And now, back to our regularly scheduled catastrophe. So what does the AIG takeover – not conservatorship, apparently – mean?
Let’s step back a second and understand the two risks the Feds have been trying to weigh in the balance.
On the one hand, if they allowed AIG to fail, that would not only be the largest corporate default in history, it would have global repercussions that nobody wanted to risk. Just to give one example: money-market funds are big owners of AIG debt. The money market industry is already in serious trouble because of Lehman. AIG would be at least an order of magnitude bigger hit.
On the other hand, if they ponied up money, that would be a signal to the rest of the banking system not to lend. After all, if you are a bank and are terrified of lending to another bank whose books may contain toxic debt, but you’re also terrified of the consequences of a major bank failure to yourself, now you know that the government will be there to lend when nobody else will. So why stick your neck out?
So the government opted for a mid-range solution, neither allowing AIG to fail nor simply giving them a loan. They gave them a loan, but it’s a loan that structurally subordinates all other debtholders and was made on the assumption that AIG will now proceed with asset dispositions as rapidly as possible in order to pay that loan back. And the government gets 80% of the company.
There are three possible outcomes from here with AIG.
Best case, the asset sales proceed in a timely fashion, the loan is repaid, and AIG gets back on its feet. In that case, the government will make a tidy profit on its equity stake and everyone will breathe a sigh of relief.
Mid case, the asset sales go poorly, but they go. The loan is repaid, but the remainder of the company is still unhealthy. Unsecured AIG bonds are still trading below 50 cents on the dollar; the market still thinks there’s a very good chance the company ultimately fails, and bondholders don’t get back their whole principal. In this case, the government gets back its loan, and the pain in the market isn’t as bad as it would have been if AIG had failed today, but much of that pain is just deferred rather than avoided.
Worst case, the asset sales don’t happen, and the government takes over a bankrupt AIG instead of getting back its money. This is unlikely, as AIG’s operating subsidiaries in its traditional insurance businesses are generally considered to be quite healthy. But if the macro environment really takes a leg down, this case could materialize.
But before any of the above happen, we are already seeing the negative consequences of the bailout for bank lending: it has stopped. LIBOR – the rate at which banks lend to each other overnight – has gone through the roof. Expectations are growing that Morgan Stanley will need to be sold (as of this morning, we were talking about HSBC; now we’re talking about merging with Wachovia, which isn’t too healthy itself) and even teflon-coated Goldman Sachs is not immune.
I do not want the Federal Government to run America’s financial system. I’m just funny that way; I don’t think the Russian/Venezuelan model is right for America. And that’s where we’re headed with this rolling bailout – not literally in that I don’t think we’re headed for a soft dictatorship, but in the sense that waiting for critical institutions to get to the point of failure, and then debating whether they are too big to allow them to fail, is a recipe for repeated failure and ever-increasing government ownership. The alternative to buying up failing institutions is to buy up failing assets. Obama thinks it’s premature, but I’m inclined to agree with Barney Frank that it’s time to start setting up an RTC-style entity to buy up mortgages and put a floor under the market. So I guess I mind it less if Uncle Sam is my landlord than I do if he’s my banker.
Once we’ve stabilized things, then we can talk about the right kind of regulation that should be imposed. About which more later.