Why did AIG Collapse?

Originally posted by Sleepyguy
You mean didn't find that hearing encouraging? Jeebus, what a mess.

That was a lot to take in but four things really stood out to me...

1. The failure of regulators that allowed this debacle was not strictly due to a lack of authority by the regulators. It was instead a lack of knowledge, foresight, coordination, and will by the regulators. As Po ...[text shortened]... hose CDO's was, I think, fraud.

4. The Treasury was a no show? WTF? That was weak.

good points, those.

remember that DOJ and SEC are doing criminal investigations, so that inhibits Treasury and the others a lot -- I think OTS will not dodge the bullet altogether, but Polakoff did the smart thing. His soft answer turneth away wrath that should be directed at the previous Administration's policy of deregulation. Polakoff is not a political appointee, and he's a Fed, so the New York guy and Dr. Kohn got to take the shots, since they werent' admitting anything.

Reuters:
WRAPUP 2-U.S. officials admit huge regulatory gaps on AIG
Thu Mar 5, 2009 1:19pm EST
* A top AIG regulator backs regulatory overhaul
* Lawmakers demand detail on how AIG bailout funds spent
* OTS supports regulating credit default swaps

By Karey Wutkowski

WASHINGTON, March 5 (Reuters) - U.S. regulators failed to spot how much risk insurer AIG was piling on, and by the time they understood, they had no choice but to pour in tens of billions of public dollars, officials said on Thursday.

At a Senate Banking Committee hearing on what went wrong at American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz), lawmakers expressed outrage that taxpayers were kept in the dark about exactly where rescue money went as the government stepped in repeatedly to prevent its disorderly collapse.

"That we find ourselves in this situation at all is ... quite frankly, sickening," said Senator Christopher Dodd, the Democrat who chairs the committee. "The lack of transparency and accountability in this process has been rather stunning."

The fact that a "multitude of regulators" missed the warning signs at AIG highlighted the need to establish a systemic risk regulator to monitor firms that are large and complex enough to destabilize the financial system, said Scott Polakoff, acting director of the Office of Thrift Supervision.

"Where OTS fell short, as did others, was in the failure to recognize in time the extent of the liquidity risk to AIG" of certain credit default swaps held in the portfolio of the company's financial products division.

That unit, although a small part of the global insurance giant's worldwide operations, racked up such heavy losses that it threatened the entire company's survival, eventually forcing the Treasury Department and Federal Reserve to launch a series of costly bailouts.

"No one was minding the whole company and looking at how things interacted, and whether the whole company would, under some circumstances, put the financial system at risk," said Federal Reserve Vice Chairman Donald Kohn.

Under a revised bailout deal announced on Monday, the amount of funds committed to help AIG increased to about $180 billion, although the insurer has not tapped it all and plans to pay back roughly $38 billion soon. The U.S. government holds about an 80 percent stake in the insurer.

AIG sold insurance-like protection, known as credit default swaps, against declines in the value of securities -- including subprime mortgages that began defaulting at an alarming rate when the housing market tumbled.

BLIND SPOTS

Fed Chairman Ben Bernanke said earlier this week that the unit operated like an unregulated hedge fund, and he expressed anger that its risky behavior put taxpayers on the hook.

But Republican Senator Bob Corker questioned whether the central bank could have safeguarded the financial system at considerably lower cost by guaranteeing AIG's credit default swaps rather than paying them off.

"Couldn't you have just said ... 'We're not going to put up the collateral. I'm sorry. The company is bankrupt. But what we will do as the Fed is we will stand behind the obligation so that in the event there's ever a credit issue, we'll stand behind it?'" he asked Kohn.

"We thought it was a short-term liquidity situation -- in mid-September this is what we thought -- and that if we could bridge this situation with liquidity, then the company could make the adjustments to keep itself a going concern," Kohn replied. "It turned out that the problems were deeper, the financial markets were a lot worse, became a lot worse, and the whole situation deteriorated badly."

OTS' Polakoff detailed the agency's interaction with AIG going back to 1999. But despite that, OTS still failed to understand that the insurer's finances could be devastated by the activities of the financial products division.

"No one predicted, including OTS, the amount of funds that would be required to meet collateral calls and cash demands on the credit default swap transactions," he said.

In retrospect, if regulators had recognized that risk, they could have told AIG to reduce its exposure, he said.

New York Insurance Superintendent Eric Dinallo, whose agency oversees AIG's insurance business but was not the primary regulator of the financial products arm, said the unit had written some $440 billion in credit default swaps and should have been subject to more and better regulation.

Polakoff said a key lesson learned from the AIG episode was that the United States needed a systemic risk regulator that would have responsibility for monitoring companies that are so large or so interconnected that their failure would pose a risk to the country's financial stability.

