The Real AIG Scandal
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AIG is on the hook for such a large sum of money, I can't imagine they can be bailed out forever.
I am curious if AIG is writing more of the same contracts that took them down this path in the first place. I wouldn't be suprised if they are because the people behind this bailout believe deep down that CDO's and other similiar contracts are still good for the economy.
But there is no reason that I shouldn't be allowed to sell you a guarantee that "X" won't happen (for any value of "X"). But, you are responsible for making sure that I'm liquid enough to pay in case "X" does happen - because if I'm not I'll just go bankrupt and you can try to claim your share of my assets just like everyone else.
These sort of contracts help hedge risk - as long as they are done responsibly. When they are done irresponsibly, the involved parties should be made to suffer, not bailed out with tax payer funds.
But you aren't really looking at the total effect of these contracts. Derivative contracts "spread risk" but, as we've seen, they don't avoid risk. So what they do is turn the individual risk of corporate bankruptcy into the risk of systemic collapse.
That is called an "externality of production". Individual companies sometimes don't mind taking gambles that have a downside for people not otherwise involved with them. Much of governmental regulation is specifically for preventing these externalitie from impacting people - this is why banks are regulated, why companies must proper precautions handling toxic materials, why automobile drivers must have insurance, etc.
So, ultimately, these kinds of contracts are bad. They need to be regulated in the same way that banks are regulated and for the same reasons.
And they were, by several US govt agencies. (Since these contracts were used for banking purposes, specifically securing assets, banking regulators were involved. Insurance regulators were involved. The SEC too.) Yes, this includes the London groups.
I am confused about how foreign banks got stung, what with all their superior regulation and all.
My impression is Alan Greenspan specifically nixed regulation of CDOs around 1999.
I suppose I am talking about derivatives in general, in fact. Everything I've ever read claimed they were entirely unregulated. I would like to hear if that's not the case.
http://files.ots.treas.gov/87171.pdf
That report comes from the Office of Thrift supervision (OTS). They started regulating AIG in 1999 when AIG applied to become a "Federal Savings Bank". (The application wasn't approved until 2000.) OTS regulates and supervises both FSBs and their holding companies.
The report also documents OTS cooperation with and the existence of AIG regulation by "a multitude of regulators in over 100 countries".
As the report documents, AIG's problem is liquidity. One of the paragraphs that I found interesting says: "AIGFP's CDS provide credit protection to counterparties on designated portfolios of loans or debt securities. AITFP provided such credit protection on a 'second loss' basis, underwhich it repeatedly reported and disclosed that its payment obligations would arise only after credit losses in the designated portfolion exceeded a specified threshold amount or level of 'first losses.' Also known as 'super senior', AITFP provided protection the layer of credit risk superior to the AAA risk layer. The AIGFP CDS were on the safest portion of the security from a credit perspective. In fact, even today, there have not been credit losses on the AAA risk layer."
FWIW, AIG became concerned about this biz in 2005 and stopped selling these instruments in late 2005 and started unwinding then. I'd agree that they did so too slowly.
> My impression is Alan Greenspan specifically nixed regulation of CDOs around 1999.
Greenspan wasn't ever in a position to make that call.
> Everything I've ever read claimed they were entirely unregulated. I would like to hear if that's not the case.
Yes, there are unregulated financial instruments. (Leases and ownership aren't regulated either.) However, the existence of such instruments does not imply that regulated institutions (such as AIG or its customers) can use them to escape supervision.
For banks and insurance companies, regulators define what counts as an asset, how it is valued, and regulate exposure to different kinds of assets. That applies to all assets, whether they're "regulated" or not.
Note that OTS says that the portfolios that AIG insured have not had losses, the asset valuation has held up even as the market cratered, so it's a little unclear why AIG is making payments. I suspect that they're caught in mark-to-market, which is a regulatory creation. (Assets that are throwing off cash are not worthless even if there are no buyers today.)
Did AIG screw up - yes. But there's no evidence to show that more regulation would have done better. More to the point, it is simply wrong to argue for more regulation on the theory that lack of regulation was a factor. It wasn't. If anything, regulation failed.
