Opinion

Felix Salmon

Why AIG Wasn’t Allowed to Fail

Reuters Staff
Mar 17, 2009 12:38 UTC

Justin Fox wonders whether we should have just let AIG fail — or at least the holdco and the AIGFP subsidiary. They certainly deserved to fail. So why did we bail them out? Because of the systemic fragility of the CDS market, is the answer — it’s basically the same reason why the government stepped in to prevent Bear Stearns from being forced into liquidation. It feared a cascade of counterparty failures which could kill the entire financial system.

Here’s the fear: AIG goes bust, and can no longer make good on the promises it made when it said that it would pay out on a CDS contract in the event that a certain credit defaults. Default protection sold by AIG, in other words, becomes worthless. Now let’s say you’re a CDS desk at, say, JP Morgan. You’re buying and selling default protection all the time, and so long as the amount you’ve bought, on any given credit, is equal to the amount you’ve sold, you reckon that you have no net exposure.

The minute that AIG fails, everybody else’s net position alters substantially, and in a very unpredictable way. The protection that JP Morgan bought from AIG is worthless, while the offsetting protection that JP Morgan sold to some hedge fund remains outstanding. So JP Morgan now has a large position it never wanted.

Now there’s a good chance that JP Morgan will have hedged its counterparty risk to AIG — but that doesn’t make the risk go away, it just shunts it elsewhere in the financial system. And the web of connections between the thousands of counterparties in the CDS market is so complex that no one really has a clue who would have ended up holding the multi-billion-dollar bag. All those AIG losses which are currently being borne by the government wouldn’t have disappeared if AIG had failed: they would simply have turned up somewhere else in the financial system.

But no one would have had a clue where in the financial system, exactly, those losses would have ultimately come to rest. And given the magnitude of the losses, you can be sure that no one would have wanted to have any kind of dealings with the poor schmucks who ended up on the hook for all those billions of dollars. And since those pooor schumcks could be pretty much anybody, no one would do any kind of business with anybody else: you’d get settlement risk run amok. The entire global financial system could grind to a halt overnight, due to the inability of any given institution to persuade any other institution that it was actually solvent.

We don’t know for sure that this kind of worst-case scenario would have happened if AIG had been allowed to fail. But we don’t know that it wouldn’t have happened — and the US government felt that it simply couldn’t take that kind of risk.

What’s more, bailing out AIG had the pleasant side-effect of putting the entire global CDS market on a much stronger footing. Remember that CDS, like all derivatives, are a zero-sum game: for every loser, there’s an equal and opposite winner. Very few institutions were net sellers of protection; AIG was by far the largest. So what that means is that the rest of the CDS market, ex AIG, is now a net winner to the exact extent that AIG is a loser: a hundred billion dollars or more. Given worries about the fragility of the CDS market and the systemic risks that it posed, bailing out the single largest net seller of protection essentially meant injecting a large amount of government cash into the part of the market that regulators were most worried about. It was quite an elegant solution, in its way: rather than trying to unpick the CDS knot institution by institution, you could just bail them all out at once by backstopping AIG.

Remember that what regulators were most worried about at the time was systemic risk. Whether or not AIG deserved the money was pretty much beside the point: the key thing was that if it didn’t get the money, the entire global financial system would be put at risk of collapse. In which light, the cost of the AIG bailout looks positively modest, compared to its benefit.

Reprinted from Portfolio.com

How Much Worse Can AIG Get?

Reuters Staff
Mar 17, 2009 09:09 UTC

Today is a day for dark warnings about what might happen at AIG should the bonuses not get paid:

"It’s going to blow up," said a senior Financial Products manager, who spoke on condition of anonymity because he was not authorized to speak for the company. "I have a horrible, horrible, horrible feeling that this is going to end badly."

Um, hasn’t it already ended badly for AIGFP? Hasn’t the unit already lost hundreds of billions of dollars and effectively bankrupted its parent? How much worse can things get? Well, let’s ask Andrew Ross Sorkin:

If you think this economy is a mess now, imagine what it would look like if the business community started to worry that the government would start abrogating contracts left and right…
Here is the second, perhaps more sobering thought: A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it.
A.I.G. employees concocted complex derivatives that then wormed their way through the global financial system. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it.
So as unpalatable as it seems, taxpayers need to keep some of these brainiacs in their seats, if only to prevent them from turning against the company.

This is overstated. No one is saying that the government should start abrogating its contracts — which is to say, the contracts entered into by the government. But if a company runs itself into the ground by entering into all manner of bad contracts, and it’s then taken over by the government as the only alternative to letting it fail outright, the case for honoring those contracts is much weaker, and the precedent of reworking some of those contracts does not mean that "the government would start abrogating contracts left and right".

