The True Story of AIG

 This article was featured in The Bulletin (Philadelphia-area newspaper) on 3/19/09. See the newspaper version here (go to pg. 23).

Last October, we watched with shock and fear as the stock market began its sharpest downturn since The Great Depression. Market indices, which normally fluctuated between .25% and 1%, were suddenly thrown into whipsaw-like volatility, with shifts of 6% and 7% often occurring in the final hour of trading alone. Financial titans and landmark American companies once thought too large to fail fell almost daily: Bear Sterns; Lehman Brothers; Merrill Lynch; Wachovia; Washington Mutual, to name a few. At the bottom of the rubble was insurance giant AIG, a company that, just a year earlier, had been praised by analysts for its dominant cash flow and surplus capitalization. AIG’s stability was its hallmark (in 2007 it was ranked as the 47^thmost valuable brand in the world), building its brand around the now ironic tagline, “The Strength to Be There.” The story behind its collapse is more telling than a simple $165 million bonus payout. What happened?

AIG, like many other financial companies, got caught in the complex web of derivatives trading. With real estate and housing investment booming, investors were scrambling to grab a piece of the profit. For an insurance company like AIG, this meant trading credit default swaps. Essentially, AIG would agree to take on the default risk of a group of mortgages (called a tranche) in exchange for a highly profitable payment from the investor. Investment banks would approach AIG with a group of AAA rated mortgage bonds, and would buy what equates to an insurance policy against the group’s default. This allowed investment banks and traders to buy up mortgages and loans without absorbing any of the risk–all of the risk was in AIG’s hands, and all of the profit was with the investment banks. Or so they thought. The problem was that once the housing bubble burst, and the underlying sub-prime mortgages came to bear, AIG owed billions of dollars in insurance payments to cover the defaults. The loss was so large and so sudden, that AIG did not have the capitalization to pay for the losses. Add to this the fact that the derivatives traders had leveraged the risk at a near 20:1 ratio ($1 million dollars of loss now equated to $20 million), and the powerful titan of AIG suddenly owed substantially more than it was worth.

AIG was unable to pay those investors it had promised to insure, so its investors had to scramble to cover their own losses. No one had the capitalization to do so, and the fabric of Wall Street was ripped to shreds in a few short months. Government officials felt they needed to do something, so they quickly passed the Troubled Asset Relief Program (TARP). The goal was to give taxpayer money to banks to help recapitalize them, allowing them to cover their losses or pass off toxic assets. AIG was seen as essential to this process, as it owed so much to so many–it was too important to fail. The government rushed in, took an 80% ownership stake, and poured billions of dollars into reviving the company.

Now, AIG has been thrown back into the spotlight for the recent revelation of its $165 million bonus payouts to the derivatives traders that invited all the risk. Why the outrage? Because people hate to see their money given away indiscriminately, especially to those who contributed first hand to the economy’s decline.

But where was this outrage when the government issued more than one thousand times this amount to failing companies in TARP I and TARP II? This misallocation was equally egregious–taxpayer money was paying for someone else’s indiscretion. We were taking on billions of dollars of debt to bailout companies that placed bets with worse odds, and nearly equal consequences, to a game of Russian roulette. All because the government felt it would be for our greater good; that a bailout would lead to stabilization, stabilization to economic growth, and economic growth to a return of taxpayer money.

The AIG story unveils a company, and its web of financial partners, who took unprecedented risk and fell because of it. It also unveils a government that was willing, for the supposed good of the public, to pour its citizens’ money into a broken financial system. But if capitalism is to run its course, companies that take unwise risk must be allowed to fail. By placing taxpayer money into the inefficient hands of companies like AIG, the government has only prolonged the downturn at the expense of capitalism.

Perhaps most significantly, however, we have invited in the moral hazard of government control in the marketplace, and government control of consumer investment. As an investor, you would never pour your own money into a company like AIG, carrying such a toxic balance sheet that you would be assured long-term loss. The true outrage, then, should not be about the $165 million paid in bonuses, but instead about the nearly $1 trillion taken from taxpayers and poured into faulty investment. AIG and its financial partners fell because they took foolish financial risk–taxpayers should not be asked to pay for their mistake. The true sin came long before the bonus payouts; it was berthed the moment capitalism died.

-Matt Benchener from TruPolitics.net