Thank you for the link and for expanding your point.
I think a careful read of the document you link to shows that the only regulatory action that took place was the OTC becoming concerned in 2008 that AIG's previous derivative contracts had now become dangerous. They noticed nothing when the derivative contracts actually were issued.
Also note the comment in the text: "the level of review and amount of resources needed to asses a complex structure such as AIG's is vastly deeper and more resource-intensive than what would be required for a less complex holding complex", which is something of statement that OTS really wasn't up to very much supervision of this "vastly complex" enterprise.
But this is not really the main issue...
>> My impression is Alan Greenspan specifically nixed regulation of CDOs around 1999. > Greenspan wasn't ever in a position to make that call. He was indeed not a regulator of that but his testimony to congress influenced the resulting lack-of-legislation on the issue of derivatives when the official who would have regulated them asked for the ability.
> Yes, there are unregulated financial instruments. (Leases and ownership aren't regulated either.) However, the existence of such instruments does not imply that regulated institutions (such as AIG or its customers) can use them to escape supervision. > For banks and insurance companies, regulators define what counts as an asset, how it is valued, and regulate exposure to different kinds of assets. That applies to all assets, whether they're "regulated" or not.
There indeed, is the rub. Being modeled as "very safe", my impression again, is that CDS were in fact often considered "off-balance-sheet-instruments". But that's again secondary...
Now that we have gotten into the details of these things, I should say "there are regulations and there are regulations". Bank deposits are and have been rightfully regulated actively in terms of explicit, apriori limits on deposits because deposit expansion and contraction can have a powerful effect on the economy as a whole. Derivatives have only been regulated in terms of one institution or another keeping loose track of what's happening and not particularly limiting anything until things seem worrisome - which now turns out to be long after the horse has left the barn.
What I am saying that derivatives should be regulated in a similar fashion to bank deposits, with limits to who can issue, how much can be issued, how much systemic risk they create and so-forth.
This is again consistent with state's necessary regulatory role. State regulation basically require apriori legislation to prevent private actions which can cause harm beyond the ability of a private actor to repay the victims of that harm. The OTS might indeed have looked at the risk of failure which AIG's actions involved for its depositors, its stock holders and even for Uncle Sam in his role as deposit insurer. The OTS clearly didn't look at the systemic risk which AIG's issuance of derivatives created.
What should be required, in the future, is such apriori limits on derivatives. Either no institution can take on risk beyond a certain multiple of capital or whatever other formula would work best. This is because, despite many claims to the contrary, unregulated derivatives have become what Warren Buffet calls "financial weapons of mass destruction" through their ability to first expand and then contract the money supply (or the velocity of money if you prefer).
> Did AIG screw up - yes. But there's no evidence to show that more regulation would have done better. More to the point, it is simply wrong to argue for more regulation on the theory that lack of regulation was a factor. It wasn't. If anything, regulation failed.
Consider that folks are not really concerned with a hypothetical failure of AIG in itself. By money-size, AIG wasn't "too big to fail". It is rather the systemic failure that would accompany AIG's failure that has people up in arms.
You could argue that the OTS or other bodies already had the authority needed to place limits on issuance of derivatives. This might be true but the real point is that neither the OTS or other bodies are charged with directly reducing systemic risk because they can't calculate systemic risk. Indeed, consider that Large modern economies (or, as another example, the world's ecology) are complex beyond all mathematical models - despite economists' earlier protests to the contrary (protests that look pretty shoddy now). Because of this, regulation must involve simply forbiding those actions which create unquantifiable systemic risk (including but limited to unlimited dervative issuance, unlimited deposit expansion or discharge of known polutants into the environment).
I saw an interview with Nassim Nicholas Taleb where he sketched a future version of capitalism where all investors put their money into either rather strongly regulated funds or very explicitly risky and unregulated funds, with only those who could show they could sustain the loss being allowed to jump into the risky funds.
