
The Real AIG Scandal - dpapathanasiou
http://www.thebigmoney.com/articles/-best-policy/2009/03/17/real-aig-scandal?page=0,0
======
gscott
Through AIG banks could lend more since their investments were insured, so
they didn't have to hold so much in reserve. Banks around the world used AIG
so the AIG bailout is propping up banks everywhere, not just the US.

AIG is on the hook for such a large sum of money, I can't imagine they can be
bailed out forever.

I am curious if AIG is writing more of the same contracts that took them down
this path in the first place. I wouldn't be suprised if they are because the
people behind this bailout believe deep down that CDO's and other similiar
contracts are still good for the economy.

~~~
smanek
The contracts themselves are good in principle, they were just executed
stupidly (and the stupidness was rewarded with a bailout).

But there is no reason that I shouldn't be allowed to sell you a guarantee
that "X" won't happen (for any value of "X"). But, you are responsible for
making sure that I'm liquid enough to pay in case "X" does happen - because if
I'm not I'll just go bankrupt and you can try to claim your share of my assets
just like everyone else.

These sort of contracts help hedge risk - as long as they are done
responsibly. When they are done irresponsibly, the involved parties should be
made to suffer, not bailed out with tax payer funds.

~~~
joe_the_user
You mean that the contracts seem logical to you - when you just look at the
relation between two companies.

But you aren't really looking at the total effect of these contracts.
Derivative contracts "spread risk" but, as we've seen, they don't avoid risk.
So what they do is turn the individual risk of corporate bankruptcy into the
risk of systemic collapse.

That is called an "externality of production". Individual companies sometimes
don't mind taking gambles that have a downside for people not otherwise
involved with them. Much of governmental regulation is specifically for
preventing these externalitie from impacting people - this is why banks are
regulated, why companies must proper precautions handling toxic materials, why
automobile drivers must have insurance, etc.

So, ultimately, these kinds of contracts _are_ bad. They need to be regulated
in the same way that banks are regulated and for the same reasons.

~~~
anamax
> So, ultimately, these kinds of contracts are bad. They need to be regulated
> in the same way that banks are regulated and for the same reasons.

And they were, by several US govt agencies. (Since these contracts were used
for banking purposes, specifically securing assets, banking regulators were
involved. Insurance regulators were involved. The SEC too.) Yes, this includes
the London groups.

I am confused about how foreign banks got stung, what with all their superior
regulation and all.

~~~
joe_the_user
Uh, Can you document that?

My impression is Alan Greenspan specifically nixed regulation of CDOs around
1999.

I suppose I am talking about derivatives in general, in fact. Everything I've
ever read claimed they were entirely unregulated. I would like to hear if
that's not the case.

~~~
anamax
> Uh, Can you document that?

<http://files.ots.treas.gov/87171.pdf>

That report comes from the Office of Thrift supervision (OTS). They started
regulating AIG in 1999 when AIG applied to become a "Federal Savings Bank".
(The application wasn't approved until 2000.) OTS regulates and supervises
both FSBs and their holding companies.

The report also documents OTS cooperation with and the existence of AIG
regulation by "a multitude of regulators in over 100 countries".

As the report documents, AIG's problem is liquidity. One of the paragraphs
that I found interesting says: "AIGFP's CDS provide credit protection to
counterparties on designated portfolios of loans or debt securities. AITFP
provided such credit protection on a 'second loss' basis, underwhich it
repeatedly reported and disclosed that its payment obligations would arise
only after credit losses in the designated portfolion exceeded a specified
threshold amount or level of 'first losses.' Also known as 'super senior',
AITFP provided protection the layer of credit risk superior to the AAA risk
layer. The AIGFP CDS were on the safest portion of the security from a credit
perspective. In fact, even today, there have not been credit losses on the AAA
risk layer."

FWIW, AIG became concerned about this biz in 2005 and stopped selling these
instruments in late 2005 and started unwinding then. I'd agree that they did
so too slowly.

> My impression is Alan Greenspan specifically nixed regulation of CDOs around
> 1999.

Greenspan wasn't ever in a position to make that call.

> Everything I've ever read claimed they were entirely unregulated. I would
> like to hear if that's not the case.

Yes, there are unregulated financial instruments. (Leases and ownership aren't
regulated either.) However, the existence of such instruments does not imply
that regulated institutions (such as AIG or its customers) can use them to
escape supervision.

For banks and insurance companies, regulators define what counts as an asset,
how it is valued, and regulate exposure to different kinds of assets. That
applies to all assets, whether they're "regulated" or not.

Note that OTS says that the portfolios that AIG insured have not had losses,
the asset valuation has held up even as the market cratered, so it's a little
unclear why AIG is making payments. I suspect that they're caught in mark-to-
market, which is a regulatory creation. (Assets that are throwing off cash are
not worthless even if there are no buyers today.)

Did AIG screw up - yes. But there's no evidence to show that more regulation
would have done better. More to the point, it is simply wrong to argue for
more regulation on the theory that lack of regulation was a factor. It wasn't.
If anything, regulation failed.

