybe we can get our tax dollars back. Then put regulations into effect that limit how big a bank can get so that we don't have a collapse like we are in now.
Posted by: Ed at March 11, 2009 05:55 AM
AIG has to have the most lax management of any companies to let this happen. Till this day they are still hiring, paying bonuses and giving raises with our tax dollars. Oh and they also operate in those same "tax haven countries" so they dont have to pay US taxes
Posted by: Tricked American at March 11, 2009 05:57 AM
There's a great post by the anonymous blogger over at A Credit Trader (URL link below) on the many problems with AIG's CDS strategy. Maybe his most interesting allegation is this, regarding why did the investment banks buy CDS's from AIG when it was widely known in the CDS community that AIG was selling insurance too cheaply and was a very vulnerable counterparty to disaster:
"Why did Banks buy Protection from AIG?
Did the banks realize the value of its protection held against AIG was zero? Of course they did - they aren’t as dumb as the media suggests. The reason they continued to pay the full market CDS offer (rather than a much lower level due to AIG’s massive wrong-wayness) to AIG was because they considered it a cost that allowed them to continue originating CDOs. If they could not offload super-senior risk to someone, their originating desks would be effectively shut down.
So, while the trading desks continued to buy super-senior protection from AIG, the risk management desks, realizing that the protection was effectively worthless, bought protection on AIG itself from the street and clients in large size. In fact, I would imagine the size they needed to buy was too large and they likely ended up buying puts on the AIG stock or just shorting outright."
Now I posted a question to the anonymous "A Credit Analyst" suggesting that since the WSJ has reported that Goldman and Deutschebank were each paid $6 billion in CDS counterparty claims by the US government between mid-September and December 2008 that the investment banks were effectively being paid TWICE: once as their short hedges against AIG paid off, and then again as the US government made good on AIG's counterparty liabilities. And if you check the comments section, you can see that he backed off a little. But I do remember that Goldman insisted all along that they'd hedged their counterparty risk with AIG !
Posted by: Anarchus at March 11, 2009 06:08 AM
"Split AIG into a core business we want to protect-- with enough equity to be a viable operation, and a hefty fraction of the existing management team fired-- and a derivatives business that's going to be systematically liquidated in large part by abrogation of outstanding contracts."
Why would we want to fire any of the management team in AIG's non-financial services units, let alone "a hefty fraction" of them? Seriously, think about it. Do you think a managing director in the P&C division had anything to do with writing protection on CDOs? What about an executive in AIG's coveted aircraft lease financing unit? Should he get the axe too? Call me crazy, but I think it's bad policy to fire people for decisions they had absolutely nothing to do with just because it'll make you feel better.
Also, abrogating AIG's outstanding CDS on ABS and CDOs is a terrible idea. That would suddenly force all the money center banks to raise hundreds of billions of dollars to meet regulatory capital requirements. This would set off another round of forced liquidations, declining asset prices, margin calls, and yet more forced liquidations -- essentially, it would be Lehman all over again. I've seen that movie before.
Finally, one of the main reasons we rescued AIG was that we didn't know who would suffer collateral damage if AIG failed. And we still don't know, because we'd need to know which assets the banks would dump into illiquid markets in order to meet regulatory capital requirements. So your idea for a "collateral damage minimization fund" is fundamentally flawed.
Posted by: Economics of Contempt at March 11, 2009 06:11 AM
Thanks professor, that was an excellent post.
Posted by: GWG at March 11, 2009 06:20 AM
Ever so slightly off topic, but there was a good interview with somebody on Bloomberg talking about Citi this morning who put yesterday in perspective.
Right now the banks all have a cost of funds that's very very low, so their net interest spreads are at incredibly wide levels. Importantly, even for the major banks with asset quality problems, such as Citi, net interest margins haven't been pinched AT ALL by non-performing loans, because nearly all of the super senior mortgage derivative stuff is still 100% current due to the large overcollateralization of the structures.
The problem is that in the market, the super senior mortgage junk is listed at best at $0.30 on the dollar and is trading in meaningful size at only $0.20 on the dollar. And of course Citi and a few other major banks are carrying the super senior mortgage pools on their books at (undisclosed) valuations that are totally and completely out of line with market valuations, because if they did they'd be insolvent several times over.