As for the bomb metaphor, the bomb has already exploded. It’s far too late to defuse it. The job of the highly-paid employees at AIGFP is simply to clean up the mess, post-explosion.

Since they know where the shrapnel has landed, are they well placed to "trade against A.I.G.’s book" should they leave? Yes, probably. But AIG is still an insurance company, and AIGFP is, at heart, an insurance company in run-off. It’s hard to trade against such a thing.

Now it’s possible that AIGFP still has a large trading book holding lots of positions which need to be unwound in a relatively short period of time. And it’s also possible that those positions are so complex that only the people who put them on are really qualified to unwind them. But no one at AIG has really come out and said this. So unless and until I’m told that this is a major problem by someone qualified to make that determination, I’m going to stick with my view that the dangers of not paying these bonuses might not be all that great.

Reprinted from Portfolio.com

Goldman Wealth Datapoint of the Day

Reuters Staff
Mar 17, 2009 08:12 UTC

Truly the recession is biting:

One former Goldman partner estimated that a quarter of the bank’s roughly 100 partners are now worth $5 million or less because of losses on their company stock and other investments.

The good news is that Goldman is letting them borrow money against their future income, which is going to be substantial, even if it doesn’t ever regain the giddy heights of the past few years. But still, less than $5 million? There are lawyers who are worth more than that!

Reprinted from Portfolio.com

Are You Qualified to Make Stock Forecasts?

Reuters Staff
Mar 17, 2009 00:04 UTC

In the wake of Nouriel Roubini’s latest 6,000-word jeremiad on the subject of the fate of the stock market, Joe Wiesenthal writes:

Here’s the real question: What on earth are Roubini’s qualifications to make stock forecasts?
The dude’s an international economist.
I understand your desire to defend him against the mob, but can you justify him [giving] buy/sell advice as he did in his latest piece? Or giving quotes like, "equities will decline by 20%"
It’s hogwash.

Well, yes, stock forecasts are hogwash: nobody knows where stocks are going. But that’s precisely why it’s silly to single out Roubini for criticism on that front.

People make stock forecasts every day, normally because they have some kind of financial interest in doing so. (Roubini certainly does: he’s a highly-paid pundit, and there are many people who want to know where he thinks stocks are headed.)

The forecast part of any stock forecast is worthless: if you reduce a piece of research to its buy/hold/sell recommendation, you’re basically stripping it of all its added value. Insofar as stock forecasts are interesting or useful, it’s because of everything else they contain: the reasoning behind the forecast. And whatever you think about Nouriel, his pieces contain a very great deal of reasoning.

What’s more, Roubini’s forecasts do have the added benefit of having been right of late. He’s clearly on a roll here, and he’s going to continue to be right, until he’s wrong; what’s more, there’s no real reason to believe that his streak has come to an end. So if you believe that any stock-market forecasts have value, you might well be interested in Nouriel’s. If you don’t believe that any stock-market forecasts have value, then there’s really no point in picking on his in particular. But anybody — or nobody — is qualified to make stock forecasts. There’s no elite stock-forecasting club into which only a select few have been inducted.

Reprinted from Portfolio.com

Why Houses Now Are Like Stocks in 2002

Reuters Staff
Mar 16, 2009 15:39 UTC

An astute comment comes today from wcw, whose blog seems to have sadly gone dormant:

Bubbles are hard to squash. The Case-Shiller 10-city composite remains 70% higher than ten years ago as of December. Equities, on the other hand, are down -30% over the recent ten-year period — and that’s with dividends reinvested. You are better off, I posit, with $500k in stocks right now than owning a home instead of renting. The equity bubble, in other words, has finally popped. The housing bubble, not so much, just as the equity bubble hadn’t actually popped yet in 2002.

Analogies are dangerous things, but this is a good one: houses now are like equities in 2002. Prices are down substantially from their highs, and a few of the most bubblicious assets (dot-com stocks, Miami condos) have imploded spectacularly, but the faith of the general public in the asset class as a whole has not been shaken.

What’s more, nominal house prices are being supported by artificially low interest rates and massive government intervention: the housing market is truly too big to fail, and if the bubble is going to burst, it’s going to have to do so very slowly, over many years, through the combination of modest nominal price declines alongside a good dose of inflation.

The house-price decline that we’ve seen to date feels particularly bad because so many Americans bought or refinanced their houses during the boom years, leaving a thin sliver of equity which has long since evaporated. If you put your life savings into buying a house, then a 20% price decline can wipe those savings out entirely; if you put your life savings into an S&P 500 index fund, then a 50% price decline still leaves you with half your money.