~~~
joe_the_user
Hmm,

Thank you for the link and for expanding your point.

I think a careful read of the document you link to shows that the only
regulatory action that took place was the OTC becoming concerned in 2008 that
AIG's previous derivative contracts had now become dangerous. They noticed
nothing when the derivative contracts actually were issued.

Also note the comment in the text: "the level of review and amount of
resources needed to asses a complex structure such as AIG's is vastly deeper
and more resource-intensive than what would be required for a less complex
holding complex", which is something of statement that OTS really wasn't up to
_very much_ supervision of this "vastly complex" enterprise.

But this is not really the main issue...

>> My impression is Alan Greenspan specifically nixed regulation of CDOs
around 1999. > Greenspan wasn't ever in a position to make that call. He was
indeed not a regulator of that but his testimony to congress influenced the
resulting lack-of-legislation on the issue of derivatives when the official
who would have regulated them asked for the ability.

> Yes, there are unregulated financial instruments. (Leases and ownership
> aren't regulated either.) However, the existence of such instruments does
> not imply that regulated institutions (such as AIG or its customers) can use
> them to escape supervision. > For banks and insurance companies, regulators
> define what counts as an asset, how it is valued, and regulate exposure to
> different kinds of assets. That applies to all assets, whether they're
> "regulated" or not.

There indeed, is the rub. Being modeled as "very safe", my impression again,
is that CDS were in fact often considered "off-balance-sheet-instruments". But
that's again secondary...

Now that we have gotten into the details of these things, I should say "there
are regulations and there are regulations". Bank deposits are and have been
rightfully regulated _actively_ in terms of explicit, apriori limits on
deposits because deposit expansion and contraction can have a powerful effect
on _the economy as a whole_. Derivatives have only been regulated in terms of
one institution or another keeping loose track of what's happening and not
particularly limiting anything until things seem worrisome - which now turns
out to be long after the horse has left the barn.

What I am saying that derivatives should be regulated in a similar fashion to
bank deposits, with limits to who can issue, how much can be issued, how much
systemic risk they create and so-forth.

This is again consistent with state's necessary regulatory role. State
regulation basically require apriori legislation to prevent private actions
which can cause harm beyond the ability of a private actor to repay the
victims of that harm. The OTS might indeed have looked at the risk of failure
which AIG's actions involved for its depositors, its stock holders and even
for Uncle Sam in his role as deposit insurer. The OTS clearly didn't look at
the systemic risk which AIG's issuance of derivatives created.

What should be required, in the future, is such apriori limits on derivatives.
Either no institution can take on risk beyond a certain multiple of capital or
whatever other formula would work best. This is because, despite many claims
to the contrary, unregulated derivatives have become what Warren Buffet calls
"financial weapons of mass destruction" through their ability to first expand
and then contract the money supply (or the velocity of money if you prefer).

