Tuesday, September 16, 2008

Too big to fail meets too dumb to survive


AIG is generally regarded as very smart sophisticated insurance firm.

But how does a firm that big and bright make such a huge and dumb bet?

Future History
What will history tell us about what is really weighing down the stock of this firm? Is it really just sub-prime guarantees or is there something else? How many bad bets did their 'rocket scientists' make on other things? Sure glad these guys weren't there calculating trajectories for Apollo 13, or Tom Hanks might not be alive today (joke). Surely sub-prime mortgages weren't the only mistake?

We always ask what happens when irresistible force meets immovable object? We are about to find out. The same dilemma arises when 'too big to fail' meets 'too-bad to survive'.

AIG is TOO big, TOO interconnected, TOO global TOO many things to fail. AND mostly it's TOO BIG AND PUBLIC AN EXAMPLE TO GET WRONG IF YOU DECIDE TO HELP IT.

So what's a government to do? A good precedent was set when the government bailed out a very beleaguered Chrysler Corp years ago. It got warrants on Chrysler stock and when Chrysler was recovered, the government exercised its warrants, sold the underlying shares, and pocketed its profits: good pay for a rescue well done.

Now if we compare this sort of thing to when we were cave men and women we can see that there is still a problem- a downside to helping. If some cave man were being attacked by a Mastodon he foolishly engaged in the open field, it would surely kill him. But if we, from the future, appeared in a time machine and saved him allowing him to come home alive and his fellow cave men thought he was a great hunter to survive (even if the Mastodon got away) or that he was favored by the 'gods' who saved him, his genes might come to dominate cave people to our demise today. We want the genes from the guy who could kill the Mastodon or plan a clever trap for it. We don't want the genes from the blithering idiot who survived by some fluke of luck or external assistance.

Plan in a nut shell
It is not just about saving AIG. It's about the signal and the incentives as well as allowing them to go on they same way they have been. A plan to save AIG must include the government getting a big portion of the upside potential on its shares as well as a pledge for change. The latter means a management change - and maybe one from the OUTSIDE. Those two things would allay our fears about moral hazard and survival of the least fit. They would set an example no firm would want to follow. Also, it would line the government's pockets with cash- eventually.

But some will still question government interference. Fair enough. I understand ideology.

How to justify it to naysayers
What we have as an excuse for government intervention is a market imperfection. I assert that most people would still agree that (1) AIG is really big and (2) AIG is really smart but (3) AIG did make a really stupid bet or two. Now with other firms having so many eggs in the same basket as AIG, no one wants to take on more of them. In this environment the government plays the role of the stabilizing speculator. The externalities here are of course many. Any bankruptcy the government saves is going to save it a lot of work, risk anguish and lost TAX REVENUES. A government 'bail out' under these conditions would put AIG stock up sharply and instantly put the government's warrants on AIG stock in the black squelching cries of wasted tax-payer money before they are uttered. Since the government is in it for the long haul, if the economy has good fundamentals the AIG guarantees will eventually become unneeded and will be 'costless' to the US. Real estate prices will rebound if the economy is on basically sound footing. . Every one will live happily ever after. AIG shareholders will avoid huge losses. Most AIG personnel will keep their jobs - not at the top however. The government will make a bundle of money. AIG will have been disciplined to mind its "Ps" and "Qs" in the future. Life as we know it will go on.

I think there is a way for this to work and to not create distortions. I believe intervention can be justified on economic grounds. There is simply no supply of capital for what AIG needs.

It's a solution that may not be ideal but it solves a lot of issues, keeps the government's nose clean and pockets full. That's better than the other way around.

1 comment:


Nothing should be to big to fail nothing.