Thursday, March 19, 2009

Of Scams, Bad Bets, and Deregulation

The news this week is all about bonuses and "retention payments" at AIG. Public outrage over the ongoing series of bailouts is currently focused on bonuses paid to employees of AIG's division that is viewed as having caused the crisis at their company -- a crisis that must now be mitigated by government intervention and public money. The underlying problem at AIG, however, remains in the background. By reading various news accounts and watching cable news, all we appear to know at this point is that "the insurance giant AIG" (which has become the company's semi-official name) engaged in a bunch of complicated deals that went bad.

As I noted at the end of my post on Tuesday, tucked inside the excellent work that Jon Stewart has done on "The Daily Show" to expose the poor journalism and hucksterism at CNBC was an interview with Joe Nocera of The New York Times, whose Feb. 27 column on AIG purported to explain the "scam" that AIG had perpetrated. Stewart told Nocera that, because of that column, Stewart finally understood what had really happened. Unfortunately, Nocera's arguments make no sense. While it is surely true that AIG's employees did some things that have had very bad consequences, it is important to know what they did not do wrong as well as what they did, in order to know how to proceed.

Nocera, to his credit, concedes "the conventional wisdom" that AIG cannot be allowed to fail because of the likely domino effect on the rest of the financial system if AIG's commitments are not met. This has to be the lesson of allowing Lehman Brothers to go into bankruptcy. Still, Nocera says, "we should be furious" about all of this. Yes, we are. Nocera, in one paragraph, uses phrases such as "extreme hubris," "shady techniques," and "utter recklessness" to describe AIG's actions, and he tells us that it should make our "blood boil" to know that the company must be bailed out precisely because it acted so badly. Get out your pitchforks!

I do not mean to downplay the seriousness of the situation. My concern is that Nocera's rhetoric -- not to mention his actual analysis, as I describe below -- makes it more difficult to have a serious discussion about what to do now. The recent surge of populist outrage has been fueled in large part by loose talk like Nocera's. Still, if his underlying analysis were sound, we might forgive him. Ahem.

Nocera starts by describing AIG's strategy as being based on "regulatory arbitrage" and "ratings arbitrage." Applied to AIG's situation, he says that the word arbitrage "means taking advantage of a loophole in the rules. A less polite but perhaps more accurate term would be 'scam.'" Definitions of the word scam usually include "deceit" and "fraud" as the operative terms. What is the fraud at the heart of Nocera's argument? AIG, he says, sold "credit default swaps," which were insurance policies to cover losses if securities backed by mortgages were to default: "In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses."

What is the problem with insuring against losses? AIG had a AAA rating for its financial soundness, and "when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too." That is the "ratings arbitrage" that allowed AIG to exploit its reputation. Perhaps Nocera is leaving something out, but this is simply not a meaningful indictment of AIG's practices. According to this description, a large insurance company agreed to guarantee the value of a financial asset, which made the financial asset more valuable. How is this different, at its core, from a student asking her parents to co-sign on a loan? With a low (or non-existent) credit rating, the student needs someone to tell a lender not to worry. The reason the lender makes the loan is precisely because the parents have "sprinkled their holy water" on the loan. That's what guarantees and insurance are all about: assuring one party that another party is less of a risk because a more reliable person or institution stands behind them.

Of course, if the parents lie about their assets or plan to dissipate their assets after the loan is disbursed, then that would be fraud (deceit, scam, swindle, etc.). "What was in it for A.I.G.? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets — housing — could only go up in price." Again, where is the scam? Is it that the company charged fees to people who wanted to buy its products? That the company issued insurance in the hope that it would not ultimately have losses that would need to be covered? If so, then every insurance company is engaged in fraud every day. Nocera's argument to this point reduces to an indictment of the concept of insurance. There must be more to it than this.

We thus move on to the real problem. AIG was selling unregulated insurance products, which meant that there were no minimum amounts of money that must be kept on hand to cover losses. "So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it." Note that Nocera is claiming now that AIG did not understand the real risk, which moves us out of the realm of scams and into the world of mistakes. Arrogant mistakes, no doubt. Most importantly, though, AIG's mistakes were made possible by virtue of a deregulated financial environment.

Nocera, however, is not finished. He then faults AIG for agreeing to "collateral triggers" for some of its insurance contracts, "meaning that if certain events took place, like a ratings downgrade for either A.I.G. or the securities it was insuring, it would have to put up collateral against those securities." Collateral is bad? "Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them." Yes, when you agree to provide something valuable to the other party in a contract, you usually get something in return. Which brings us back to bad business judgment. "And again, it assumed that the triggers would never actually kick in and the provisions were therefore meaningless. Those collateral triggers have since cost A.I.G. many, many billions of dollars. Or, rather, they’ve cost American taxpayers billions."

Nocera's description of "regulatory arbitrage" is just as odd. He argues, in essence, that banks (especially in Europe) used AIG insurance to shift risk from their own balance sheet to AIG's, allowing them to satisfy regulators that their assets were "risk-free." Once again, however, it is difficult to see what is wrong with this as a concept. If I am running a bank, and I have mortgage-backed securities among my assets, it is simply good business practice to insure against losses. "And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do." Exactly! That is what insurance companies do. Why Nocera is shocked that this was an "open secret" is difficult to fathom.

For his final argument, Nocera describes another form of insurance ("2a-7 puts") that allowed money-market funds to hold riskier assets than they would otherwise hold. AIG invested the cash that it received in mortgage-backed securities, which (we now know) were part of the problem. Without that 20-20 hindsight, though, there is nothing obviously wrong with the idea that an insurance company would put its cash assets into something that would earn a rate of return. Not doing so, in fact, would have been a breach of fiduciary duty.

Why go on at such length about one fatuous column from three weeks ago? It provides a lesson in how easy it is to scare and anger people when the subject is complicated. No one (not even otherwise very smart and motivated people like Jon Stewart) understands finance and insurance; so when someone with purported expertise comes along and says it's all about "scams" and "pure greed," people fall for it. At most, however, Nocera has proved two things: (1) AIG should have been regulated, and (2) An unregulated AIG took risks that look bad in hindsight.

I will not discuss here other's (possibly stronger) arguments that AIG was engaged in activities for which it might be civilly or criminally liable. The point is only this: It matters whom we blame, and why we are blaming them. If the message that comes out of this mess is not that we need a better regulatory system but rather that some bad people at AIG took the taxpayers to the cleaners, then we have missed an important opportunity to minimize the risk of future catastrophes.

-- Posted by Neil H. Buchanan