> Did AIG screw up - yes. But there's no evidence to show that more regulation
> would have done better. More to the point, it is simply wrong to argue for
> more regulation on the theory that lack of regulation was a factor. It
> wasn't. If anything, regulation failed.

Consider that folks are not really concerned with a hypothetical failure of
AIG in itself. By money-size, AIG wasn't "too big to fail". It is rather the
systemic failure that would accompany AIG's failure that has people up in
arms.

You could argue that the OTS or other bodies already had the authority needed
to place limits on issuance of derivatives. This might be true but the real
point is that neither the OTS or other bodies are charged with _directly_
reducing systemic risk because they can't calculate systemic risk. Indeed,
consider that Large modern economies (or, as another example, the world's
ecology) are complex beyond all mathematical models - despite economists'
earlier protests to the contrary (protests that look pretty shoddy now).
Because of this, regulation must involve simply forbiding those actions which
create unquantifiable systemic risk (including but limited to unlimited
dervative issuance, unlimited deposit expansion or discharge of known
polutants into the environment).

I saw an interview with Nassim Nicholas Taleb where he sketched a future
version of capitalism where all investors put their money into either rather
strongly regulated funds or very explicitly risky and unregulated funds, with
only those who could show they could sustain the loss being allowed to jump
into the risky funds.

~~~
anamax
>>> My impression is Alan Greenspan specifically nixed regulation of CDOs
around 1999.

>> Greenspan wasn't ever in a position to make that call.

> He was indeed not a regulator of that but his testimony to congress
> influenced

In other words, he didn't "nix" anything.

> the resulting lack-of-legislation on the issue of derivatives when the
> official who would have regulated them asked for the ability.

How about a cite...

I've already commented on Greenspan's successor's "knowledge" in this area.

~~~
joe_the_user
This is an interesting discussion.

One of many articles on Greenspan's resistance to the regulation of
derivatives can found in this NYTimes article:
[http://www.nytimes.com/2008/10/09/business/economy/09greensp...](http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?pagewanted=2)

A google of "Brooksley E. Born" will show a considerable amount more.

Perhaps we could each start a blog to debate the various point here. They are
interesting enough to warrant more exposure than a fading thread on hn.

Best,

JTU

~~~
anamax
Since Greenspan wasn't a decision maker wrt regulation, it's unclear why his
opinion on regulation is any more relevant than his opinion on bubblegum. It's
particularly interesting that his opinion is thought more important than the
actions of congress critters who actually had a role in regulation.

I note that Dodd, Obama, Sen. Clinton, and Kerry all received significant
donations from AIG and other investment houses and oversaw their regulation.
Barney Franks was particularly vehement in telling us that Fannie and Freddie
were perfectly safe and didn't need any regulation. (Which reminds me, Fannie
and Freddie announced significant bonuses recently.)

Yet, we're talking about Greenspan.

The fact remains that there was significant regulation of AIG's biz. Any
argument which starts from the assumption that there wasn't is fatally flawed.

~~~
joe_the_user
"Since Greenspan wasn't a decision maker wrt regulation, it's unclear why his
opinion on regulation is any more relevant than his opinion on bubblegum. "

Sheesh, it seems like you're just stretching your argument for the sake of it.
By now, it's not like anyone else is even "listening" to this discussion, so
neither of us have anything to prove.

Sure, Greenspan indeed had no official power in the matter but the press
universally credits him with wielding sufficient influence to decide the
question. I documented, as you requested, the fact that Greenspan testified
against the regulation of derivatives. Now you say it doesn't matter. I would
agree that the legislative branch was also instrumental in deciding derivative
regulation BUT that discussion is pretty much irrelevant to the immediate
question.