That's wrong and the error is not "secondary". If something is "off-balance-sheet", it's useless to a bank. Banks need on-balance-sheet assets to match their liabilities. And assets are heavily regulated.
> Bank deposits are and have been rightfully regulated actively in terms of explicit
Deposits, the money that customers put in banks for "safe keeping" (and interest), aren't regulated and there's no reason to regulate them.
Deposits are liabilities, promises that the bank has made. Assets are what a bank keeps so that it can return deposits to customers, so it can satisfy its liabilities.
When you deposit $100, the bank books $100 in liabilities and $100 in assets. It can exchange the $100 cash that you gave it for assets of equivalent or greater value, but all that is regulated so that the bank can pay you $100 when you ask for it.
Yes, deposits are insured, but that's something entirely different. And, the way that deposits are insured is by regulating assets.
> The OTS might indeed have looked at the risk of failure which AIG's actions involved for its depositors, its stock holders and even for Uncle Sam in his role as deposit insurer.
AIG's problems had nothing to do with returning money to depositors.
>> Greenspan wasn't ever in a position to make that call.
> He was indeed not a regulator of that but his testimony to congress influenced
In other words, he didn't "nix" anything.
> the resulting lack-of-legislation on the issue of derivatives when the official who would have regulated them asked for the ability.
How about a cite...
I've already commented on Greenspan's successor's "knowledge" in this area.
One of many articles on Greenspan's resistance to the regulation of derivatives can found in this NYTimes article: http://www.nytimes.com/2008/10/09/business/economy/09greensp...
A google of "Brooksley E. Born" will show a considerable amount more.
Perhaps we could each start a blog to debate the various point here. They are interesting enough to warrant more exposure than a fading thread on hn.
Best,
JTU
I note that Dodd, Obama, Sen. Clinton, and Kerry all received significant donations from AIG and other investment houses and oversaw their regulation. Barney Franks was particularly vehement in telling us that Fannie and Freddie were perfectly safe and didn't need any regulation. (Which reminds me, Fannie and Freddie announced significant bonuses recently.)
Yet, we're talking about Greenspan.
The fact remains that there was significant regulation of AIG's biz. Any argument which starts from the assumption that there wasn't is fatally flawed.
Sheesh, it seems like you're just stretching your argument for the sake of it. By now, it's not like anyone else is even "listening" to this discussion, so neither of us have anything to prove.
Sure, Greenspan indeed had no official power in the matter but the press universally credits him with wielding sufficient influence to decide the question. I documented, as you requested, the fact that Greenspan testified against the regulation of derivatives. Now you say it doesn't matter. I would agree that the legislative branch was also instrumental in deciding derivative regulation BUT that discussion is pretty much irrelevant to the immediate question.
I simply criticized Greenspan, I didn't criticize-Greenspan-to-get-the-democrats-off-the-hook. I have no partisan axes to grind here, though I get the feeling you might. I would see the whole Washington establishment, democrat and republican, as enabling Wall Street's normal operations (which lead us to this crisis). Lots of folks can be blamed but Greenspan is very widely credited as being the articulator of the hand-off ("market fundamentalist") approach. Saying that he didn't have legal power over this or that is not a sufficient argument to challenge his status as architect of overall Washington approach.
Sure, I think by now I've acknowledged there has been plenty of regulation of AIG. As I think I've said, the point isn't regulation but what kind of regulation. Here, I would follow Doug Noland and others who see derivatives, CDOs and other entities as Wall Street devices for the creation of money-like-items - synthetic bonds with a AAA rating were the product was pumped out with the assistance of elaborate constructs like CDS's. This unlimited creation of money-like-objects ran part and parcel with a massive inflation of the value of assets - the bubble.
This process is ultimately equivalent the money-multiplier effect without any underlying capital requirement. Thus, it did not require just any-old-regulation but regulation like banks. The regulations on a savings banks is not simply to keep a single bank safe but to limit the money which banks as a whole inject into the system as a whole.
....
Did I mention regulation-like-banks?
