Page 2 of 5 Too big to fail versus moral hazard
By Henry C K Liu
Black Monday crash of 1987. The TED spread is a measure of liquidity and shows
the degree to which banks are willing to lend money to one another. It is also
an indicator of market perception of credit risk, as T-bills are considered
risk free while the LIBOR rate reflects counterparty credit risk in lending
between commercial banks. As the TED spread increases, the risk of default
(also known as counterparty risk) is considered to be increasing, and investors
will develop a preference for safer investments.
The Securities and Exchange Commission announced drastic curbs on naked
short-selling (shorting shares without owning them) to stop sharp price
declines in shares under attack. But the new rules failed to stop heavy selling
of financial stocks. The S&P 500 fell 4.7%, led by an 8.9% drop in
financials. Price volatility in
equities was near its highest level since March. Gold bullion price leaped
11.2% to a three-week high of $866.47 per ounce.
Some critics are suggesting that the Fed needs to define clearly the threshold
above which it would intervene in the market. The problem with not being clear
is that if the threshold is set too low, it increases moral hazard, and if it
is set too high, it becomes self defeating as a way to stabilize the market.
Furthermore, when the Fed set rules arbitrarily, it becomes cat and mouse to
guess what the Fed would do next time. But playing cat and mouse with market
participants is the traditional game the Fed plays to neutralize the effect of
rational expectation. The game is played every three months when the Fed Open
Market Committee meets to consider the Fed funds rate target.
The way the Fed has been trying to stabilize the financial market in this
horrendous credit crisis since it burst open in August 2007 is looking like
punching new gaping holes in the throat of the patient to deliver more air to
his lungs. One of these days, it may accidentally puncture a jugular vein to
end the game. The lender of last resort has become a predator of last resort,
nationalizing all dying enterprises. But it seems to be racing headlong onto
the road of nationalization not so much as to help the common people as to keep
dying financial dinosaurs alive. The Fed continues to pretend that firms likes
AIG are merely going through a liquidity crunch.
The fact is the undercapitalization is by definition a solvency problem. The
problem is not that good assets are temporarily hit with prices below their
real worth and that new capital is needed to maintain debt to equity ratio. The
problem is that all these debts were not worth their face value to begin with.
The highly inflated market values of these assets were held up by circular
trading of debt by assuming that they could always be sold at still higher
prices way beyond their true worth.
Now that the market is finally adjusting the price bubble downward and a lot of
firms that were incredibly profitable on the way up are falling like leaves in
autumn in a bear market. The Fed is merely trying to inject money to keep the
prices not supported by fundamentals from falling. It is a prescription for
hyperinflation. The only way to keep price of worthless assets high is to lower
the value of money. And that appears to be the Fed's unspoken strategy.
The US Treasury had briefly considered taking over AIG under a conservatorship,
as it did with the GSEs. But it was a nonstarter, because insurance companies,
unlike Fannie Mae and Freddie Mac which are government sponsored enterprises,
are regulated by state insurance commissions, not the Federal government. As an
insurance company, rather than a bank, AIG was supervised by the state of New
York where it is domiciled, rather than a national regulator.
Roots of AIG's woes
AIG's current trouble has its roots in a decision in the late 1980s to take
over a group of derivatives specialists from Drexel Burnham Lambert, which went
bankrupt due to speculative losses in junk bonds. AIG Financial Products
(AIGFP) wrote hundreds of billions of dollars of derivatives, spilling over
from AIG's insurance business. The business model rested on leveraging AIG's
low-cost of short-term funds to profit from high-yield long-term investments.
With its AAA credit rating, AIG was an attractive counterparty for swap
transactions. The Financial Products division, unregulated because it is not an
insurance entity nor a banking operation, fell between the regulatory crack. It
expanded geometrically over the decades into areas such as credit-default swaps
(CDS), which insure against risks of default, as well as originating mortgages
and consumer debt.
CDS are not insurance policies but only swap instruments that act like
insurance policies. During the bubble years, this business model paid off with
spectacular profits in fees when default rates were uncommonly low. Part of its
expansion plan included insuring investors against defaults on collateralized
debt obligations (CDOs), or pools of securities backed by unbundled risks with
compensatory yields. The $41 billion write-downs that AIG suffered in recent
months were mostly in these swaps.
AIG insures only "super-senior" deals, which were previously deemed so safe by
the rating agencies they held a triple-A rating. AIG could profit from the low
return from these near risk-free instruments because of its low cost of funds.
This advantage allowed AIG to become a key player and preferred counterparty in
the top layer of the structured finance market.
During the first seven years of this decade, AIGFP steadily increased its
presence in this opaque, and esoteric, corner of finance and, when the credit
crunch started in August 2007, a significant portion of the insurance group's
exposure to the structured credit world was in the form of super-senior debt.
When the credit crisis struck, the AIGFP management expressed little concern
about these holdings. As a result, AIG announced on December 5 that its
cumulative loss had been just $1.4 billion.
However, one factor that forced AIG to conduct a U-turn in accounting terms at
the end of 2007 was that banks came under intense pressure from auditors in the
closing months of 2007 to revalue their super-senior holdings. AIG's auditors
then forced it to also revise its super-senior losses from $1.5 billion to $6
billion, for the period ending November 30, 2007. Shortly, afterwards, AIG
raised this estimate again to $11.5 billion - and on May 8 the company declared
that the losses had swelled by an additional $9.1 billion.
With the ABX derivatives index continuing to decline, the market feared that
further write-downs could be needed. The ABX Index is a series of
credit-default swaps based on 20 bonds that consist of subprime mortgages. ABX
contracts are commonly used by investors to speculate on or to hedge against
the risk that the underlying mortgage securities may not be repaid as expected.