I _simply_ criticized Greenspan, I didn't criticize-Greenspan-to-get-the-
democrats-off-the-hook. I have no partisan axes to grind here, though I get
the feeling you might. I would see the whole Washington establishment,
democrat and republican, as enabling Wall Street's normal operations (which
lead us to this crisis). Lots of folks can be blamed but Greenspan is very
widely credited as being the articulator of the hand-off ("market
fundamentalist") approach. Saying that he didn't have legal power over this or
that is not a sufficient argument to challenge his status as architect of
overall Washington approach.

Sure, I think by now I've acknowledged there has been plenty of regulation of
AIG. As I think I've said, the point isn't regulation but what kind of
regulation. Here, I would follow Doug Noland and others who see derivatives,
CDOs and other entities as Wall Street devices for the creation of money-like-
items - synthetic bonds with a AAA rating were the product was pumped out with
the assistance of elaborate constructs like CDS's. This unlimited creation of
money-like-objects ran part and parcel with a massive inflation of the value
of assets - the bubble.

This process is ultimately equivalent the money-multiplier effect without any
underlying capital requirement. Thus, it did not require just any-old-
regulation but regulation like banks. The regulations on a savings banks is
not simply to keep a single bank safe but to limit the money which banks as a
whole inject into the system as a whole.

....

Did I mention regulation-like-banks?

~~~
anamax
> I would agree that the legislative branch was also instrumental in deciding
> derivative regulation BUT that discussion is pretty much irrelevant to the
> immediate question.

To be clear, you're saying that Greenspan's influence over the legislative
branch is relevant but what they actually did is irrelevant...

> I simply criticized Greenspan, I didn't criticize-Greenspan-to-get-the-
> democrats-off-the-hook.

You found Greenspan's comments important enough to criticise. You didn't find
other people's actions significant enough to rate a comment.

If your comments don't reflect your priorities....

> Did I mention regulation-like-banks?

And for the ntheenth time, AIG was regulated as a bank - that's what the
office of thrift supervision does. AIG was also regulated as an insurance
company.

If you're going to claim that "regulation-link-banks" would make a difference,
surely the fact that AIG was actually was regulated like a bank is relevant.

You keep bringing up things (unregulated assets and the like) that have
nothing to do with AIG. (Banks and insurance companies get no benefit from
unregulated/off-balance-sheet assets.) Perhaps you ought to be discussing
institutions to which they actually apply.

------
lssndrdn
I have been wondering some of the same questions. It seems like Goldman Sachs
is one of the best-positioned large bank in this whole thing. Now they get to
eat the cake and have it too? Am I missing something?

~~~
Tangurena
Treasury Secretary Paulson was CEO of Goldman Sachs. He went to save his own
buddies.

<http://en.wikipedia.org/wiki/Henry_Paulson>

~~~
HSO
The timeline goes much longer, and the involvement much deeper. As for the
timeline, former treasury secretaries Summers and Rubin were both at high-
level positions at Goldman, Rubin actually was co-CEO. Then Friedman (his
"co") who is Republican worked as chief advisor for Bush. Then Paulson, who as
you said also was Goldman CEO. Now we got the Rubin people in there again,
Geithner was his protege at treasury (as Rubin himself says in his
autobiography) and Summers (now chief advisor to Obama) was Rubin's protege at
Goldman. Note that Goldman paid out about 10 or 11 billion in 2008 for
compensation, in the same year it received about the same sum officially (i.e.
not counting the AIG shadow payments). Someone on a panel once said that if
this same thing happened not in the US but some "developing" country, we would
now hear big lectures about "crony capitalism". I used to admire Rubin and
Goldman but this does not look good. This looks like Russian oligarchs, just
in a richer country.

------
jibiki
It's a little off-topic, but does anyone else here feel like Spitzer kind of
got a raw deal from the media?

~~~
numair
How about NO...

He ruined Hank Greenberg, one of the greatest businessmen in this country, and
put AIG in the very position it is in today -- all for what, a shot at
becoming the next Giuliani? It's utterly retarded. He is the classic "bad cop"
who is off doing shady crap in his free time, punishing perfectly good law-
abiding citizens as part of his power trip. I mean, really, Hank Greenberg was
the squeaky-cleanest guy you could find; yeah, there were the backroom deals
and whatnot, but that's called "the old boys' club," and nothing that was
severely impacting the fate of the global economy. Leaving AIG in the hands of
Marty Sullivan and his gang of idiots, however... Well, we see what has
happened; AIG is now so impotent that it is used as a mere pawn by the banks
and the Fed. Spitzer practically shouldn't be allowed to write about this
without acknowledging that he created the problem.

The problem with politics is ... When Miley Cyrus says she will "ruin"
Radiohead, we all laugh; when the Miley Cyruses of the political world say
they are going to "ruin" someone, the power given to them by the people allows
them to make inroads into doing just that.

~~~
jhancock
Can you please elaborate on two things:

1 - "Hank Greenberg was the squeaky-cleanest guy you could find"

2 - "He ruined Hank Greenberg, one of the greatest businessmen in this
country, and put AIG in the very position it is in today"

------
zurla
yes. i've been disappointed that the controversy about the bonuses on the
order of $200M have gotten more press and attention than the AIG bailout which
is orders of magnitude more taxpayer dollars.

~~~
padmanabhan01
One private company (AIG) insured 10 other private companies, and that one
private company is now not in a position to honor the insurance policies. and
now the Govt. on behalf of the public is giving money to that private company
to save other companies.

isn't this wrong in many levels? this is against capitalism, this is rewarding
bad behavior, it is immoral - in the sense that Govt is taking money from
Peter to pay Paul, this approach is not going to work on top of all this, I
just feel this is just wrong.

~~~
mikedouglas
If you think the extent of AIGs insurance business was 10 companies, you're
hugely mistaken. AIG is the backer of a huge number of corporate, state and
municipal bonds. The usual terms of those bonds state that if the insurer
fails, the bond becomes due right away. In a single day, we'd see a huge
percentage of the solvent/proper economy just evaporate.

AIG would take an enormous part of both the private and public economy with
it, if it ever failed.

~~~
gnaritas
I like the idea that if a company is too big to be allowed to fail, then it's
to big to be allowed to exist. After we recover, possibly if, companies like
AIG that are single points of failure need to be broken up.

I don't know if this is practical or not, but what if future regulation were
aimed at limiting the total size/amount of money/whatever that a company is
allowed to own with the goal of keeping risk distributed enough so that we
wouldn't fear letting bad companies fail?

They'd also have to monitor board membership and stock ownership to ensure you
didn't end up with hundreds of companies being virtually one giant company
behind the scenes all following the same bad policies.

I'd imagine this isn't all that dissimilar to dealing with monopolies. Too
little competition is bad and now we've learned that allowing any single point
of failure is just as bad.

As all hackers know, single points of failure are risky, even if a crash is
unlikely. Our economies load needs to be better distributed.

~~~
jacoblyles
>"I don't know if this is practical or not, but what if future regulation were
aimed at limiting the total size/amount of money/whatever that a company is
allowed to own with the goal of keeping risk distributed enough so that we
wouldn't fear letting bad companies fail?"

Interestingly, during the Great Depression there existed laws which limited
the number of branches that banks could have. Politicians preferred to keep
banks small, fearing the power of larger banks. You see, anti-capitalism and a
populist distaste for financiers are nothing new.

Perhaps surprisingly, states that forced banks to be small were the hardest
hit by bank failures in the Depression. The tiny, unthreatening banks did not
have the margin of error to wait out the financial chaos. Meanwhile, places
like Canada that allowed large national banking conglomerates avoided bank
failures almost entirely.

Our recent crisis was very different from the Great Depression. Contrary to
the 1930s, scale was often a vulnerability, and not an asset. However, the
example of the Great Depression ought to drive home to us the danger of
optimizing to the last crisis, lest we precipitate a new one in our rashness.

There is also danger in drawing simple, neat lessons from a messy crisis.
Scale was not always our enemy. We must remember that several private firms
were bailed out, not by public dollars, but by private acquirers. Wachovia's
sale to Wells Fargo would have been legal under many of the world's regulatory
regimes, and it was legal in the 2008 United States, but it would not have
been legal in the 1998 United States when we still had anti-scale laws on the
books. If those regulations were still in place, at least a few more large
firms would have been at the government's door, hat in hand.

Populism is politically fruitful, but it can wreak havoc on an economy, and it
is almost never thoughtful or well-informed. We ought to pause before giving
in to its mellifluous rhetoric.