I'd add that importantly this is a very positive cash flow structure for Citi in the short run - not only are the spreads extremely wide, but the cash flows are very positive and strong as well - it's just that the market has correctly figured out that before long mortgage defaults will chew completely through the overcollateralization protection, and when that happens the game is OVER.
Posted by: Anarchus at March 11, 2009 06:52 AM
The bogeyman here is not the failure of any one "TBTF" institution like AIG but of their simultaneous failures. What is needed is a set of staggered bankruptcy events with the only Treasury/Fed role being that of DIP provider or guarantor.
Also, the failure of Lehman was not a policy error, but leading the markets on to believe that there might be a bail-out, reprising Bear Stearns, was a major policy fiasco. (It prevented the market from an orderly mark down of Lehman debt to expected recovery levels and prevented counterparties from gracious exits from positions.)
We have bankruptcy laws with well established legal case law for insolvent companies. Those laws unambiguously establish who should pay. Let the rule of law return. Broadly and vigorously announce that return first. The DIP role is to facilitate the staggering of the dominoes. Realistically, the only alternative scenario to staggered bankruptcies is the one we are in: continue to shovel the money, talking as though some large institution might be allowed to fail--stress tests, etc.--but never actually allowing it because of FUD over Lehman 2.0. The existence of the shoveling reinforces the bail-out expectation so that an actual BK would be Lehman 2.0 writ larger. The worst part of the continued shoveling is the end game: we have the victory of a saved Citi or AIG, whose TBTF status has been, by that time and by virtue of the shoveling itself, become cast in concrete and whose license to loot in the sense of Ackerlof & Romer has been not curbed but institutionalized with not only governmental approval but backing as well.
Posted by: d4winds at March 11, 2009 07:03 AM
I believe that your premise that AIG's investment strategy was a "miscalculation" is faulty. I accept the "looting" presented by Leonhardt in today's NYT and in the research paper by Akerlof and P. Romer with the same title.
It is clearly a good corporate strategy to "privatize gains, socialize losses." That it makes the rest of us pay for these extortionary financial activities with the support of vested interests in White Houses (Bush & Obama) and Congress (Dems & Republicans) is disgusting.
These "financiers" are really "extortionists." They ought to be treated as criminals and their criminal enterprises shut down.
Posted by: Terry at March 11, 2009 08:01 AM
Could AIG's counterparties have been thinking that their payments would come not from AIG but from the Federal Reserve and taxpayers?
James: that goes beyond garden variety moral hazard. That's looting.
Posted by: Dave Schuler at March 11, 2009 08:19 AM
I have a theory: the computer models used to manage risk became infected from a virus from the IPCC Anthropogenic Global Warming modelers.
These programs have a serious bug which means they can ONLY predict a secular upward trend that never ends - be it temperature or house prices: The so called "hockey stick" effect.
Of course, anyone, with even the remotest common sense, knows that climate is variable and temperatures have had both warm and cold periods over decades, centuries and millenia.
So why wasn't the error noticed or detected?
Basically, human pride took control and caused the fall: people in the business wanted so desperately to "believe" that things would continue to go up forever (be it more bonuses or more research grants and hysterical media coverage) - so all historical evidence got completely ignored and everyone is told we are in a "new paradigm".
Welcome to the "new paradigm"! The end of the world is coming, and as Prince Charles points out: we have merely 100 months left! So the bailouts are all irrelevant anyway - simply party on like there was no tomorrow, 'cause there ain't!
Posted by: Anon at March 11, 2009 08:34 AM
It is my understanding from a long investigative article in the Washington Post from about two months ago, that the fundamental ending of full hedging at AIG Financial Products dates back to the late 1990s, but that the situation worsened after 2005. Greenberg is not fully out of the woods on this business.
Posted by: Barkley Rosser at March 11, 2009 08:36 AM
One problem is that under existing law derivative counerterparties get to attach the firm's assets. Derivatives get to grab collateral which cannot be assigned in bankruptcy. Its not clear to me that property rights have been well defined.