For regular payments of insurance-like premiums, ABX swaps offer protection if
the securities default. A decline in the ABX Index signifies investor sentiment
that subprime mortgage holders will suffer increased financial losses. A rise
in the ABX Index signifies investor sentiment that subprime mortgage holdings
will perform better.
Outside its financial products division, AIG holds valuable insurance assets.
These businesses include the largest commercial and industrial insurer in the
US, and a business offering mainly car insurance to individuals. Yet these
assets will decline in market value in a severe depression caused by the credit
crisis. AIG also owns 59% of Transatlantic Holdings, a separately listed
reinsurer. AIG is also one of the US's biggest life assurers, dominating the
market for fixed annuities, a popular retirement savings product.
Globally, AIG is a big player in 130 countries, particularly big in Asia. In
addition, it owns one of the world's biggest aircraft leasing operations and a
sizeable asset management business. With such valuable assets, there should be
no shortage of interested buyers for AIG's units in normal times. Prudential of
the UK, Warren Buffett, Allianz, Munich Re, have all indicated interested in
acquiring some parts of AIG's businesses. But these are not normal times. Asset
deflation can be expected to last some years, causing the market value of AIG
asset to stay way below the company's current liabilities.
Maurice Greenberg, the former chairman of AIG, claimed publicly on television
that the company only needs a bridge loan, not a bailout. The company faces a
liquidity crisis, not a solvency problem. Its core insurance operations, both
in the US and abroad, are financially sound, and it can raise more than $20
billion through orderly asset sales, Greenberg said. For these reasons, a
bridge loan - from the federal government if sufficient private capital is not
forthcoming - will not mean a bailout. A temporary bridge loan will prevent
further rating agency downgrades, which would require AIG to post billions of
dollars in additional collateral and which would likely prove fatal.
Bridge loan grows
But the Fed decided that the bridge loan needed to be $85 billion, more than
four times the amount Greenberg said the company could raise by selling assets.
And $85 billion was in addition to the $20 billion AIG had already borrowed
from its subsidiary as approved by New York State insurance regulators as an
emergency measure. The best accountants in the business could not tell how much
AIG would really need to become solvent again.
Greenberg asserts that it is in US national interest to save AIG because it of
the number of countries in which it operates, employing more than 100,000
employees worldwide, some 62,000 in Asia. It provides credit protection to tens
of thousands of financial institutions and other companies around the world.
About 40% of its $54 billion in annual life insurance premiums and retirement
services fees is from Asia, not counting Japan. Its failure would pose systemic
risk to the US and the international financial systems.
According to Greenberg, AIG is not an ordinary company. It has opened markets
for the US all over the world and, for more than three decades, stood at the
vanguard of the liberalization of global trade in services. Its stock is owned
directly or indirectly by millions of US citizens. And it has contributed
significantly to the US gross domestic product directly and indirectly over the
four decades of its existence.
Yet a case can be made that AIG contributed to the bubble economy in the last
two decades of disguising debt as wealth. It is not clear if Greenberg's
argument is a reason for saving AIG or a reason for dismantling liberalization
of global trade.
It is true that allowing AIG to default on its obligations would be more
dangerous than allowing Lehman to go bankrupt. Yet it is not clear that keeping
AIG afloat could stop this raging financial fire. AIG may be just one domino in
an interconnected pile of falling dominos, albeit the biggest one to date.
AIG is faced with $441 billion of exposure to credit-default swaps and other
derivatives. Losses on these contracts have driven AIG into a vicious downwards
spiral in which it needs ever more cash to remain a top-rated counterparty.
JPMorgan Chase and Goldman Sachs had been charged by the government with
finding $75 billion from private sources to rescue failing firm. They both
failed. The shares of Morgan Stanley and Goldman Sachs themselves were down
sharply one day after the Fed issue an $85 billion bridge loan to keep AIG from
defaulting.
Currently, the only regulatory checks on credit-default swaps are requirements
on counter-party risk. As long as AIG continued to be over-rated by lenient,
even unrealistic, credit-rating companies, it seemed to be an excellent
counter-party. It increased its systemic importance as it became less stable.
Regulators put unjustified faith in credit-rating companies whose judgment can
be impaired by conflicts of interest.
Outdated structures
The disjointed structure of US regulatory agencies is outdated for dealing with
today's brave new world of complex and interwoven financial instruments. As big
financial "supermarkets" came into existence through deregulation, systemic
risk can be short-circuited while it appears to be dispersed. National and
supranational regulators remained on the roadside on the superhighway of
globalization. Regulators generally lack adequate mandates and expertise to
keep pace with the supersonic speed of innovative financial products and
processes that they are suppose to regulate.
AIG may be too big and too interconnected to fail. But governmental measures to
date to save the failing company appear to have had very limited effect on an
escalating meltdown of the global financial market.
In the US, where loan
securitization is widespread, banks are tempted to push risky loans by passing
on the long-term risk to non-bank investors through debt securitization.
Credit-default swaps, a relatively novel form of derivative contract, allow
investors to hedge against securitized mortgage pools. This type of contract,
known as asset-back securities, has been limited to the corporate bond market,
conventional home mortgages, and auto and credit-card loans. Last June [2005],
a new standard contract began trading by hedge funds that bets on home-equity
securities backed by adjustable-rate loans to sub-prime borrowers, not as a
hedge strategy but as a profit center. When bearish trades are profitable,
their bets can easily become self-fulfilling prophesies by kick-starting a
downward vicious cycle.
On May 17, 2007, three months before
the credit crisis first broke
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