~~~
gnaritas
> You see, anti-capitalism and a populist distaste for financiers are nothing
> new.

No surprise, financiers ripping us is nothing new either.

> The tiny, unthreatening banks did not have the margin of error to wait out
> the financial chaos. Meanwhile, places like Canada that allowed large
> national banking conglomerates avoided bank failures almost entirely.

Perhaps they didn't set the right limits, kept them too small. Because we
failed to get it right once doesn't mean we should stop trying and just accept
being ripped off as a cost of doing business.

Either we figure out how to regulate the market such that this won't happen in
the future or we nationalize the banking industry like others have done and
admit that the only thing that's really to big to fail is the government.

> There is also danger in drawing simple, neat lessons from a messy crisis.

That, I agree with. But our current system has clearly failed, something needs
to be done, time for another experiment.

> We ought to pause before giving in to its mellifluous rhetoric.

Talking about possible solutions on a website _is pausing_ , it's not like
we're implementing policy here or anything. It's just an interesting things to
speculate about.

~~~
jacoblyles
>"No surprise, financiers ripping us is nothing new either."

Is this what you really think about finance?

If I were to weigh the good and the bad that finance has done for the human
species, I have little doubt to which side the scale would tilt. Finance is an
essential part of an advanced economy, and advanced economies are much more
fun to live in than the other kind.

Populism is driven by basic, tribal emotions and explanations that appeal to
the lowest common denominator. Humans fear that which is complex and hard to
understand. They are envious creatures with a poor natural grasp of economics.
They reason that if the goldsmith is getting richer, why, then I must be
getting poorer!

Populism hasn't really progressed since the days of goldsmith banking. That's
not what it is built to do.

I don't think populism is the wisest way to modify the banking system, but
sadly we have decided that voting is the best method to make such decisions.
Since populism is simple and appeals to the gut instinct, it wins out in
votes. So populism is what we get.

> "Because we failed to get it right once doesn't mean we should stop trying"

The first failure caused immense human suffering. What we have now needs some
tinkering, but it is immensely better. It would be foolish to make large, rash
actions to experiment recklessly when the costs are so high. Speaking of
which:

>"or we nationalize the banking industry like others have done and admit that
the only thing that's really to big to fail is the government."

I can think of three nations off the top of my head that nationalized banks.
One was temporary (Sweden). The other two had immense problems with bad debt
in _good_ times (Japan and China, if I recall correctly). It turns out that
the profit motive does help banks make good loans.

> "But our current system has clearly failed, something needs to be done, time
> for another experiment."

Our system has produced the most prosperous society in the history of the
world. It did a bad job reacting to a novel circumstance. It needs to be
patched, not scrapped.

>"Talking about possible solutions on a website is pausing, it's not like
we're implementing policy here or anything. It's just an interesting things to
speculate about."

There are a few places where temperate, informed discussion of these issues
take place. None of them has little voting arrows to click on next to the
content, nor do they exchange information in short soundbites.

~~~
gnaritas
> Is this what you really think about finance?

All of finance, of course not, I was talking about the bad ones, the
criminals.

> What we have now needs some tinkering, but it is immensely better.

You'll note, I was discussing tinkering. When I say our system has failed, I
don't mean throw out the whole system and start over. I was specifically
talking about tinkering with how large we allow the banks to get. Me thinks
you're over reacting a bit and assuming I'm wanting to completely change the
current system.