When dealing with an AIG and maybe with risk adverse bank bond holders this involves a huge problem of asymetric information. Its not clear to me that property rights have been well defined. In the case of investment banks and hedge funds everyone has to be assumed to be an adult. But when dealing with public facing institutions like banks and insurance funds I think that the property rights need to be discarded.
Posted by: gnat at March 11, 2009 08:43 AM
Second that GWG.
TBTF is an acronym that needs some more scrutiny in my TSTS (too small to succeed) opinion. Failure and size are not necessarily connected, but power (capacity, strength...) and failure are.
If I may join forces with Mogden at the beginning, the vested parties under these umbrellas (AIG, Citi, Goldman...) are taking us down...because they can...so far, with UE @ 8%.
Posted by: calmo at March 11, 2009 08:52 AM
Systemic risk need not be spread via too big too fail institutions. In an alternative scenario, a bunch of teeny-weeny companies could get into trouble at the same time, leading to essentially the same situation we're in now.
Everyone's looking for easy answers, painless fixes. Life isn't easy. Or painless.
Posted by: Jimbo at March 11, 2009 08:58 AM
Just a few thoughts on the issue. It is not quite clear from the news reports and the posting above, whether the transfers from the Federal Government through AIG to its counter-parties were in the nature of posting margins/collaterals on the deteriorating positions on AIG's books, or unwinding of the transactions as stated or a combination of both. If it is the margining issue then all that is a temporary(?!) transfer of collateral from AIG to the counter-parties, if it is an unwind, then it is a permanent one time transfer. The distinction is important because, in one case the transaction is still on the books while in the other it is wiped out.
Whatever it is, the most surprising thing about all this is that if funds are being transferred on the underlying instruments, they must be based on valuations and if so why is it then so hard for the regulators to get a handle on the actual market valuations of the so called toxic instruments?
I am assuming that AIG is not transferring funds because its counter-parties are using some Material Adverse Change (MAC) Clause to ask for more security but in response to perceived valuation changes. Most of the instruments/underlying contracts have not expired nor have the defaults have taken place on all the tranches. All the discussions I have seen to date are muddying the waters rather than carifying the issue and identify how the transferred/payment amounts were arrived at in the first place.
Posted by: sr at March 11, 2009 09:37 AM
d4winds writes : "...The worst part of the continued shoveling is the end game: we have the victory of a saved Citi or AIG, whose TBTF status has been, by that time and by virtue of the shoveling itself, become cast in concrete and whose license to loot in the sense of Ackerlof & Romer has been not curbed but institutionalized with not only governmental approval but backing as well."
That's correct. Final vision of the GS money club.
From my ex-buddies at GS : loud laughing about the stress test. Everything runs perfect.
Posted by: John Lee at March 11, 2009 11:42 AM
It's a shame that the Fed actually unwound AIG's trades thus basically locking in a loss to the US taxpayers (AIG sold low and the Fed bought back high - in fact probably at the top of the market spreadwise). What the Fed should have done is simply have taken over AIGs contracts so that AIG's counterparties now faced the US government, rather than AIG. That would have allowed US taxpayers to make back much of the bailout cash (assuming of course the AAA ABS CDOs will not have been impaired) that we will now never see.
There was some discussion above on the hedges done by counterparties that I touch on in my post on AIG:
Posted by: Anon at March 11, 2009 11:51 AM
Wrong math, according to Taleb. Gaussian vs Mandelbrotian. Gaussian grossly underestimated the impact of a decline in prices.
Instead of a slow leak, it was kaboom: a gas leak in the basement that blew up the entire building.
Posted by: beezer at March 11, 2009 12:56 PM
While the bivariate Gaussian copula has "Gaussian" in its name, the fact that it mixes two distributions makes it allow for fat tails and is not Gaussian itself, which was why copulas were so widely used at one point for the sorts of CDSs that got AIG Fin Prod in trouble, although the bivariate Gaussian one was always about the most simple-minded of these.
Posted by: Barkley Rosser at March 11, 2009 01:00 PM
Sorta like explaining how the grizzly bear mauled you: it was a Big Bear Gun alright but not the Grizzly Bear Gun.
I refuse to be quantized.
