The Black Hole: AIG
In astronomy there is a phenomenon known as a black hole. Black holes are very massive concentrated matter. They are so massive that nothing that ventures too close can escape destruction. The sheer gravity of the black hole pulls the object into a death grip that stretches the object thinner and thinner until only a stream of atoms races inward to the voracious hellhole. Berkeley’s Ted Bunn characterizes trying to escape a black hole this way, “You might try to avoid it by firing your rockets, but it’s futile: no matter which direction you run, you can’t avoid your future. Trying to avoid the center of a black hole once you’ve crossed the horizon is just like trying to avoid next Thursday.” Thus, the most effective method for avoiding being destroyed by a black hole is simply to not get too close to one.
The insurance giant, AIG, is a financial black hole. It possesses an insatiable appetite for capital. It consumes cash, appears to be extremely dangerous, and may be ripping the financial markets to shreds. G.W. Bush positioned the federal government perilously close to the AIG black hole and now the government is too heavily invested to allow the company to die. We keep hearing that AIG is too important an asset to allow it to die. In essence, we are told, AIG is the foundation upon which the U.S. economy rests. Now, we the people, (or is it the federal government – the two don’t seem to be the same anymore), are left with an 80% stake in a failing company with losses that seem to have no limit.
At the heart of the problem is AIG’s Financial Products unit. AIG-FP has been losing torrents of money in something most of us never heard of, Credit Default Swaps. CDS, as the company refers to them, are essentially, a credit derivative. Much like an insurance policy, the purchaser pays the seller a premium for protection against financial default. The problem arises because credit default swaps are not regulated, are highly volatile, and in a recession, extremely likely to be paid. AIG has had to pay out nearly $100 million more than it has billed for CDS policies in the past five quarters. This is not only due to the high number of business failures, but because payouts can be triggered by much more than default. If a covered business goes bankrupt, undergoes a restructuring, or simply has its credit downgraded. Like a life insurance policy, the buyer pays premiums until a credit event triggers the insurer to make a payment. At that time, AIG would pay the amount of the loss and the insured stops paying on the policy. There is no way to recoup the loss. This even sounds like a bad idea. Perhaps, in a booming economy, this might seem innovative and smart, but in recent years?
Fed Chairman, Ben Bernanke, described it this way, “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.” What I don’t understand is how any smart CEO could or would have endorsed such a product – regardless of regulations.
So who is responsible? Is it former CEO, Hank Greenberg or current CEO Ed Liddy? If you listen to either of them, it’s obviously the other guy. Liddy complains that Greenberg is responsible since the financial products unit was created during Greenberg’s tenure. Greenberg counters that he had “risk controls” in place and those were eroded or removed after he left the company. Risk controls or not the entire concept is insane. CDS policies encourage companies to engage in risk-taking they might otherwise avoid. These policy holders know AIG will absorb the cost of any wreckless action on their part. Simply put; Greenberg set the company up for failure and as an unintended consequence the entire world economy.
Greenberg moved the company out of the safe secure well-established insurance business and into the uncharted and unlimited risk world of CDS. At the time Greenberg was forced out, there were both internal and external investigations swirling around Greenberg. Greenberg refused to cooperate then and has since been fighting charges coming from various sources. Clearly, Greenberg set the company up and Liddy has done little to stop the implosion aside from trying to take down the entire U.S. government with him.
Since September, AIG has sucked up $180 BILLION in taxpayer dollars and shows every sign of wanting more. But why? To herald back to the second paragraph it is because, we are told, if AIG defaults, then all those companies who bought CDS would be faced with billions in loses and would collapse. Not to mention the 30 million U.S. policyholders with coverage we can relate to, such as life, property, auto, and the like. Thus, by saving AIG the government is effectively saving hundreds of other companies as well as ordinary citizens. So, the AIG bailout isn’t really about AIG, it’s about the economy in general. There you have it; the Obama administration has adopted the Bush policy.
In a joint statement defending the AIG bailouts, the Treasury Department and the Federal Reserve said, “Given the systemic risk AIG continues to pose and the fragility of markets today, the potential cost to the economy and the taxpayer of government inaction would be extremely high.” But what of the risk involved in owning a company with such high-risk assets? What is a reasonable estimate of our potential losses? I don’t hear any estimates coming from AIG or the government. Why is no one asking this question?
Joe Nocera, in his blog, Executive Suite, asked, “Who bought the credit default swaps?” Knowing this might allow investors and American citizens to estimate our potential losses. The question seems not only valid but also important. According to Nocera, an unnamed government official claimed releasing this information “would amount to a violation of the Trade Secrets Act – unless the counterparties agreed to it, which they never will.”
There appears to be some frustration with AIG at the Fed. Yesterday, the normally cool Bernanke told a Senate hearing, “I think 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.” However, the overall theme was continued bailout money to “to avoid a much more severe crisis in our global economy.” He offered no answers on how to end this or how deep the problem is.
It is no surprise then that the markets continue to plunge. So far, five straight days of negative performance and numbers we have not seen since the mid-90s. The reason is clear; investors have no faith in Obama’s plan. They the problems in the economy are worse than the rest of us can understand. They also know that AIG’s huge losses are an indicator of just how bad the economy is and that does not support optimism in investments. When that black hole stops sucking we’ll have a good indication that the economy is stabilizing, until that time all we can do is watch our money wither away.