Originally posted by uzless
I would agree to a large extent with what you've put forth. However, allowing M & A's does have an impact on the future competitive structure of the industry. When a merger occurs, it eliminates any potential for the merged company to create their own subsidiaries. These (hypothetical) subsidiaries would have competed directly against AIG. I view M & A's ...[text shortened]... y unfolding. Lessons will be learned. But those lessons will no doubt be forgotten in time.

well, in fact I agree with you and Dr. Stiglitz, whom I believe I've quoted elsewhere. These too big to fail companies perhaps should simply be broken up the way the government has done under anti-trust laws. We may need, however, an enabling statute to do it:

CNN:

Commentary: How to prevent the next Wall Street crisis

By Joseph Stiglitz
Special to CNN
Editor's note: Joseph E. Stiglitz, professor at Columbia University, was awarded the Nobel Prize in Economics in 2001 for his work on the economics of information and was on the climate change panel that shared the Nobel Peace Prize in 2008. Stiglitz, a supporter of Barack Obama, was a member and later chairman of the Council of Economic Advisers during the Clinton administration before joining the World Bank as chief economist and senior vice president. He is the co-author with Linda Bilmes of the "Three Trillion Dollar War: The True Costs of the Iraq Conflict."

NEW YORK (CNN) -- Many seem taken aback by the depth and severity of the current financial turmoil. I was among several economists who saw it coming and warned about the risks.
There is ample blame to be shared; but the purpose of parsing out blame is to figure out how to make a recurrence less likely.
President Bush famously said, a little while ago, that the problem is simple: Too many houses were built. Yes, but the answer is too simplistic: Why did that happen?

One can say the Fed failed twice, both as a regulator and in the conduct of monetary policy. Its flood of liquidity (money made available to borrow at low interest rates) and lax regulations led to a housing bubble. When the bubble broke, the excessively leveraged loans made on the basis of overvalued assets went sour.
For all the new-fangled financial instruments, this was just another one of those financial crises based on excess leverage, or borrowing, and a pyramid scheme.

The new "innovations" simply hid the extent of systemic leverage and made the risks less transparent; it is these innovations that have made this collapse so much more dramatic than earlier financial crises. But one needs to push further: Why did the Fed fail?
First, key regulators like Alan Greenspan didn't really believe in regulation; when the excesses of the financial system were noted, they called for self-regulation -- an oxymoron.

Second, the macro-economy was in bad shape with the collapse of the tech bubble. The tax cut of 2001 was not designed to stimulate the economy but to give a largesse to the wealthy -- the group that had been doing so well over the last quarter-century.
The coup d'grace was the Iraq War, which contributed to soaring oil prices. Money that used to be spent on American goods now got diverted abroad. The Fed took seriously its responsibility to keep the economy going.

It did this by replacing the tech bubble with a new bubble, a housing bubble. Household savings plummeted to zero, to the lowest level since the Great Depression. It managed to sustain the economy, but the way it did it was shortsighted: America was living on borrowed money and borrowed time.

Finally, at the center of blame must be the financial institutions themselves. They -- and even more their executives -- had incentives that were not well aligned with the needs of our economy and our society.

They were amply rewarded, presumably for managing risk and allocating capital, which was supposed to improve the efficiency of the economy so much that it justified their generous compensation. But they misallocated capital; they mismanaged risk -- they created risk.
They did what their incentive structures were designed to do: focusing on short-term profits and encouraging excessive risk-taking.
This is not the first crisis in our financial system, not the first time that those who believe in free and unregulated markets have come running to the government for bail-outs. There is a pattern here, one that suggests deep systemic problems -- and a variety of solutions:

1. We need first to correct incentives for executives, reducing the scope for conflicts of interest and improving shareholder information about dilution in share value as a result of stock options. We should mitigate the incentives for excessive risk-taking and the short-term focus that has so long prevailed, for instance, by requiring bonuses to be paid on the basis of, say, five-year returns, rather than annual returns.

2. Secondly, we need to create a financial product safety commission, to make sure that products bought and sold by banks, pension funds, etc. are safe for "human consumption." Consenting adults should be given great freedom to do whatever they want, but that does not mean they should gamble with other people's money. Some may worry that this may stifle innovation. But that may be a good thing considering the kind of innovation we had -- attempting to subvert accounting and regulations. What we need is more innovation addressing the needs of ordinary Americans, so they can stay in their homes when economic conditions change.

3. We need to create a financial systems stability commission to take an overview of the entire financial system, recognizing the interrelations among the various parts, and to prevent the excessive systemic leveraging that we have just experienced.

4. We need to impose other regulations to improve the safety and soundness of our financial system, such as "speed bumps" to limit borrowing. Historically, rapid expansion of lending has been responsible for a large fraction of crises and this crisis is no exception.