To be clear, you're saying that Greenspan's influence over the legislative branch is relevant but what they actually did is irrelevant...
> I simply criticized Greenspan, I didn't criticize-Greenspan-to-get-the-democrats-off-the-hook.
You found Greenspan's comments important enough to criticise. You didn't find other people's actions significant enough to rate a comment.
If your comments don't reflect your priorities....
> Did I mention regulation-like-banks?
And for the ntheenth time, AIG was regulated as a bank - that's what the office of thrift supervision does. AIG was also regulated as an insurance company.
If you're going to claim that "regulation-link-banks" would make a difference, surely the fact that AIG was actually was regulated like a bank is relevant.
You keep bringing up things (unregulated assets and the like) that have nothing to do with AIG. (Banks and insurance companies get no benefit from unregulated/off-balance-sheet assets.) Perhaps you ought to be discussing institutions to which they actually apply.
The problem with this argument is that the issuance is irrelevant. My standing on a street corner selling billion dollar cats isn't a problem.
The problem was that regulators said "sure, buy as many of those cats as you can find and hold them as assets". The unregulated firms saw that for the crock that it was.
We got hit by two problems. One was subprime loans, which were pretty much a creation of regulation and govt action. The other is bogus assets accepted by regulated institutions. Again, regulators failed.
Yes, the unregulated institutions have also taken a hit, but only to the extent that they counted on the regulated ones.
There's another thread in HN about folks driving more dangerously because they think that their cars have some feature that reduce the risk more than it does. (Or, as a friend of mine puts it, the folks with a winch are the ones who get stuck.)
As I pointed out, Greenspan wasn't in a position to make that call. However, his successor is a source of misinformation on this point.
From http://dealbook.blogs.nytimes.com/2009/03/05/as-regulator-wa...
A lack of regulatory oversight has been suggested as a reason why a relatively small group of A.I.G. employees in London were able to hobble the entire company with risky bets. Ben Bernanke, the chairman of the Federal Reserve, testified this week that "there was no regulatory oversight because there was a gap in the system."
But Scott Polakoff, acting director of the Office of Thrift Supervision, which was A.I.G.’s primary regulator, told lawmakers Thursday that his office knew about the A.I.G. unit in London and had oversight over its operations.
Jack Reed, a Rhode Island Democrat who sits on the Senate Banking Committee, drove this point home at Thursday’s hearing on the government’s A.I.G. bailout.
"The perception that this London operation was some rogue group that were unsupervised, that you had no access to it and that your regulatory authority didn’t reach there is not accurate," he said to Mr. Polakoff.
"Correct," Mr. Polakoff responded. "That would be a false statement."
Foreign banks had subsidiaries in the US or UK which could participate in unregulated derivatives trading.
Isn't that what happened in the famous 1995 collapse of Barings Bank as well? Enormous losses from speculative trading were made in the Singapore market by the local branch of Barings, which led to the insolvency of the entire UK-based bank.
Foreign banks bought "insurance" from AIG to get around legal regulations in their own countries: http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/09...
That article says that foreign regulators let their banks treat AIG insurance policies as assets.....
To be fair, US regulators did the same, but since the claim was that foreign regulators were better, we're back to looking for a difference that demonstrates said superiority.
"The regulatory arbitrage was even seamier. A huge part of the company's credit-default swap business was devised, quite simply, to allow banks to make their balance sheets look safer than they really were. Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements. The less risky the assets, obviously, the lower the regulatory capital requirement.
"How did banks get their risk measures low? It certainly wasn't by owning less risky assets. Instead, they simply bought A.I.G.'s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more 'risk-free' assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began."
More details here: http://www.nytimes.com/2009/02/28/business/28nocera.html?ref...
>> Under a misguided set of international rules that took hold toward the end of the 1990s
The citation says that AIG did what regulators let it do.
If you're going to argue that regulation is the solution, why do we ignore what regulation has actually done?
AIG exploited a loophole; it was a case of complying with the letter of the rule, but going against its spirit.
