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Paulson’s folly: Throwing good money after bad at AIG

By Reuters Staff
November 10, 2008

morici– Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission. The opinions expressed are his own. –

By Peter Morici

The Treasury is injecting another $27 billion into AIG and raising the taxpayers’ investment to $150 billion. Secretary Paulson appears more intent on helping his pals on Wall Street than protecting taxpayer interests.

AIG has solid businesses in industrial, commercial and life insurance, but like a lot of financial firms, was attracted to easy profits writing credit default swaps on mortgage backed bonds—so called collateralized debt obligations (CDOs).

AIG received fees to guarantee repayment of those mortgages, or the funds obtained through foreclosures when homeowners defaulted. Like most on Wall Street, AIG executives believed home prices would rise faster than household incomes forever, so these CDOs really bore little risk.

This credit default swap business was outside AIG’s highly-regulated, solid insurance businesses but was backed by the value of those businesses. Essentially, if the CDOs fell too much in value, AIG pledged the value of those businesses.

If an abnormal number of the mortgages failed, the held to maturity value of the CDOs would fall, and obligations would trigger for AIG to post collateral. When that happened in 2007, AIG deposited cash or other liquid assets with the investors holding the CDOs. With the housing market so depressed by the summer of 2007, AIG could not raise enough cash to meet all its obligations.

On September 16, the Federal Reserve provided $85 billion in loans to AIG in exchange for warrants—the right to buy common stock—equal to 79.9 percent of the company.

AIG was to pay 8.5 percent above Libor for the first $85 billion. AIG was to use the loans to honor obligations to holders of the credit default swaps, and AIG was to sell parts of its insurance businesses to repay the loans to the Federal Reserve. That loan proved inadequate, and the Fed advanced another $38 billion on October 9.

The $123 billion was not enough to finance AIG’s short-term credit default swap obligations, and it cannot sell enough pieces of its good insurance businesses to pay back the Federal Reserve in the current environment.

Now, the Federal Reserve and Treasury are agreeing to restructure $60 billion of the original loan, lowering the interest rate to 3 percent above Libor and invest about another $27 billion AIG.

The interest rates on the loans were lowered, in part, because large shareholders complained about heavy handed government action.

The monies will be used to set up two special funds. The first will seek to buy up some of the CDOs that have declined in value for about 50 cents on the dollar, permitting AIG to recoup its collateral paid in cash. This fund will not buy up the most troubled CDOs, whose values are even lower than 50 cents on the dollar.

The second fund will be used to solve liquidity problems at AIG’s securities lending business. It rents securities to short sellers in the stock markets.

This is all folly.

The government assumes greater risks without getting benefits for the taxpayer. Many firms who purchased the original credit default swaps from AIG have used the collateral posted by AIG on the less risky CDOs for other purposes and may not want to sell AIG their CDOs. Also, many of the swaps have been resold to firms that don’t hold the CDOs, as part of complex derivatives transactions.

The short selling business is a whole new headache, and it should make taxpayers ask, what else is lying around at AIG.

If the deal works out, AIG executives get to keep their jobs; but if the plan fails, the U.S. government may get stuck holding the bag on billions of dollars of false promises to pay from AIG. Its warrants may prove not worth very much as AIG’s obligations overwhelm the value of its businesses.

If AIG can’t make it on the money the taxpayers have already apparently squandered, then the Treasury should simply exercise its warrants, take control of AIG, and sell off AIG’s solid insurance businesses for what they are worth. The Treasury can buy back the CDOs for common shares in the company and reorganize the new AIG with more responsible management.

The executives at AIG certainly have not behaved well since the first bailout. They have enjoyed lavish golf retreats in California and luxurious hunting trips in Britain.

While Americans make monthly tax payment to Washington, AIG executives hunt quail on the English countryside.

Comments
15 comments so far | RSS Comments RSS

Say no to these bailouts. This approach that the feds are taking is nothing but a bottomless pandora’s pit of trouble.

By Marion TD Lewis, Esq.

 

how could our congress allow this to happen to our tax dollars. it’s hard to believe it’s happening.

Posted by alex habibe | Report as abusive
 

One reason why these bailouts dont work is because the companies that are granted this privilege do not profit from it.

They are given the money by the government, expect them to use that money to pay back debt to shareholders and CDO holders and within less than 3 years, return the loan to the government. If you do not see the problem yet, its just simply shifting the debt. Nothing has changed, the company still doesn’t make money, of course it seems like a bad solution because it is one.

What the government should do is extend the loan period, maybe 5 years, to give time to companies like AIG to earn back consumer trust to make profit so that the debt can really be cleared off instead of as stowing it aside for 2 years.

