Propping Up a House of Cards

February 28, 2009
Talking Business

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Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion, which will affirm, yet again, A.I.G.’s sorry status as the most crippled of all the nation’s wounded financial institutions. The recent quarterly losses suffered by Merrill Lynch and Citigroup — “only” $15.4 billion and $8.3 billion, respectively — pale by comparison.

At the same time A.I.G. reveals its loss, the federal government is also likely to announce — yet again! — a new plan to save A.I.G., the third since September. So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat. It has softened the terms it set for the original $85 billion loan it made back in September. To ease the pressure even more, the Federal Reserve actually runs a facility that buys toxic assets that A.I.G. had insured. A.I.G. effectively has been nationalized, with the government owning a hair under 80 percent of the stock. Not that it’s worth very much; A.I.G. shares closed Friday at 42 cents.

Donn Vickrey, who runs the independent research firm Gradient Analytics, predicts that A.I.G. is going to cost taxpayers at least $100 billion more before it finally stabilizes, by which time the company will almost surely have been broken into pieces, with the government owning large chunks of it. A quarter of a trillion dollars, if it comes to that, is an astounding amount of money to hand over to one company to prevent it from going bust. Yet the government feels it has no choice: because of A.I.G.’s dubious business practices during the housing bubble it pretty much has the world’s financial system by the throat.

If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.

I don’t doubt this bit of conventional wisdom; after the calamity that followed the fall of Lehman Brothers, which was far less enmeshed in the global financial system than A.I.G., who would dare allow the world’s biggest insurer to fail? Who would want to take that risk? But that doesn’t mean we should feel resigned about what is happening at A.I.G. In fact, we should be furious. More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin.

“They were the worst of them all,” said Frank Partnoy, a law professor at the University of San Diego and a derivatives expert. Mr. Vickrey of Gradient Analytics said, “It was extreme hubris, fueled by greed.” Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet — and this is the part that should make your blood boil — the company is being kept alive precisely because it behaved so badly.

When you start asking around about how A.I.G. made money during the housing bubble, you hear the same two phrases again and again: “regulatory arbitrage” and “ratings arbitrage.” The word “arbitrage” usually means taking advantage of a price differential between two securities — a bond and stock of the same company, for instance — that are related in some way. When the word is used to describe A.I.G.’s actions, however, it means something entirely different. It means taking advantage of a loophole in the rules. A less polite but perhaps more accurate term would be “scam.”

As a huge multinational insurance company, with a storied history and a reputation for being extremely well run, A.I.G. had one of the most precious prizes in all of business: an AAA rating, held by no more than a dozen or so companies in the United States. That meant ratings agencies believed its chance of defaulting was just about zero. It also meant it could borrow more cheaply than other companies with lower ratings.

To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. (Its insurance divisions remain profitable today.) But one division, its “financial practices” unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities. Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. 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. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too. That was the ratings arbitrage. “It was a way to exploit the triple A rating,” said Robert J. Arvanitis, a former A.I.G. executive who has since become a leading A.I.G. critic.

Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to A.I.G., and the AAA rating made the securities much easier to market. 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.

That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. 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.

Second, in many of its derivative contracts, A.I.G. included a provision that has since come back to haunt it. It agreed to something called “collateral triggers,” 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. Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them. 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.

The regulatory arbitrage was even seamier. A huge part of the company’s credit-default swap business was devised, quite simply, to allow banks to make their balance sheets look safer than they really were. Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements. The less risky the assets, obviously, the lower the regulatory capital requirement.

How did banks get their risk measures low? It certainly wasn’t by owning less risky assets. Instead, they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began.

At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do.

It’s not as if this was some Enron-esque secret, either. Everybody knew the capital requirements were being gamed, including the regulators. Indeed, A.I.G. openly labeled that part of the business as “regulatory capital.” That is how they, and their customers, thought of it.

There’s more, believe it or not. A.I.G. sold something called 2a-7 puts, which allowed money market funds to invest in risky bonds even though they are supposed to be holding only the safest commercial paper. How could they do this? A.I.G. agreed to buy back the bonds if they went bad. (Incredibly, the Securities and Exchange Commission went along with this.) A.I.G. had a securities lending program, in which it would lend securities to investors, like short-sellers, in return for cash collateral. What did it do with the money it received? Incredibly, it bought mortgage-backed securities. When the firms wanted their collateral back, it had sunk in value, thanks to A.I.G.’s foolish investment strategy. The practice has cost A.I.G. — oops, I mean American taxpayers — billions.

Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. Indeed, that may be the single most important reason it can’t let A.I.G. fail. If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful.

I asked Mr. Arvanitis, the former A.I.G. executive, if the company viewed what it had done during the bubble as a form of gaming the system. “Oh no,” he said, “they never thought of it as abuse. They thought of themselves as satisfying their customers.”

That’s either a remarkable example of the power of rationalization, or they were lying to themselves, figuring that when the house of cards finally fell, somebody else would have to clean it up.

That would be us, the taxpayers.

Government Bailout Hits $8.5 trillion

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Kathleen Pender

The San Francisco Chronicle

November 26, 2008

The federal government committed an additional $800 billion to two new loan programs on Tuesday, bringing its cumulative commitment to financial rescue initiatives to a staggering $8.5 trillion, according to Bloomberg News.

That sum represents almost 60 percent of the nation’s estimated gross domestic product.

Given the unprecedented size and complexity of these programs and the fact that many have never been tried before, it’s impossible to predict how much they will cost taxpayers. The final cost won’t be known for many years.

The money has been committed to a wide array of programs, including loans and loan guarantees, asset purchases, equity investments in financial companies, tax breaks for banks, help for struggling homeowners and a currency stabilization fund.

Most of the money, about $5.5 trillion, comes from the Federal Reserve, which as an independent entity does not need congressional approval to lend money to banks or, in “unusual and exigent circumstances,” to other financial institutions.

To stimulate lending, the Fed said on Tuesday it will purchase up to $600 billion in mortgage debt issued or backed by Fannie Mae, Freddie Mac and government housing agencies. It also will lend up to $200 billion to holders of securities backed by consumer and small-business loans. All but $20 billion of that $800 billion represents new commitments, a Fed spokeswoman said.

About $1.1 trillion of the $8.5 trillion is coming from the Treasury Department, including $700 billion approved by Congress in dramatic fashion under the Troubled Asset Relief Program.

The rest of the commitments are coming from the Federal Deposit Insurance Corp. and the Federal Housing Administration.

Only about $3.2 trillion of the $8.5 trillion has been tapped so far, according to Bloomberg. Some of it might never be.

Relatively little of the money represents direct outlays of cash with no strings attached, such as the $168 billion in stimulus checks mailed last spring.

Where it’s going

Most of the money is going into loans or loan guarantees, asset purchases or stock investments on which the government could see some return.

“If the economy were to miraculously recover, the taxpayer could make money. That’s not my best guess or even a likely scenario,” but it’s not inconceivable, says Anil Kashyap, a professor at the University of Chicago’s Booth School of Business.

The risk/reward ratio for taxpayers varies greatly from program to program.

For example, the first deal the government made when it bailed out insurance giant AIG had little risk and a lot of potential upside for taxpayers, Kashyap said. “Then it turned out the situation (at AIG) was worse than realized, and the terms were so brutal (to AIG) that we had to renegotiate. Now we have given them a lot more credit on more generous terms.”

Kashyap says the worst deal for taxpayers could be the Citigroup deal announced late Sunday. The government agreed to buy an additional $20 billion in preferred stock and absorb up to $249 billion in losses on troubled assets owned by Citi.

Given that Citigroup’s entire market value on Friday was $20.5 billion, “instead of taking that $20 billion in preferred shares we could have bought the company,” he says.

It’s hard to say how much the overall rescue attempt will add to the annual deficit or the national debt because the government accounts for each program differently.

If the Treasury borrows money to finance a program, that money adds to the federal debt and must eventually be paid off, with interest, says Diane Lim Rogers, chief economist with the Concord Coalition, a nonpartisan group that aims to eliminate federal deficits.

The federal debt held by the public has risen to $6.4 trillion from $5.5 trillion at the end of August. (Total debt, including that owed to Social Security and other government agencies, stands at more than $10 trillion.)

However, a $1 billion increase in the federal debt does not necessarily increase the annual budget deficit by $1 billion because it is expected to be repaid over time, Rogers said.

Annual deficit

A deficit arises when the government’s expenditures exceed its revenues in a particular year. Some estimate that the federal deficit will exceed $1 trillion this fiscal year as a result of the economic slowdown and efforts to revive it.