Posted by: calmo at March 11, 2009 01:36 PM
Possibly the market for Credit Default Swaps could survive if it was moved from an unregulated OTC market to an exchange/clearinghouse with position limits, standardized contracts and mark-to-market margins. This should mitigate the risks while permitting the economic benefit of credit "insurance".
By the way, AIG's 2007 annual report gets interesting on about page 122 (!), where they provide some detail on their CDS positions.
Posted by: John Elder at March 11, 2009 01:45 PM
Very good professor.
I do have some concerns with some of your statements that do not pertain to the main thrust of your post.
1. We are not suffereing from a miscalculation but one of the most sectacular mistakes in financial history. A miscalculation is when you put bad data into a working model. In this case the model itself was a failure. It was not miscalculation but error.
2. You say, "When the flow of credit stopped and house prices began to fall, the same forces operated impressively in reverse, now leading otherwise credit-worthy borrowers to default in increasing numbers." Falling housing prices cannot cause a default by a credit-worthy borrower unless the borrower has a catastrophic event to deal with such as losing a job. Appraised values of homes have nothing to do with paying the contractual mortgage. Falling home prices only lead to defaults if the borrower is not credit-worthy.
3. Bernanke states: "...the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. Virtually all government intervention is intended to reduce market discipline. A most obvious example is FDIC insuring bank deposits. The whole purpose is to protect depositors from market discipline so the depositor takes not purdent action to investigate the bank. The FDIC assumes all of the risk and the depositor received no discipline.
4. The government has pledged $160 billion to AIG. This is easier to grasp if you understand that this means that an average family of four will give AIG over $2,000. But even worse, since only 50% of citizens pay taxes, a family of four that pays taxes will give AIG over $4,000. And remember that is only one company. You could have bought a lot of stock in AIG for $4,000.
Concerning the main thrust of your post, your comment that "The relevant question then is, what combination of parties is going to absorb the loss?
The concern I wish to raise is that any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Societe Generale, and Calyon, to pick a few names at random, as major contributors to this particular collateral-damage-minimization relief fund.
To a normal person this would be a no-brainer. To congress it is business as usual - no-brains!
But I would suggest that it is impossible for the government to regulate every possible circumstance. So what this AIG example demonstrates is the inherent weakness and inability of a central planning government to appropriately regulate.
Proper action would be to allow bankruptcy and then stop the government from preventing the market discipline necessary to repair the damage.
Posted by: DickF at March 11, 2009 02:34 PM
Thanks for a good summary and putting your finger on the key question - what combination of parties is going to absorb AIG's CDS losses. The combination of parties depends on the size of the losses. If the losses are "a few hundred billion more",(Case A) I suspect the Federal government will remain on the hook, and we taxpayers will eventually pay the bill. I'm not pleased, but I think this is reality. There are scenarios where AIG's CDS losses may be trillions (Case B). Simon Johnson (former Chief Economist of the IMF) has described some of them. If these events occur, I doubt that US taxpayers will stand for paying trillions in losses. Some very grand negotiation with several foreign countries would be required, in that case, because the full faith a credit of the US government would then be at stake. No public information is available to tell whether Case A or Case B is the more likely. I believe this information should be made available and people could begin to make the very complex analyses that are needed to gain understanding of the risks. But I doubt that the information will be released, so counterparty question that you pose will likely be decided by events.
Posted by: Mike Laird at March 11, 2009 02:59 PM
Your prescription a good one
With this upgrade
ï¿½Split off or sell the insurance cos
ï¿½Give the corporate bondholders first loss on the CDSï¿½s.
ï¿½Think about only making good on CDSï¿½s used as insurance, namely those holders that have the underlying asset hedged by the CDS.
AIG has been called, including by Bernanke, a nice collection of insurance companies topped by a hedge fund selling CDSï¿½s.
All the points by you and guests about those CDSï¿½s insurance type contracts with no reserves are right. But not all buyers were using as insurance. Many were speculating, in this case doing the bonds equivalent of shorting the stock or the MBS pool. I donï¿½t have a problem with stock shorting. But why do we guarantee AIG as a speculative bet counterparty? Thatï¿½s for the buyer to worry about. Sure AIG was AAA but what happens when all these CDSï¿½s that are now held by hedge funds with a Caymen Islands Etc. PO Box do not pay out? Maybe originally issued by AIG and traded?