Posted by Maurice | Report as abusive
 

These bailouts should be stopped. It’s like reviving a dead man time and time again. Your government is pledging money left and right without a hope of ever paying it back. It’s the drunkard let loose in the bottle store.
I bet a large portion of the obscenely large amounts are used on the stock exchange manipulating a stock market that must surely sink.
Leave it alone and get it over with, for the current system has been shown to be utterly corrupt, and will implode irrespective.

Posted by G. Kaiser | Report as abusive
 

The bailout will not work for the common man because everyone is operating on personal greed. The fat cats and their pals in the government will mooch the taxpayer dollars and leave.
Who authorised the reduction in the interest rates? My bank would not reduce the rate on my loan after it has been issued, much more so if I was asking them to double my credit line. What nerve?
This is the wrong way of doing things. The experts are all crooks and they are out there to sweep the broken glass under the carpet. =(

Posted by Himanshu | Report as abusive
 

Not good business! Who got the 3 trillion gollars that Paulson forwarded last week? Please, who is minding the store? Are we in to dep since October to turn around?

Posted by Wm Hancock | Report as abusive
 

We, as US taxpayers, are getting painted into a corner by these bailouts, and application of tired Keynesian stimulus principles. Down the road not very far there will be only three options-Raise taxes, repudiate debt or quit spending, and the more “solutions” of the type we are seeing, the bigger the size of the problem.
This is obviously the mother of all Black Swans and Minsky Moments and our government is beginning to make collapse look like the best alternative.Continuing down the current path is just a process of moving the net worth of those who saved into the hands of those who made investment mistakes, and those who facilitated the mistakes.

Posted by Gary Leeper | Report as abusive
 

A neighbor of mine with a kid has just been thrown in the streets because he lost his job abd could not afford his mortgage any longer while these arrogant AIG executives are out there enjoying taxpayers money. Somebody has got to put a stop to this. The whole company should be investigated and the executives should be held accountable and prosecuted.

Posted by Anna | Report as abusive
 

I find it interesting that on the one hand, they wanted the government to bail them out, and on the other, the large shareholders complained about heavy handed government action. If you ask for a favor, you don’t always get to dictate the terms.

As a small business owner, if I make bad decisions, I have to live with the consequences. When there are no consequences for bad management, it becomes acceptable. We should not bail them out.

Posted by Julie Gross | Report as abusive
 

folks, this is only going to get worse under the new administration. they wont stop here. now its autos (and you and i both know the best thing that could happen for them would be to declare bankruptcy)and where do they stop. the feds have loaned out under pretenses of “top secret” 2 trillion dollars somewhere to hide this. we have to somehow take our country back. the revolution is coming.

Posted by d a hick | Report as abusive
 

It is obvious that throwing money at every problem is like the investor panaking and selling at a huge loss. In a majority of cases time itself solves most problems. Had there been in place a government regulator to halt trading underspecified circumstances(such as companies whose price deterioration can affect the proper functioning of the financial market place)then substantial loss might have been averted to some extent. That type of action prevents a contagion effect and could have saved substantial loss to pensioners, municipalities and others relying upon an orderly income streams. That is not to say that companies with broken models shouldn’t fail.

Posted by edward m walsh | Report as abusive
 

Follow the money! Anybody remember the savings and loan bailouts about 3 decades ago? Incompetent people stayed in positions to continue their own self interest. Same thing here, but the “Doctors” behind the financial issues have to make money on their own advise, and, believe me, they will pin the blame on the taxpayers, as greedy, who should have known better, etc., etc. Paulson is a rat along will everyone else that says the taxpayers will bail them out! We don’t get to vote on it do we? Nothing but slaves in the 21st century… don’t you taxpayers love it? It’s time we taxpayers take up arms of a sort and force these degenerates out of our bank accounts!

 

Can someone just remove Paulson from his treasury position? So far, all he has done is to fatten the pay checks of his wall street fatcat pals, while draining the treasury.
Honestly can you really trust a cat to look after a pond of fishes?

Posted by M Foor | Report as abusive
 

Once the fat cats finish looting us for all we have (ably assisted by our representatives), they will sit back and watch the Second Great Depression. The money they’ve stashed will come in useful when the country slowly, painfully rebuilds itself with a new renewable energy based/manufacturing economy. Why is it these jerks never lose their homes?

 

If a time bomb exploded in a man’s hand, a doctor’s best advice is to amputate the failing limbs. Trying to save failing limbs only hurts other viable parts of the body and delays recovery.

Posted by American International Government | Report as abusive
 

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