The AIG Rescue And The Failure Of Regulation

In this morning’s Financial Times, there is a great piece on the AIG (AIG) rescue, the potential impact if the government had allowed the company to fail, and the failure of regulation:

From the FT:

AIG was not too big to fail, but too connected. Bankruptcy would have in effect cancelled the debt insurance that AIG provided, and triggered emergency capital raisings from counterparties around the world. The Fed’s rescue is on punishing terms: AIG must repay the $85bn loan at a storecard-like 8.5 percentage points over Libor, liquidating perfectly fine assets to do so. But resolution – of a sort – has been achieved.

Meantime, chalk this up to a failure of regulation. AIG was laid low by mark-to-market losses in its Financial Products division, which wrote insurance on thousands of fixed income securities held by banks. But what AIGFP offered was not straightforward protection, in the sense of covering for potential losses. It was regulatory arbitrage. Banks that entered credit default swaps with AIGFP could assure auditors and regulators that the risk of the underlying asset going bad was protected, and with a triple-A rated counterparty.

Under international rules on capital adequacy, the banks were therefore allowed to keep less cash in reserve. Holding cash, of course, is what no bank wants to do: the fee paid in premiums over the period of the contract was reckoned to be less than the opportunity cost of keeping cash or cash equivalents on the balance sheet. All this is within the rules: in a recent 10-Q filing, AIG made no secret that FP had been built “to provide regulatory capital relief rather than risk mitigation.” But it should not have been beyond the wit of the Basel II committee to see that dangerous levels of counterparty risk would accumulate in institutions willing, as AIGFP was, to write insurance on very attractive terms.

As CreditSights notes, the Fed’s rescue package has been delicately crafted to avoid any of the buzz words – such as “default, receivership, conservatorship” – that would trigger a credit event for CDS. Regulators are still tiptoeing around instruments they barely understand. The AIG implosion should result in much higher risk-weightings for CDS contracts. That will result in further capital pressures for banks, at the worst possible time. Tough.

In other words, the Government’s takeover of AIG wasn’t about protecting AIG from collapse, it was about protecting the banks that would’ve needed to raise cash if AIG had failed. This (of course) brings up the following question: isn’t it rather spurious that many banks are only adequately capitalized via “regulatory arbitrage”. Doesn’t that suggest that many are operating under the illusion of pure financial health and might need to raise more cash anyway?

I know, I know, the system has worked for decades and I’m probably being a reactionary bear on some level. However recent events have made it plainly obvious that many companies in the financial world are always operating on the precipice of disaster, and could easily fall into ruin if the right dominoes fall. Some thought needs to be given towards how to restructure things so that they’re better able to survive a crisis, as opposed to being structured in a way that appears to assume that things will always be at least near the best case scenario.

Sources:

The Financial Times: “AIG Rescue” — September 17, 2008.

Disclosure: at the time of publishing the author didn’t own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn’t be viewed as financial or investment advice.

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Comment by Kiwi

2008-09-17 17:18:06

Good article.
The cover offered by AIG will probably expire after a fixed period, letting AIG off the hook.
The banks will then need to either find cash big time (Fed) or pay much larger insurance premiums (Fed again) depending on costs and availability. So the Fed takes the risk on banks that dont fail and also on banks that do fail, did I miss the upside? The leveraged risk has not gone away, it still demands cash, big cash. This might be one election that nobody would want to win.

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