But a look at how far house prices rose over the past decade or so is all it takes to see how much downside still remains. Price-to-rent ratios are still far too high, especially since rents in many places are falling as quickly as prices. And in New York City, for one, prices have a very long way to fall:

A review of preliminary figures for the first quarter, through last week, put the average condo closing price at $1.82 million, with a median price of $1.195 million. The average price was about 14 percent above that of the second half of 2008, and only 4 percent below the peak average price in the first quarter of 2008, when many apartments were closing at very expensive new developments like 15 Central Park West.

These kind of pockets-of-bubble don’t exist in the stock market any longer: it’s been well and truly squashed. Certainly, the stock market can continue lower — and it’s even possible that house prices will rally, much as stocks did between 2002 and 2007. But looking out over the long term, the long-equities, short-housing arbitrage still seems to be a smart trade to put on right now.

Reprinted from Portfolio.com

How to Not Pay the AIG Bonuses

Reuters Staff
Mar 16, 2009 12:53 UTC

Barack Obama is a lawyer — and a very good one, too, by all accounts. Andrew Cuomo, too, is a lawyer, and is attorney general of New York. And neither of them seem remotely impressed by AIG’s protestations that it’s contractually obliged to pay out $165 million in bonuses to members of the very financial products group which brought the company to its knees.

Is there a legal way to stop these payments being made? I don’t know. Cuomo’s attempt to paint the bonuses as "fraudulent conveyance" seems like a bit of a stretch, while a legislation trying to retroactively claw the bonuses back would easily pass Congress, only to face certain appeal on the grounds of being unconstitutional.

But right now, even Cuomo hasn’t seen the contracts which AIG is convinced are so ironclad. And it might just be the case that AIG’s contractual obligation to make the bonus payments is a bit like an underwater homeowner’s contractual obligation to make his mortgage payments. If AIG simply didn’t pay the bonuses, would the employees of the financial products arm really fancy their chances in court were they to sue to receive them?

It’s possible that they would "win" such a court case — if by winning you mean having your picture splashed across every TV screen in the land as an exemplar of out-of-control greed and avarice. Which is why AIG could probably have quite a persuasive conversation with the AIGFP employees, along these lines:

"We know we promised you this money, but it’s clearly politically impossible for us to pay it to you. So you’re not getting the bonus you were counting on. Sorry about that. At this point, you have three choices. You can continue to work for us, and keep your job. You can quit, and find a better-paying job elsewhere. Or you can quit, and sue us for the bonus that we promised you. Your call. But if you choose the third option, you’ll probably want to hire a PR person at the same time as you hire a lawyer."

I suspect that most of the affected employees would not sue AIG, and that the bonus payments would therefore be saved. It’s hardball, but it might well be effective.

Reprinted from Portfolio.com

Stanford’s $4 Million Victim: His Nonexistent Lawyer

Reuters Staff
Mar 16, 2009 12:22 UTC

Alan Stanford, obviously, needs a lawyer. But his assets have been frozen, so he can’t afford one. It’s just not fair, according to one lawyer Ashby Jones spoke to:

The lawyer we spoke to said while he’d “love to get involved,” the money simply isn’t there. “You’d need $3 or $4 million to really get this case off the ground in the way it needs to be handled. And it’s not there.”
The lawyer said he thought it was “totally unfair” for a judge to authorize the freezing of money without allowing Stanford access to money to pay a lawyer.

I think I might have met this chap at a party once: he told me he was a criminal lawyer, and I asked him if he’d ever thought of going straight. Clearly not.

Reprinted from Portfolio.com

The Roubini Portfolio

Reuters Staff
Mar 16, 2009 12:11 UTC

Is Nouriel Roubini really 100% invested in equities, as Eddy Elfenbein and John Authers think? I asked him directly, and of course it’s a bit more complicated than that.

Roubini, as a professor at NYU, has a 401(k) — and that is invested in a broad range of domestic and international equities. Whatever percentage of his NYU salary that Roubini puts into his 401(k), then, will indeed be allocated 100% to equities. But apart from that, Roubini is 100% in cash. He’s a boldface name these days, in high demand as a speaker around the world, and all those speaking fees — which I should imagine add up to a substantial sum over the past three years or so, and which undoubtedly dwarf his 401(k) contributions over the same timeframe — have gone into nothing but cash.

What’s more, Roubini has a large equity stake in his company (and my former employer), Roubini Global Economics. Does that count as being "invested in equities"? Or is it more what Barbara Kiviat is talking about when she says that increasingly our jobs are our most important asset?

My feeling is that Nouriel, like me, is at heart old-fashioned when it comes to money: we don’t believe we can beat or time the market, and we reckon that the best way to improve our net worth is to make money on the labor market, spend less than we earn, and save the difference. Gone are the days of making more money from your home than from your job: now we all need to go back to working for a living.

Reprinted from Portfolio.com

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