As a general rule handing out trillions before losses are realized is ready, FIREï¿½ oops aim. Good accounting needed first, let the bank and other bondholders take their losses. Then decide who to rescue that restores the system. Decide if a dollar of rescue aids recovery more than a dollar (or trillion) of spending you like or a tax cut?
What is seen so far is basically a purely political struggle between taxpayers and bondholders. The bondholders are winning. But the side effect is their lying accounting is leaving the system frozen
Posted by: AWH at March 11, 2009 03:20 PM
Prof. Rosser: I did not mean to imply guilt or innocence. From admittedly cursory reading about this and that institution, it just seems that some sort of "regime change" seems to have taken place around 2005 and volumes/risk taking really took off. I don't know whether it was systemic changes, for example changes in regulation, or just coincidence with contemporaneous management changes. Thanks for the reference to the WaPo article, hadn't caught that one.
beezer: Are you kidding?
Posted by: Anonymous at March 11, 2009 03:28 PM
Prof. Rosser: You once corrected me on this weblog about my incorrect use of "complicated" vs "complex". In a similar vein, may I suggest that perhaps the Gaussian copula is conceptually more "simple" but not necessarily "simple-minded"? ;)
Posted by: Anonymous at March 11, 2009 03:37 PM
Hank Paulson presumably was head of GS when its positions were taken with AIG. He knew, or should have known, of them all along.
When he asked for bailout dollars and committed them to AIG for GS amonth others, wasn't that a conflict of interest as to GS.
Hasn't he breached conflict of interest laws by taking an action directly benefitting an entity he had served before going into Government?
Posted by: ek77 at March 11, 2009 04:38 PM
EK77 - conflict of interest doesn't apply for past tense. Now, if Paulson makes a decision that affects the value of stock options he holds at the time of the decision related to his former employment at GS then that is an issue.
Posted by: TEBB at March 11, 2009 06:01 PM
There is one solution to the funding for some of this risk, and you can deduce the answer to it by asking this question: who is the beneficiary of a defaulted CDS obligation assumed by the government, and should this person be taxed on its paid insurance policy by the government. Afterall, Goldman chose AIG; shouldn't it pay for concentrating its risk with one counterparty, and shouldn't there be a consequence so that persons are more selective in chosing a counterparty. Tax Goldman and other for the "gain" they made over what would have otherwise been a default by AIG.
Posted by: bill at March 11, 2009 06:30 PM
Now that the Federal Reserve Board has put in place so many ways to backstop the world’s financial system, Bernanke can no longer argue that any firm is too big to fail. What could happen? Collapse of the market for commercial paper? Fed money sent. European banks weakened? Dollars sent to Central Banks in exchange for EUROS.
U.S. banks weakened? Several new ways to provide financing for domestic banks.
All the bases are covered.
The difference between Sept. 17, 2008 and March 10, 2009 is the difference between panic over a new reality and resignation over the collapse of the old way of profit making. Panic required not allowing AIG to fail. Resignation that the old system is dead opens the door to a subdued response to the bankruptcy of AIG.
AIG needs to be allowed to go into bankruptcy and all their debts created by the sale of credit default insurance in the shadow banking system needs to be repudiated by the U.S. government. These debts were contracted outside the regulated insurance system. What happened in the non regulated system needs to stay within the non-regulated system. Bernanke says the old system, under which these debts were contracted, must not be allowed to be recreated. Good. Neither should the debts created in a flawed system be paid by the Federal government.
It has been five months since Paulson told the Congress he must have $700 billion in emergency funds to remove the “toxic assets” from the books of banks and insurance firms. Slight progress has been made toward that objective. The quickest and cheapest way to achieve Paulson’s goal is to allow insolvent firms to go bankrupt and to backstop with Federal money only those debts contracted within the regulated system – life insurance, annuities, insured deposits, bonds sold to finance regulated activities, etc.
Bernanke, in his speech on March 10, talked about the dangers of creating the expectation that the Federal government will backstop all debts created by very large firms. Then he ignores what should be done today. Allowing AIG to fail will destroy the undesirable expectation.