If you're going to argue that regulation is the solution
Not my assertion at all; I'm merely answering your original question about how foreign banks got stung by their involvement with AIG.
Credit default swaps are derivatives. They were deregulated in the http://en.wikipedia.org/wiki/Commodity_Futures_Modernization... so as to be completely unregulated.
You can't insure 35 times your cash reserves, but you can issue just such a derivative.
Insurance was ok. Insurance gone mad in the form of derivatives literally tanked our economy.
At the end of the day, yes, it feels right to not only AIG but those counterparties should also feel the pain.. at least they should not be given 100 cents on a dollar!
He ruined Hank Greenberg, one of the greatest businessmen in this country, and put AIG in the very position it is in today -- all for what, a shot at becoming the next Giuliani? It's utterly retarded. He is the classic "bad cop" who is off doing shady crap in his free time, punishing perfectly good law-abiding citizens as part of his power trip. I mean, really, Hank Greenberg was the squeaky-cleanest guy you could find; yeah, there were the backroom deals and whatnot, but that's called "the old boys' club," and nothing that was severely impacting the fate of the global economy. Leaving AIG in the hands of Marty Sullivan and his gang of idiots, however... Well, we see what has happened; AIG is now so impotent that it is used as a mere pawn by the banks and the Fed. Spitzer practically shouldn't be allowed to write about this without acknowledging that he created the problem.
The problem with politics is ... When Miley Cyrus says she will "ruin" Radiohead, we all laugh; when the Miley Cyruses of the political world say they are going to "ruin" someone, the power given to them by the people allows them to make inroads into doing just that.
1 - "Hank Greenberg was the squeaky-cleanest guy you could find"
2 - "He ruined Hank Greenberg, one of the greatest businessmen in this country, and put AIG in the very position it is in today"
isn't this wrong in many levels? this is against capitalism, this is rewarding bad behavior, it is immoral - in the sense that Govt is taking money from Peter to pay Paul, this approach is not going to work on top of all this, I just feel this is just wrong.
AIG would take an enormous part of both the private and public economy with it, if it ever failed.
I don't know if this is practical or not, but what if future regulation were aimed at limiting the total size/amount of money/whatever that a company is allowed to own with the goal of keeping risk distributed enough so that we wouldn't fear letting bad companies fail?
They'd also have to monitor board membership and stock ownership to ensure you didn't end up with hundreds of companies being virtually one giant company behind the scenes all following the same bad policies.
I'd imagine this isn't all that dissimilar to dealing with monopolies. Too little competition is bad and now we've learned that allowing any single point of failure is just as bad.
As all hackers know, single points of failure are risky, even if a crash is unlikely. Our economies load needs to be better distributed.
Interestingly, during the Great Depression there existed laws which limited the number of branches that banks could have. Politicians preferred to keep banks small, fearing the power of larger banks. You see, anti-capitalism and a populist distaste for financiers are nothing new.
Perhaps surprisingly, states that forced banks to be small were the hardest hit by bank failures in the Depression. The tiny, unthreatening banks did not have the margin of error to wait out the financial chaos. Meanwhile, places like Canada that allowed large national banking conglomerates avoided bank failures almost entirely.
Our recent crisis was very different from the Great Depression. Contrary to the 1930s, scale was often a vulnerability, and not an asset. However, the example of the Great Depression ought to drive home to us the danger of optimizing to the last crisis, lest we precipitate a new one in our rashness.
There is also danger in drawing simple, neat lessons from a messy crisis. Scale was not always our enemy. We must remember that several private firms were bailed out, not by public dollars, but by private acquirers. Wachovia's sale to Wells Fargo would have been legal under many of the world's regulatory regimes, and it was legal in the 2008 United States, but it would not have been legal in the 1998 United States when we still had anti-scale laws on the books. If those regulations were still in place, at least a few more large firms would have been at the government's door, hat in hand.
Populism is politically fruitful, but it can wreak havoc on an economy, and it is almost never thoughtful or well-informed. We ought to pause before giving in to its mellifluous rhetoric.
