Tuesday, March 17, 2009

Time to Reorganize AIG

The continuing outrage over AIG's dumber than dumb payment of executive bonuses and retention payments after receiving federal bailout money threatens to undermine the government's efforts to prop up the financial system. Not only were many of the executives involved at the scene of the crime when shiploads of losses were incurred, some that received "retention payments" have already left AIG. This suggests that AIG isn't just spectacularly stupid. One wonders whether AIG is no longer functional as an organization. Perhaps the decision making process within the company has lost touch with the larger world and become so tone deaf to political sensibilities that it cannot effectively run the company any longer. The fact that AIG continues to book losses and soak up a never ending stream of taxpayer money only heightens these concerns.

Worst of all, the AIG situation has so outraged the public that the federal government no longer has the political capital to stage another major bailout should one be necessary. While we won't name any names, anyone who has even casually followed recent financial news knows that there are at least one or two very large banks that may be teetering at the brink, and which may require comprehensive federal action sooner or later. But with AIG's insufferable insensitivity to political sensibilities fresh in mind, the taxpayers won't stomach another big bailout. What would happen, then, isn't likely to be pretty.

It's time to end the bailout of AIG. No more federal assistance. It's too late, baby.

However, we shouldn't simply let AIG fail. The taxpayers have already sunk $170 to $180 billion into AIG, and own almost 80% of the company. A liquidation might result in substantial losses for the taxpayers. Instead, the company should be reorganized in a way that would maximize the value of the company for its various constituencies without any more checks from the United States.

One subsidiary, AIG Financial Products, caused the bulk of AIG's problems. For the most part, its other subsidiaries are real insurance companies that offer traditional products like property and casualty coverage, auto policies, life insurance and so on. These latter operations have real value. AIG should be split into two entities: AIG Financial Products by itself ("Bad AIG"), and the rest of AIG ("Good AIG"). Such a split accomplishes two things. First, a traditional liquidation could precipitate a "run" on the good AIG subsidiaries by customers seeking to cash out policies. That might lead to the unwarranted collapse of those subsidiaries. Splitting up AIG separates the problem child from the healthier parts of the company. That should help prevent a run. Second, a split up allows taxpayers to make profits that might be lost in a traditional liquidation. Here's how.

Good AIG would be given the capital its constituent subsidiaries now maintain to meet state law requirements. That would protect the customers. The customers of Good AIG have the highest priority to AIG's assets in the event of a liquidation and need to be protected to dissuade them from staging a run. Appropriately capitalized, Good AIG could continue doing business as usual.

AIG-FP's customers, however, don't have the same level of protection as, say, AIG's life insurance customers, since FP didn't sell traditional insurance products. Instead, it was basically a really large hedge fund. Its customers (i.e., its counterparties) are actually creditors, and have substantially less negotiating strength than traditional insurance customers. The counterparties could be given stock in both Good AIG and Bad AIG. The United States, along with other current stockholders, would also receive stock in Good AIG and Bad AIG. The relative amounts of stock each would receive would depend on the value of FP's counterparties' claims assuming there are no more federal bailouts (as well there may not be), relative to the amount of the United States' contribution of $170 to $180 billion as a secured lender (see below), with a proportionate allocation for other current shareholders. Figuring out what these proportions would be might not be easy, but it can be done.

Why would FP's counterparties go along with this idea? First, the prospects of further U.S. bailouts for AIG is growing dim and the counterparties have few choices in the absence of a bailout. The United States' interest in AIG actually consists mostly of loans collateralized by AIG's assets, along with a warrant and senior preferred stock. The warrant and preferred stock give the United States an equity interest, but the U.S. is first and foremost a secured lender. As such, the U.S. has first dibs on the assets over creditors like the counterparties. The latter would likely be up the creek sans paddle if they tried to slug it out in court with the U.S. Besides, vulture investors swoop into liquidations with bids so low catfish couldn't find them. There wouldn't be that much to fight over in a liquidation, and the counterparties would very possibly come out quite badly.

Second, forcing AIG into a traditional liquidation would likely cause a "run" not only on AIG but also on insurance companies worldwide. FP's counterparties are major banks (see our preceding blog) that either own insurance operations or have intricate connections with the insurance industry. If they precipitate a general run on insurance companies, they would make their own problems much worse. The U.S. government now serves as Sugar Daddy to the world's largest financial institutions (see our preceding blog). FP's counterparties would have to go along with a reorganization of AIG if that's what their Sugar Daddy wanted.

The taxpayers and other shareholders of Good AIG could profit by holding their stock for 5 to 10 years, until the financial sector recovers, and then selling. Since Good AIG consists of basically sound businesses that sell products people need, there is a strong likelihood of long term profits. Maybe these would be large profits.

The taxpayers and other shareholders of Bad AIG have a more complex problem. They would have to evaluate how to make the most out of the complex contracts into which FP entered. If, however, Bad AIG understands that it would receive no federal bailouts, then its shareholders and management would have to reach for their bootstraps and do their best. Perhaps they'd find a way to make a little money; perhaps not. Either way, because there would be no more federal assistance, Bad AIG could pay whatever salaries and bonuses it wanted in order to hire and retain whoever it thought to have the abilities it needs. While AIG richly deserves the criticism it has received for its mistakes, it is not wrong in contending that it needs highly specialized and relatively expensive help to unwind FP's holdings. The way for it to hire and retain those people without further criticism is to stop taking federal money.

Of course, cutting AIG off from the federal trough means that many of AIG's counterparties may have to book losses. It's unclear how large those losses would be. Some of the counterparties may require further government assistance to stay afloat. American banks in such straits can resort to the TARP and other alphabet soup bailout measures federal authorities now offer. Foreign banks can turn to their home governments. U.S. taxpayers have already forked over $57 billion to foreign counterparties of AIG (see our preceding blog). It's time for their home governments to pitch in and help. Those governments have regulatory authority over their banks and didn't stop them from dealing with AIG-FP. Since those governments share some of the blame, they ought to bear some of the costs.

It's unclear that taxpayers would necessarily secure an overall net profit from a reorganization of AIG, because of the potential need of counterparties for more governmental assistance. However, AIG has become a black hole, and taxpayer losses from the status quo could, for all we know, be gargantuan (if they aren't already). Most importantly, AIG's bad behavior is undermining the legitimacy of the entire federal program to stabilize the financial system. As things stand now, the public won't put up with another big bailout. But reality is that another one may be needed.

Fed Chairman Ben Bernanke has predicted that the recession might be over by the end of this year if the financial system is stabilized. That's a really big "if" and it got bigger as a result of AIG's recent insensitive and supercilious arrogance (redundancy intended). It's time to say enough already of AIG. Break it up, take it off the dole, and hope for the best, because we certainly aren't getting the best now.

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