5. We need better consumer protection laws, including laws that prevent predatory lending.

6. We need better competition laws. The financial institutions have been able to prey on consumers through credit cards partly because of the absence of competition. But even more importantly, we should not be in situations where a firm is "too big to fail." If it is that big, it should be broken up.

These reforms will not guarantee that we will not have another crisis. The ingenuity of those in the financial markets is impressive. Eventually, they will figure out how to circumvent whatever regulations are imposed. But these reforms will make another crisis of this kind less likely, and, should it occur, make it less severe than it otherwise would be.

Originally posted by Scriabin


Polakoff said a key lesson learned from the AIG episode was that the United States needed a systemic risk regulator that would have responsibility for monitoring companies that are so large or so interconnected that their failure would pose a risk to the country's financial stability.

Ok, so this guy is saying rather than keep companies small enough that they can't damage the system should they fail, he'd rather we just regulate them instead.

Hmm, sounds like a recipe that requires human intervention to ensure stability.....always risky imo.

Originally posted by Scriabin
good points, those.

remember that DOJ and SEC are doing criminal investigations, so that inhibits Treasury and the others a lot -- I think OTS will not dodge the bullet altogether, but Polakoff did the smart thing. His soft answer turneth away wrath that should be directed at the previous Administration's policy of deregulation. Polakoff is not a politi ure would pose a risk to the country's financial stability.

After reading the article you quoted and your comments, another point occurred to me from that hearing. Someone said (I think it was Dinallo) that the reason the CDS side of AIG received no regulatory scrutiny is that the CFMA (The Commodity Futures Modernization Act of 2000) specifically prohibited credit derivatives from regulation. So if we taxpayers want to know where to lay the blame I think that's the logical place to start. Consider this blurb on the CFMA from Wikipedia...

The "Commodity Futures Modernization Act of 2000" (H.R. 5660) was introduced in the House on December 14, 2000 by Rep. Thomas W. Ewing (R-IL) and cosponsored by Rep. Thomas J. Bliley, Jr. (R-VA) Rep. Larry Combest (R-TX) Rep. John J. LaFalce (D-NY) Rep. Jim Leach (R-IA) and never debated in the House.[2]

The companion bill (S.3283) was introduced in the Senate on December 15, 2000 (The last day before Christmas holiday) by Sen. Richard Lugar (R-IN) and cosponsored by Sen. Peter Fitzgerald (R-IL) Sen. Phil Gramm (R-TX) Sen. Chuck Hagel (R-NE) Sen. Thomas Harkin (D-IA) Sen. Tim Johnson (D-SD) and never debated in the Senate.

The Republican leadership of the House incorporated "The Commodity Futures Modernization Act of 2000(H.R. 5660)" by reference, as Section 1(a)(7), in a long and complex conference report to the 11,000 page long "2000 omnibus budget bill" formally known as "The Consolidated Appropriations Act for FY2001(Labor, Health and Human Services, and Education Appropriations Bill) (H.R. 4577)." 157 Democrats and 133 Republicans voted for the appropriations bill. 51 Republicans and 9 Democrats opposed the appropriations bill vote results in the house. The Senate version passed by "Unanimous Consent." President Clinton signed it into Public Law (106-554) on December 21, 2000.

Notice all the those R's and D's? There's plenty of blame to share there and it doesn't even mention Greenspan.

There is no difference between naked CDS trading and plain old gambling, which is why that activity was illegal prior to the CFMA. It seems to me that so many R's and D's colluding to throw common sense out the window at the behest of bankers and CEOs is indicative of a systemic problem in our government. The problem is not as simple as "deregulation", nor confined merely to the last administration, nor absent from the current one. It's much bigger than that I'm afraid. I don't know what to label it, but it has something to do with our representatives not representing us, and I think it's going to be much harder to fix than just a lack of regulation.

Originally posted by Sleepyguy
After reading the article you quoted and your comments, another point occurred to me from that hearing. Someone said (I think it was Dinallo) that the reason the CDS side of AIG received no regulatory scrutiny is that the CFMA (The Commodity Futures Modernization Act of 2000) specifically prohibited credit derivatives from regulation. So if we taxpayers ...[text shortened]... think it's going to be much harder to fix than just a lack of regulation.

It won't get fixed because that assumes it was otherwise before it got "broken."

And it never was other than broken, in a sense. We've always been a political system comprised of contending special interests. The theory was the political marketplace, like the economic marketplace, would allow for unrestrained competition and the result was bound to be self-correcting and the best one could ask for.

So, you are right, this is going to be a lot harder to turn around than anyone now really appreciates. Oh, I think Obama knows all this, alright. But I also think he's simply used the opportunity to play the game the same old way.

Of course, he hasn't much choice, given the absolute pinheads and dittoheads on the other side of the aisle. Not much there to work with.