Gretchen Morgenson, in a March 8, 2009, article in the NYTimes writes that: “Of the $302 billion in insurance outstanding at AIG, about $235 billion was sold to foreign banks and covers prime home mortgages and corporate loans. The banks that bought this insurance did so to reduce the money they must set aside for regulatory capital requirements”. Escaping from regulatory capital requirements is hardly a public purpose that would justify using federal money to pay these debts. These banks do not deserve help from the U.S. government. The contracts they signed with AIG must go unfilled.
I said above that “Bernanke can no longer argue that any bank is too big to fail”. Bernanke did not attempt to argue the point in this March 10, 2009 speech. Instead he repeated the phrase, as if too big to fail is an unquestioned assumption. How can he get away with that?
Posted by: ReformerRay at March 11, 2009 06:35 PM
"Does the fact that derivatives claims are not stayed in bankruptcy make your proposal unworkable.?" (from previous post)
Second question: Does the power of the Congress to determine Federal spending override whatever laws have been established governing bankruptcy?
The question for me is what is right and what should the Congress do. If it requires abrogating some laws and traditions, so be it.
The power to keep existing firms afloat indefinitely should not be allowed to remamin with Ben Bernanke. Congress should intervene. This is too important to let one man retain the power to increase federal debt in the amount that is likely, unless he is stopped.
Posted by: ReformerRay at March 11, 2009 06:56 PM
I remain on the lookout for defense of the idea that allowing AIG to fail will have dire consequences. I find that the reference above to "undesirable consequences" does not help. It references the supposed "confidential document" from AIG just repeating the conclusion without any justification. I didn't read all the 100 comments left on the Calculated Risk website but most of them were from cynics like me who do not accept the claim.
We are we going to find identification of which firms will fail when AIG fails?
If my prescription above is followed, the only firms to fail when AIG fails will be those whose major source of profits has been investments in Credit Default Swaps with AIG. Those are just the type of firms that should be allowed to fail. Failure of these types of firms, without the government paying for credit default insurance, will effectively reduce the number of toxic assets in the world. And it will punish the firms that helped create this problem.
Posted by: ReformerRay at March 11, 2009 07:58 PM
Pro. Hamilton and I provide a similar prescription. He say "abrogating existing contracts". I say the same except I specify which contracts. Some of the existing contracts with AIG must be sustained. I assume that a person more knowledgeable than me about the kind of contracts on AIG books could refine and improve my beginning on the topic.
It would be extremely helpful for someone, like Obama, to specify which kinds of contracts the Federal government will not stand behind.
Posted by: ReformerRay at March 11, 2009 08:11 PM
I read somewhere that the reason CDS were called "swaps" and not CDI (credit default insurance) - which is what they are - was specifically to avoid insurance regulation. Is that your understanding/
Posted by: Qingdao at March 11, 2009 08:40 PM
Posted by: calmo at March 11, 2009 11:54 PM
The 2000 law, Commodity Futures Modernization Act, identified by name a variety of "instruments" that would be excluded from Federal regulation, including Credit Default Swaps. My understanding of the 2000 law is based entirely on one article, written soon after the law was passed, by some lawyers hired by the International Swaps and Derivatives Association. Available on the web under the name of the act. They say "The Act addressses uncertainities regarding the status of over-the-counter ("OTC") deriatives and hybrid instruments . . .through a number of statutory exclusions and exemptions".
In my opinion, all such "instruments" have forfeited any right to be backstopped by the Federal government by their unregulated status.
Banks and insurance companies have their debts transferred to other firms, traditionally. That is appropriate for regualted activities because the Federal government assumes responsibility by providing the rules within which they are supposed to operate.
Posted by: ReformerRay at March 12, 2009 04:07 AM
This is the best argument I have found against my and Hamilton's proposal. "Also, abrogating AIG's outstanding CDS on ABS and CDOs is a terrible idea. That would suddenly force all the money center banks to raise hundreds of billions of dollars to meet regulatory capital requirements. This would set off another round of forced liquidations, declining asset prices, margin calls, and yet more forced liquidations -- essentially, it would be Lehman all over again. I've seen that movie before.
