Snake Eyes for the Taxpayers
I’ve devoted two posts in praise of Joe Nocera for helping the economically challenged (like me) gain a bit of knowledge (I almost said “leverage”) about the mess we’re in.
Now, to show I’m an equal-opportunity-praiser, let us now praise Gretchen Morgenson. She writes in today’s Times about, you guessed it: A.I.G., and concludes:
When you look back with the benefit of hindsight, it is truly amazing how outsized A.I.G.’s insurance commitment was, at $440 billion. After all, in 2005, when A.I.G. put many of these swaps on its books, the market value of the entire company was around $200 billion.
That means the geniuses at A.I.G. who wrote the insurance were willing to bet more than double their company’s value that defaults would not become problematic.
That’s some throw of the dice. Too bad it came up snake eyes for taxpayers.
The irony is that people there who warned that the leverage levels were too high were probably told that they were being alarmists and that it was in the interests of the stockholders not to leave money on the table. People who persisted were probably punished. And within the logic of the market, the directors were quite right.
In 1995, I was Director of Research and Risk Management for a commodity trading fund. I was asked to look into the possibility of branching out into the over the counter market for SWOPS. Even then, everyone knew that this unregulated market with its exotic investment instruments carried far more risk of a meltdown than even the commodity market. I was not risk adverse myself; I started as a commodity trader in some very volatile markets. But I reported at the time that we could not manage the risk using any of the risk management tools that we had at our disposal at the time. We did not end up going into that business.
I may look prescient now, but I was wrong from the point of view of the company. We would have made a killing these 12 years. We might have wiped the shareholders in the end, but during the ride we would have picked up massive salaries and bonuses. And no one would have been forced to invest with us.
I can envision now the directors of that company scrambling like the rest of us to hold onto a job. Their argument to the stricken faces of the investors as they explain away that last large bonus package would be “it would have been worse without us”. And if they had been big enough to have bought some politicians in Washington, they would be there arguing that the Free Market requires that they, them, themselves need to have a high place in the New Order and their losses covered by the taxpayer because, well, who knew?
To me, this story illustrates yet another inadequacy in our current financial industry regulatory regime. There is no federal equivalent of the Federal Reserve or the SEC charged with regulating the insurance industry. Insurance companies are regulated by the several states. Yet companies like AIG are multinational in the scope of their business activities.
National banks are required by federal law to keep a certain percentage of their deposits as cash reserves. Among other salutary outcomes of this policy, the reserve requirement serve as a brake on imprudent lending – the money in reserve can’t be loaned out, and the bank can’t lend out an amount that would put them in violation of the federally-mandated ratio.
Insurance companies are very familiar with reserve requirements, they maintain reserves for all sorts of liabilities and expected liabilities. But clearly their financial self-regulating failed in the matter of credit default swaps. Perhaps federally mandated reserve requirements would have limited AIG’s ability to underwrite swaps that far exceeded the total value of the enterprise.
Thank you both for your helpful further remarks!
AIG was NOT just an insurance holding company. It was and is a financial conglomerate with securities and depository institutions within its group of companies. One of those companies was a savings and loan regulated by the Office of Thrift Supervision (OTS) in the US Treasury Dept. as well as its insurance companies. OTS regulated AIG as a thrift holding company in much the same way that the Federal Reserve regulates bank holding companies. Among other things, the OTS was supposed to be looking at the umbrella structure of the holding company, AIG, its capital condition and general financial health. As part of this OTS did review the activities of AIG’s London subsidiary but apparently failed to appreciate the risks that the financial activities of this sub posed for AIG.
Under the Savings and Loan Holding Company Act, the Director of OTS has the authority to impose certain restrictions on a holding company or ANY OF ITS SUBSIDIARIES, if there is reasonable cause to believe that an activity by the holding company or a subsidiary constitutes a serious risk to the financial safety, soundness, or stability of a subsidiary thrift. See 12 U.S.C. § 1467a(p)(1). The Director of OTS has the power to order the termination of the affiliate’s activity or divestiture of the affiliate, after notice and opportunity for hearing. 12 U.S.C. § 1467a(g)(5). Thus, the Director of OTS could have forced AIG to rein in the activities of its London subsidiary if he concluded that they threatened the financial stability of AIG’s saving and loan. OTS publishes a Holding Company Handbook (see http://www.ots.treas.gov/?p=HoldingCompanyHandbook) that outlines the procedures that its personnel are to follow when evaluating a thrift holding company. It includes a special section on dealing with holding companies that are also insurance holding companies, which discusses some of the items that the states consider when evaluating insurance holding companies.
OTS admitted back in November and again last week that they failed to recognize the risks posed by the London subsidiary when they were reviewing AIG’s holding company structure. See http://articles.moneycentral.msn.com/Investing/Extra/was-aig-watchdog-not-up-to-the-job.aspx and http://www.washingtonpost.com/wp-dyn/content/article/2009/03/05/AR2009030503264.html
The state insurance regulators in the 50 states also are supposed to engage in some oversight of insurance holding companies like AIG, which meant that they should have been considering the activities of the London sub when reviewing the holding company’s financial condition. For example, New York State regulated AIG through its insurance regulators. Under New York law, AIG as a holding company for insurance companies licensed to do business in New York had to report its financial condition to the New York insurance regulators on an annual basis.
Part of the problem is that regulators in each of the three main silos in the US regulatory structure – banking, insurance, and securities – are not as well versed in the businesses of the others and are not well equipped to analyze the risks (credit, market, systemic, etc.) posed by hybrid products, like credit default swaps, as a result.
Creating a new federal agency to deal with insurance would NOT solve this problem. We need to move away from agencies based on outdated labels and to a system agencies that regulate based on the risks posed by financial products and firms (prudential, market conduct, systemic, etc.). I discuss this at length in the following article: Brown, Elizabeth F. ,The Fatal Flaw of Proposals to Federalize Insurance(2007). U of St. Thomas Legal Studies Research Paper No. 07-25. This article is available for free at SSRN: http://ssrn.com/abstract=1008993
Professor Brown, thank you for your comments and links. I wasn’t aware that AIG was in the thrift business and therefore subject to OTS oversight. So whereas I had suggested that this is an example of a regulatory vaccum, you believe it is rather an example of regulatory incompetence.
I don’t have a lot of faith in the ability of individual states to effectively regulate a large multinational. But I admit that I’m jaded in that respect by living in Ilinois!