The Fed’s activities to shore up the financial system do not show up directly on the federal budget, although they can have an impact. The Fed lends money from its own balance sheet or by essentially creating new money. It has been doing both this year.

The problem is, “if you print money all the time, the money becomes worth less,” Rogers says. This usually leads to higher inflation and higher interest rates. The value of the dollar also falls because foreign investors become less willing to invest in the United States.

Today, interest rates are relatively low and the dollar has been mostly strengthening this year because U.S. Treasury securities “are still for the moment a very safe thing to be investing in because the financial market is so unstable,” Rogers said. “Once we stabilize the stock market, people will not be so enamored of clutching onto Treasurys.”

At that point, interest rates and inflation will rise. Increased borrowing by the Treasury will also put upward pressure on interest rates.

Deflation a big concern

Today, however, the Fed is more worried about deflation than inflation and is willing to flood the market with money if necessary to prevent an economic collapse.

Federal Reserve Chairman Ben Bernanke “has ordered the helicopters to get ready,” said Axel Merk, president of Merk Investments. “The helicopters are hovering and the first cash is making it through the seams. Soon, a door may be opened.”

Rogers says her biggest fear is not hyperinflation and the social unrest it could unleash. “I’m more worried about a lot of federal dollars being committed and not having much to show for it. My worst fear is we are leaving our children with a huge debt burden and not much left to pay it back.”

Economic rescue

Key dates in the federal government’s campaign to alleviate the economic crisis.

March 11: The Federal Reserve announces a rescue package to provide up to $200 billion in loans to banks and investment houses and let them put up risky mortgage-backed securities as collateral.

March 16: The Fed provides a $29 billion loan to JPMorgan Chase & Co. as part of its purchase of investment bank Bear Stearns.

July 30: President Bush signs a housing bill including $300 billion in new loan authority for the government to back cheaper mortgages for troubled homeowners.

Sept. 7: The Treasury takes over mortgage giants Fannie Mae and Freddie Mac, putting them into a conservatorship and pledging up to $200 billion to back their assets.

Sept. 16: The Fed injects $85 billion into the failing American International Group, one of the world’s largest insurance companies.

Sept. 16: The Fed pumps $70 billion more into the nation’s financial system to help ease credit stresses.

Sept. 19: The Treasury temporarily guarantees money market funds against losses up to $50 billion.

Oct. 3: President Bush signs the $700 billion economic bailout package. Treasury Secretary Henry Paulson says the money will be used to buy distressed mortgage-related securities from banks.

Oct. 6: The Fed increases a short-term loan program, saying it is boosting short-term lending to banks to $150 billion.

Oct. 7: The Fed says it will start buying unsecured short-term debt from companies, and says that up to $1.3 trillion of the debt may qualify for the program.

Oct. 8: The Fed agrees to lend AIG $37.8 billion more, bringing total to about $123 billion.

Oct. 14: The Treasury says it will use $250 billion of the $700 billion bailout to inject capital into the banks, with $125 billion provided to nine of the largest.

Oct. 14: The FDIC says it will temporarily guarantee up to a total of $1.4 trillion in loans between banks.

Oct. 21: The Fed says it will provide up to $540 billion in financing to provide liquidity for money market mutual funds.

Nov. 10: The Treasury and Fed replace the two loans provided to AIG with a $150 billion aid package that includes an infusion of $40 billion from the government’s bailout fund.

Nov. 12: Paulson says the government will not buy distressed mortgage-related assets, but instead will concentrate on injecting capital into banks.

Nov. 17: Treasury says it has provided $33.6 billion in capital to another 21 banks. So far, the government has invested $158.6 billion in 30 banks.

Sunday: The Treasury says it will invest $20 billion in Citigroup Inc., on top of $25 billion provided Oct. 14. The Treasury, Fed and FDIC also pledge to backstop large losses Citigroup might absorb on $306 billion in real estate-related assets.

Tuesday: The Fed says it will purchase up to $600 billion more in mortgage-related assets and will lend up to $200 billion to the holders of securities backed by various types of consumer loans.

Source: Associated Press

Net Worth runs Tuesdays, Thursdays and Sundays. E-mail Kathleen Pender at kpender@sfchronicle.com.


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