Finally, one of the main reasons we rescued AIG was that we didn't know who would suffer collateral damage if AIG failed. And we still don't know, because we'd need to know which assets the banks would dump into illiquid markets in order to meet regulatory capital requirements. So your idea for a "collateral damage minimization fund" is fundamentally flawed".
I assume the action he envisions would take place, to some degree. I am convinced it will not destroy the entire financial system. The only parts of the existing financial system that it would destroy are those firms whose available capital is so low that they would be unacceptable, except for the assets on their banks consisting of "instruments" that never should have been allowed to exist. Assume all such "instruments" that are payable by AIG have zero value. All firms that would go out of existence due to the reality becoming known deserve to fail. Psychology is everything. The knowledge that the Federal Reserve Board has rescued the international banking system once (after Sept.l7, 2008) makes today different from 2008.
Whether of not the $235 billion sold to European banks by AIG would destroy any of them is not a problem the U.S. government controls or has any responsibility for.
This great cloud of uncertainty that hangs over the market today is the uncertainity of what the Federal government will do. I do not believe the assertion by Bernanke, that we stand ready to insure the continuation of existing banks, will resolve the issue because it is so contrary to the need for the U.S. to limit the growth of debt. I think, and devotely hope, Bernanke will be overrulled by somebody.
Posted by: ReformerRay at March 12, 2009 04:36 AM
After such payoffs, GS cannot want "transparency" at AIG, since this would invite more scrutiny of the exact deals and whether GS had securities to insure or just made pure racetrack bets now being paid by middle-class families with children (taxpayers).
Posted by: HB at March 12, 2009 08:06 AM
Who will identify the number of firms (banks and insurance firms) and their current market value that will be destroyed by the domino effect if AIG fails?
Firms have had 5 months to adjust their balance sheets to the reality that AIG is not going to be able to pay all their debts. Firms that remain exposed to AIG are either gamblers or firms with limited options. I hate the fact that keeping AIG alive is supporting the gambling habit.
The world has changed since Sept. 2008. Let's get on with it. Limit Bernanke's authority. He wants to act today as if yesterday should control today.
Posted by: ReformerRay at March 12, 2009 08:07 AM
I accept your emendation regarding "simple" versus "simple-minded" regarding bivariate Gaussian copulas as compared with other forms of copulas such as the multivariate Archimedian.
Posted by: Barkley Rosser at March 12, 2009 09:15 AM
Great post. I quoted Harry M. Markowitz on correlated risks in the derivatives market in Should We Save General Motors?
I spoke to the political problems of these TBTF institutions being in bed with the Fed & Treasury in No, We Can't? Bailing out AIG is more charitable relief for their counter-parties the banks.
One trillion at a time. Sounds good to me. Most credit derivatives -- 99% are credit default swaps -- should just be outlawed unless they are tied directly to the underlying. Interest-rate swaps are mostly hedges, but these need to be regulated too.
Posted by: Dave Cohen at March 12, 2009 11:31 AM
ReformerRay: here are two "bones" to chew on.
1.Any CDS is a contract. A lot of contract law exists to obligate and protect both sides of a contract. AIG's CDS portfolio is now owned by the US government. Non payment of any of these CDS contracts reflects on the full faith and credit status of the government.
2.This second "bone" is much more speculative because no facts have been published about AIG's CDS portfolio. When you suggest non-payment to speculators (however you define them), think about foreign banks as well as US banks. Foreign relations come into play, and some of the issues could be very serious. Let your imagination run a bit about the situation with Austria's insolvent banking system and think about the "knock-on" effects. Then imagine it with several countries. Whether this is real or not - who knows? That's why the data needs to be released so lots of smart people can analyze it. This is unfortunately not at all simple.
Posted by: Mike Laird at March 12, 2009 03:01 PM
We do need to get some issues out in the open.
Who says that the U.S. government owns the AIG protfolio? Giveing them some money to prevent default does not make the U.S. government liable for AIG debts. The transition you suggest - from private sector liabilities to public sector liabilities - is precisely the transition that the U.S. government must take pains to prevent.
2. The U.S. taxpayers are not responsible for the situation created by a bunch of finance people. If the banks in Europe will go broke if the U.S. does not pay up for AIG debts, that is OK with me - and should be OK with all U.S. taxpayers.
