( – promoted by Colorado Pols)
Insurance is a state business-there is no real federal insurance regulator. This is the reason the Fed had to work through the state insurance regulators in the bailout of AIG. Insurance regulators in the several states are of varying quality (which is one of the reasons the GOP pushes intrastate insurance competition-so that insurance companies can base themselves in weak regulator states). Fortunately, the New York state regulator has stepped in to bailout AIG. Why?
Let me state for the record, I’ve always hated AIG. I always thought Greenberg was a pirate and never abided their “we’re smart and have a AAA rating so we don’t need to tell you hat” attitude. “Trust me” has never gone very far with me.
But why “must” we bailout AIG : Credit Default Swaps.
Credit Default Swaps are not “securities” and have never been regulated as such. There was an attempt in 2000 to regulate them, but McCain economic advisor Phil Gramm in what one legal textbook called “a stunning departure from normal legislative practice,” the Senate tacked on a complex, 262-page amendment at the urging of Texas Sen. Phil Gramm known as the Commodity Futures Modernization Act which specifically defined them as “not securities”. Right now no US regulatory agency claims oversight jurisdiction for credit-default swaps. Not the SEC. Not the Commodity Futures Trading Commission. Not the Treasury Department. Not the Federal Reserve.
This is how CDS work: a bond investor is worried about the solvency of a corporation (agency or loan portfolio) whose bonds he holds. The investor buys an insurance policy on the bonds with terms that require the insurance counterparty to pay the claim if there is a loss event. That transfers the default risk to an insurer, who might be another institutional investor, bank or trader.
On the other hand If an investor is more optimistic about the issuer than others, he might sell an insurance policy on the bonds, pocketing a premium or even create a synthetic bond.
One problem with the CDS is that other than the contract there is no guarantee the counterparty on the other side of the contract will make good on the contract when it comes time to pay. Just like when you make a claim against your insurance, there is no guarantee they will pay. Hence, CDS traders pick up an additional risk Counterparty Risk in addition to the underlying credit risks.
But it doesn’t end there. The person who takes out insurance must not only worry about the strength of his counterparty, he must worry about the strength of his counterparty’s counterparties. The credit swaps market is no regulated. As a result, many contracts can be traded – or swapped – from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends – the insured and the insurer. And here is where AIG comes in. AIG was one of the biggest counterparties, but was often laying off credit on less credit worthy parties that were highly levered hedge funds.
A subsidiary of AIG wrote insurance in the form of credit default swaps on corporate credits, but more troubling on even the most esoteric asset-backed security pools . When the housing market collapsed, imploding home prices resulted in precipitously rising foreclosures. The mortgage pools AIG insured began to fall in value. 2007 progressed, so did the losses on AIG’s books and credit default swaps. Once the value of AIGs collateral fell they began to be hit with margin calls from their strong counterparties through the spring. When rating agencies lowered the firm’s ratings last Monday evening, it triggered an additional $14 billion collateral call as margin against AIG’s credit default swaps. AIG was done.
The argument is that giving the breadth of AIGs roll in spreading credit risk around the system, AIG’s failure would have pushed weakened institutions into bankruptcy.
At first I did’t buy it. AIG is important, but they have been run as a criminal enterprise for years. Prison not bailout is a better solution.
Failure to do due diligence or correctly provision for counterparty risk is not a failure of the system. Push the losses down and give forbearance on the back side. AIG needs to go down.
But then I looked at the details. The government is may be getting a pretty good deal and could end up making money. AIG has some great assets and government is getting an ownership stake. In addition the senior management is out.
My biggest problem with the bailout in general is that the taxpayer is just a wallet, we do not get what other providers of capital get-an equity stake. I don’t want to fully nationalize these institutions, but taxpayers should receive something for their capital infusion. It can be sold later once we have a new modern regulatory regime and people have confidence in the system.
CDS are a useful tool, but the fact that they were unregulated was ridiculous and the fact that institutions were allowed to ignore counterparty risk has been one of my major complaints for years, but truthfully I like the AIG bailout more than the “management keeps their job, shareholders get nothing” Paulson plan.