No surprise, financiers ripping us is nothing new either.
> The tiny, unthreatening banks did not have the margin of error to wait out the financial chaos. Meanwhile, places like Canada that allowed large national banking conglomerates avoided bank failures almost entirely.
Perhaps they didn't set the right limits, kept them too small. Because we failed to get it right once doesn't mean we should stop trying and just accept being ripped off as a cost of doing business.
Either we figure out how to regulate the market such that this won't happen in the future or we nationalize the banking industry like others have done and admit that the only thing that's really to big to fail is the government.
> There is also danger in drawing simple, neat lessons from a messy crisis.
That, I agree with. But our current system has clearly failed, something needs to be done, time for another experiment.
> We ought to pause before giving in to its mellifluous rhetoric.
Talking about possible solutions on a website is pausing, it's not like we're implementing policy here or anything. It's just an interesting things to speculate about.
Is this what you really think about finance?
If I were to weigh the good and the bad that finance has done for the human species, I have little doubt to which side the scale would tilt. Finance is an essential part of an advanced economy, and advanced economies are much more fun to live in than the other kind.
Populism is driven by basic, tribal emotions and explanations that appeal to the lowest common denominator. Humans fear that which is complex and hard to understand. They are envious creatures with a poor natural grasp of economics. They reason that if the goldsmith is getting richer, why, then I must be getting poorer!
Populism hasn't really progressed since the days of goldsmith banking. That's not what it is built to do.
I don't think populism is the wisest way to modify the banking system, but sadly we have decided that voting is the best method to make such decisions. Since populism is simple and appeals to the gut instinct, it wins out in votes. So populism is what we get.
> "Because we failed to get it right once doesn't mean we should stop trying"
The first failure caused immense human suffering. What we have now needs some tinkering, but it is immensely better. It would be foolish to make large, rash actions to experiment recklessly when the costs are so high. Speaking of which:
>"or we nationalize the banking industry like others have done and admit that the only thing that's really to big to fail is the government."
I can think of three nations off the top of my head that nationalized banks. One was temporary (Sweden). The other two had immense problems with bad debt in good times (Japan and China, if I recall correctly). It turns out that the profit motive does help banks make good loans.
> "But our current system has clearly failed, something needs to be done, time for another experiment."
Our system has produced the most prosperous society in the history of the world. It did a bad job reacting to a novel circumstance. It needs to be patched, not scrapped.
>"Talking about possible solutions on a website is pausing, it's not like we're implementing policy here or anything. It's just an interesting things to speculate about."
There are a few places where temperate, informed discussion of these issues take place. None of them has little voting arrows to click on next to the content, nor do they exchange information in short soundbites.
All of finance, of course not, I was talking about the bad ones, the criminals.
> What we have now needs some tinkering, but it is immensely better.
You'll note, I was discussing tinkering. When I say our system has failed, I don't mean throw out the whole system and start over. I was specifically talking about tinkering with how large we allow the banks to get. Me thinks you're over reacting a bit and assuming I'm wanting to completely change the current system.
Ah yes, the classic "I know I'm right and we just need to try harder and better and it'll work next time" argument.
The problem with that argument is that it is too powerful. It applies to everything, equally. Consequently, it's a null argument.
If you want to argue about this, you need to be more specific and not just wave this magical "Staples Easy button (TM)" at the problem.
I was proposing a specific solution, limiting the size of the banks so we keep our current system but not allowing it to get too dependent on any one bank to eliminate single points of failure. Perhaps you missed that part.
Because you make bad arguments does not imply that the only alternative is to do nothing, or that that is my opinion. That's just a non-sequitor.
My calling that into question doesn't mean "I know I'm right and I'm ignoring your evidence". Nor does the fact that a similar but not identical process been tried in the past infer that all such attempts with different constraints would fail in the future.
It's not a null argument, that's absurd. That's like saying we tried pay per click once on our site years ago, it didn't work, and holding that up as evidence that pay per click won't work for any site ever. My rebuttal was a valid response to the history cited.