I recognize that the implications of allowing firms to go broke is very serious. I also realize that the implications of saying that the U.S. government will backstop all debts created by the shadow banking system is even more serious.
Mr. Laird, I hope you are not under the illusion that the U.S. economy is in such good shape that we can ignore the impact of the increased debt that is implied by the Bernanke position that all existing firms will be prevented from failing.
Even if we knew which banks would fail if AIG goes broke, that does not solve our dilemma. Somebody, lots of bodies, are going to be hurt before our system returns to normal. I prefer to not know, so I am not discriminating for or against any firm or bank. All banks that cannot exist without receiving money from AIG should go broke.
Posted by: ReformerRay at March 12, 2009 05:25 PM
Mr. Laird says the situation is not simple. I agree wholeheartedly. This is a real keg of worms. Instead of understaning all the implications and trying to be a King Solomon, I simplify by saying who is responsible for this mess and how can the U.S. taxpayer be prevented from paying for it.
The banks and firms that participated in this system and who profited from it previously, created the mess and they should pay for its closure. Refusing to pay for debts contracted by the private sector in a system deliberately closed off from public review fits my sense of justice. You guys settle this among yourself.
Damage to the financial sytem? Already accomplished. The damage has been done. Allowing more reality to be exposed will hasten the time when a new financial system will emerge.
Bernanke is a fraidy cat. Also unrealistic to think the U.S. taxpayers are willing to support his stance.
Posted by: ReformerRay at March 12, 2009 05:34 PM
At some point the economists will figure out they were arbitraged to eliminate the costs of legal compliance and gain unlimited access to Treasury.
The cost of eliminating the legal structure to gain profits are now apparent and no, derivatives can not be summarily dismantled as the legal structure has no mechanism other than criminal law to deal with the fallout from this extra-legal system. The havoc and shifted costs to the taxpayer "CDOs" have created in the 200 year old property law system are insignificant to the utter chaos the repudiation of thousands of "individual" contracts cum tailored credit agreements cum ISDA contracts.
Hey, you guys thought economics trumped law. Now play your spades as the legal trump is now an ineffectual club.
Posted by: dd at March 12, 2009 06:11 PM
What is legal is for others to decide. What the U.S. Congress should do is for the Congress to decide. What citizens should do to try to influence Congress is for us to decide.
With a situation as fraught with peril as this one (the peril I see is excessive federal debt), U.S. citizens should focus on not paying for Credit Default Swaps with Federal money.
I don't care what traditions must be trampled to achieve the objective.
I want to see the Congress and the President agree that no more federal money will be used to support Credit Default Swaps. Obama pledged that no federal money would go to "greedy bankers". The next step is to take the spirit of that pledge a step further and extend it to Credit Default Swaps.
Posted by: ReformerRay at March 13, 2009 05:57 AM
Here is another flailing away at a dead horse.
A good way to settle the issue of what to do today about credit default swaps is to ask ourselves what would be a good post-trama role for Credit Default insurnce.
Keep it private and separate from the regulated structure. But wall off the two activities. Any regulated bank or insurance company that wants to play in that game cannot put their assets at risk. It would be illegal for any regulated bank or insurance company to pledge their assets to backstop payments for Credit Default insurance. If a regulated firms wanted to play in that market, they would be required to establish a separte firm, which they could own, but that firm would not be able to rely on the parent firm to pay any of its debts.
It would go without saying that the federal government would have no responsiblity for covering debts of bankrupt firms issuing credit default insurance.
The private system would be on its own. Purchasers of credit default swaps would need to find some private firm, not in the regulated system, that has the ability to guarantee payment.
This would free players from regulation and it would free regulated firms from paying for mistakes or problems in the unregulated system.
I propose that the U.S. Congress adopt this stance and implement it today by asserting that no federal money will be spent to make good credit default insurance that a private firm cannot pay.
Posted by: ReformerRay at March 13, 2009 07:03 AM
When the government starts talking systemic risk or big to fail this means a political response to the crisis in which it wants to select winners and losers without going through established legal pathways.
Political corruption is the face of this crisis and those with political connection demand the political mob act in their behalf rather then facing BK and being picked over by creditors.
Posted by: ron at March 13, 2009 05:22 PM