The AIG bailout, moral hazard, and regulation

The bailout seems necessary to prevent a full-blown financial panic. More or less wiping out the stockholders is good incentive management. The bondholders, too, should remain at risk. But the counterparties in swaps, and the insurance customers, need to be protected. And now that we have discovered that we need to guarantee swaps, we need to regulate the firms that make them.

1. Apparently there’s a deal in the works where the Fed makes an $85B “bridge loan” to AIG in return for 80% of the equity.

2. Why should the government bail out a private company that isn’t a regulated bank? Answer: Counterparty risk, also known as “settlement risk.” That’s a fancy way of saying “To avoid a finanancial panic.” The risk is that if AIG can’t meet its obligations, the firms it owes can’t meet their obligations, and so on, leading to a massive liquidity squeeze that shatters the financial system and has a big impact on the real economy?

3. Why shouldn’t the government bail out a private company that isn’t a regulated bank? Moral hazard. You don’t want to protect AIG shareholders from the consequences of the bad bets made by the management, or you offer every big firm the chance to gamble on a “heads I win, tails you cover my losses” basis.

4. There’s another kind of moral hazard at work. All of those “counterparties” &#8212 the people on the other side of all those swaps &#8212 will suddenly have their ability to collect from AIG insured by the federal government. That in effect protects their shareholders from management imprudence, and encourages companies dealing with similarly-placed financial giants in the future to proceed without doing their due diligence.

5. But If AIG is too big to be allowed to fail, that sort of moral hazard can be a feature and not a bug. Deposit insurance is designed specifically to encourage moral-hazard behavior, by telling depositors that their money is safe as long as it’s in a federally insured bank account (up to $100k) even if the bank goes down. That knowledge prevents “runs on the bank” of the kind that brought down Northern Rock. (Lenders to AIG, on the other hand, like lenders &#8212 as opposed to depositors &#8212 to banks, should be told they’re on their own. We certainly can’t make the government the guarantor of every loan taken out by a financial-services company.)

6. Obviously, if the government is going to, in effect, insure swaps trades, then the government is going to have to regulate and inspect the firms that make those trades, just as it now regulates and inspects the banks. That should keep them from making excessively imprudent gambles with the taxpayers’ money.

7. Given the choice between a bailout and no bailout, and given what experts seem to agree is a big risk of a full-blown panic if AIG goes down, it seems to me we have to choose “bailout,” and moral hazard be damned. But the decision to regulate in the future is implicit in the decision to offer the bailout now.

8. John McCain’s announced position against a bailout is consistent with his long-term support for de-regulation. It is inconsistent with the claim that he is competent to handle the Presidency; prudent people do not roll the dice on major economic disaster for the sake of consistency to their slogans.

9. But, asks a friend, doesn’t rolling all the institutions that are too big to fail (2B2F) &#8212 Fannie and Freddie and AIG &#8212 together under federal ownership just compound the problem by making one huge institution that is much 2B2F? Answer: No. As long as U.S. currency is “legal tender for all debts, public and private” (in particular, as long as it can be used to pay taxes) there’s no such thing as the Fed running out of money. That’s why they keep those presses down at the Bureau of Engraving and Printing. Thus there can’t really be a “run” on the Fed. The taxpayers are going to be on the hook for whatever the difference is between what those big institutions owe and that value of their assets. That can’t be avoided.

What is avoided is a fire-sale liquidation. Reportedly, the value of AIG’s “good” businesses, as sold in an orderly fashion, is more than enough to cover its losses on its bad businesses. If so, the taxpayers might be about to make some money. In any case, though, this looks like a case where inaction would be much the riskier action.

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: