Not all AIGs in one basket

Wall Street continues to feel the tremors from a week of turmoil. The US government, after allowing the bankruptcy...

Wall Street continues to feel the tremors from a week of turmoil. The US government, after allowing the bankruptcy of investment bank Lehman Brothers, has once again turned to rescue operations 8212; the Fed announced a bailout package for America8217;s biggest insurance firm AIG on Wednesday. The question being asked is the obvious one 8212;- Why rescue AIG and not Lehman? The simple answer is that AIG could not be allowed to fail because its failure posed a much bigger risk to the entire financial system than Lehman8217;s failure did.

At the heart of the explanation for why AIG8217;s collapse poses a wider systemic risk is a financial instrument known a credit-default-swap CDS. At a conceptual level it is similar to insurance. There is a buyer and a seller8212;-the buyer by paying a certain fixed fee to the seller like an insurance premium can insure his assets, say a bank8217;s loan portfolio, like getting fire insurance for your house against the possibility of a default by a third party if your house catches fire by accident. The seller, in return guarantees, repaying the loan should there be a third party default on it.

AIG, in a filing to US regulatory authorities, had declared that out of 441 billion dollars worth of credit default swaps in its portfolio, 307 billion were derivatives written to banks, primarily in Europe but also the US. This was not so much for the purpose of risk mitigation which is what it normally should be for. It was, in fact, according to AIGs declaration, meant for 8220;the purpose of regulatory capital relief 8212; in exchange for a minimum guaranteed fee, the counterparties receive protection for their diversified loan portfolios improving their regulatory capital position.8221;

In plain English, banks were buying insurance against the possibility of borrower default which they hoped would convince regulators that their loans were of low risk 8212; and indeed some of them were prime, not subprime loans. If the regulators bought the argument, they would permit banks to lend more in proportion to their capital base.

Now, if AIG were to collapse, there would obviously be questions about whether it can back up its commitments. Downgrading of AIG8217;s ratings have anyway had an impact in increasing the perceived riskiness of the loan portfolios of these banks which had CDSs with AIG. Regulators may have been forced to ask banks to thus raise more capital, which could have put a whole bunch of big and small banks in a spot of trouble with the threat of liquidity problems and a collapse. The possibility of a number of banks sinking at the same time is quite different from the prospect of a single firm going bankrupt 8212; AIG would have taken many down with it, and brought on a truly global financial crisis 8212; rather than a crisis restricted to a few firms on Wall Street Lehman8217;s bankruptcy would not have had such a contagion effect 8212; hence, the rescue was timely and sensible.

Apart from this, AIG wasn8217;t as insolvent as Lehman even though it was struggling for liquidity. A number of arms of AIG actually made good profits, including a large aircraft leasing unit. Its general insurance business was fairly solid too, and made large profits in Asia, including India. There was no good reason for all of these to sink. Still, critics of bailouts will be unhappy. However, AIG8217;s rescue has been conducted very skillfully which should answer the critics satisfactorily.

The main critical argument is that the AIG rescue creates and perpetuates the problem of moral hazard if you know that insurance will pay for your house if it catches fire, you may not have the incentive to take enough care to prevent a fire. Similarly, it is argued that if managers and shareholders know a rescue is imminent, they will not do enough to prevent a crisis. Lehman8217;s managers were caught waiting for a rescue which never came 8212; a good lesson. But then why turn the other way with AIG? The truth is that those who needed to be punished have taken a beating with the government8217;s rescue plan. The temporary nationalization 8212; the government has taken an 80 per cent stake in return for a 85 billion loan 8212; has resulted in a rout of the shareholders who have got nothing. The management is also being replaced under the new ownership.

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Yet, a system wide collapse has been prevented without creating moral hazard. Very creditable indeed. This is plainly better solution than the moral-hazard inducing one of giving cash to existing shareholders and management. In fact, the nationalisation of AIG, and that of Freddie Mac and Fannie Mae earlier, should prompt managers and shareholders, the biggest losers from government take over to take greater care in decision-making, and not undertake imprudent risk in the future.

So, a good few days for American policymakers 8212; Hank Paulson and Ben Bernanke in particular 8212; quite in contrast to the financial sector. There is still much reason for optimism over the medium term 8212; one mustn8217;t forget that capitalism works in cycles and every now and then some 8216;bad eggs8217; need to exit the system in as orderly a fashion as possible. Once that happens, and other firms restructure and restrategise, things will begin to get back to business-as-usual with the necessary corrections.

dhiraj.nayyarexpressindia.com