Monday Morning Quarterback vs. AIG


Photo by victoriabernal

Setting the Conditions For Failure

First, a flashback. Prior to last September, AIG was in the very profitable business of selling insurance to banks and other entities. These policies were a bet against the chance that the mortgages the banks were holding (or securities comprised of them) became insolvent. In that heyday AIG was raking in dough (in the form of premiums) and brought on a bunch of fancy-pants executives, who would not work for AIG without the promise of big salaries and big bonuses. AIG signed contracts with these executives committing millions of dollars as an incentive for the executive joining the company. "If person X works at AIG during the previous year, he/she will receive $Z million as a bonus for that year."

We'll put that aside for now. Concerning the topic of insurance, AIG was an enabler. When a banker looked at a securitized collection of mortgages, he/she thought "Wow, these could be profitable but they're quite risky. How could I take advantage of this profit opportunity without all that risk?" Enter AIG: the insurance they sold was cheap enough that the banker's risk was greatly reduced at the small cost of an insurance premium. In the banker's mind, AIG is a huge multinational corporation, so the odds that:

  1. The mortgages go bad, and
  2. AIG can't provide coverage in the case of failure

...are theoretically very low. Unfortunately AIG was making the same assumption about mortgages and was taking a huge risk of its own, rather than building up capital in safe investments. It bet all those premiums, along with its wedding ring, chopper, and yacht that the dealer would bust.

Experiencing Failure

When the dealer showed 21, the banker, sitting at the same table, reluctantly gave up his chips and turned to AIG, expecting most of those chips to come back. Alas, AIG was penniless. Thus, last September it was suddenly realized that AIG owed gobs of money because tons of mortgages were going sour. Why did these bankers expect money from AIG? That's easy: they had a contract. The contract stated, very roughly, "Banker X will give $Y as a premium. If the attached mortgage goes insolvent, AIG will give $Z to Banker X."

Overreaction and the Sanctity of Contracts

Fast forward to March 2009. AIG has received $170 billion from taxpayers because it owes at least that much, mostly to banks. Unfortuately for US taxpayers, the contracts it has with those banks are just as legally binding as the contracts it signed with its executives concerning their bonuses. As the government shoveled into the company, AIG simply funneled it to its debtors. It gave billions[1] to Deutsche Bank, Merrill Lynch, Bank of America, etc. etc. It then gave $165 million in bonuses to those executives who were owed money. Cue mass hysteria among the public, and even outrage from President Obama. There's some merit for the anger: how can a company that the US Government rescued from certain death turn around and dole out a chunk of it to people who were probably already richer than most Americans?

After much gnashing of teeth and wringing of hands, the US House decided that the best way to solve this "problem" was a 90% tax on bonuses for those earning over $250,000. This is incredibly dangerous. Much like the recent insanity surrounding the Terri Schiavo case, Congress decided to put the important issues on hold in order to intervene in a very specific situation, one that is arguably not theirs to solve.

What is at stake here is the sanctity of contracts. Strictly speaking there are no contracts being violated in this case, but this is essentially the same thing. The US House can't break the bonus contracts, so they decided to steal the money back instead. The message this sends to all of corporate America is: commitments mean nothing. The House's actions are simply like those of a child, pitching a tantrum on the floor because they weren't doing anything about bonuses back when the contracts were signed. AIG's name has been destroyed as a result.

Fortunately, my frustration is waning as Obama and the US Senate seem to have little interest in this silly bonus tax, and several of the bonus recipients have returned at least $50 million total. Slowly the focus is shifting back where it belongs: the birthplace of executive compensation. If these bonuses defied logic (and it seems like they did), then why were they set up in the first place? We're already the current mess, but we can prevent future problems by encouraging companies to keep their bonus policies sane.

Comments

  • Matt Malone
  • March 24, 2009
  • 12:59 pm
The problem is the contracts were signed after September when Congress had already taken control of AIG. Essentially they could write down whatever number they wanted, because they were getting an enormous influx of capital from the government. Furthermore, I disagree with your statement that AIG (and its table of smart executives) was taking huge risks. Instead they were banking (pardon the pun) on making enough short-term cash that if the machine they had created ever collapsed, they would declare bankruptcy and not owe anyone anything. They were willing participants in the breakdown of the system. Not only have they successfully used the US populace's 401k to fund their campaign, we're now paying their executives bonuses for their success (and our ultimate demise).

This situation is much worse than Enron, because it was a private entity with private contracts. Once you bring the government and the taxpayers into the contracts, it makes a huge difference.
  • Ethan
  • March 24, 2009
  • 1:26 pm
So my friend Josh has taken similar offense to my treatment of AIG's risk taking, and you're right. AIG is an insurance company, and their job is to take calculated risks and give them monetary value. I don't think any company considers bankruptcy to be a valid outcome, but I could be wrong. So the question is: did they know what kinds of risks they were taking? If not, was this the fault of other companies packaging the securities in such a way that it would be nigh impossible to determine the true risk (I would say this points to failed oversight/regulation), or was AIG simply lax in performing due diligence? Even worse, was AIG aware of the risk but unwilling to protect itself from it? I think this is less likely since they would have to know it would destroy the company.

The problem is that there are so many black areas that may never be revealed, partially due to a lack of oversight and regulation. But many entities were at fault in this collapse, not just AIG. Clinton and Bush both put emphasis on home ownership; banks had legislative incentive to give loans to people who couldn't afford them; home buyers took out loans they might not be able to afford in the future; credit agencies packaged loans without properly labeling the risk; etc. AIG was simply the last company holding all the risk, like the guy who gets stuck with a counterfeit $100 bill.

My main point in writing this post was to rebut the huge brouhaha surrounding the bonuses. $165 million is a lot of money, but it's less than 0.1% of the total AIG bailout. If it's true that the bonuses were signed over after the takeover, then that's a topic worthy of research, and changes my arguments considerably. Do we know that to be the case?
  • Matt Malone
  • March 24, 2009
  • 1:40 pm
I understand that you want to explore other possible avenues which are not so directly damning to AIG and the contractual obligations they made, however this isn't Octomom, or the latest development into Anna Nicole's death. These are serious matters, because it involves the public's money, no matter how small it is.
  • Stephanie McLeod
  • March 28, 2009
  • 8:58 am
First, more information on AIG. AIG is a publicly traded company that historically has sold insurance to safety-conscious customers. They made a little bit of money for a lot of low-risk policies, which made them successful enough to pay big bucks to get "good" talent. (As a side note, in the US, compensation packages for senior management have grown at a much higher rate than those for blue-collar employees for the past 50 years or so. Not every company gets what they pay for these days.) As an insurance company, AIG is actually forced by regulators to keep its portfolio as safe as possible.
Second, introduce the collateralized-debt-obligation, or CDO, and the credit-default swap, or CDS. Basically, a CDO is a diversified fund of debt - mortgages, credit-card loans, corporate loans, etc. Iit provided an opportunity for banks to put a bunch of bad loans in with a few good loans and create a financial product that for God knows what reason was given a AAA rating by Moody's and S&P. Combine CDOs with the government's pressure to put the lower class into homes, and you wind up with banks that were more than willing to write bad mortgages. There are even some cases where bank employees would white-out an applicant's salary and right in a higher one, so they would receive a higher commission for the sale. I'm thinking will be seeing some of these people going to jail soon. The CDS was created by the "Morgan Mafia" from JP Morgan. This is the betting, the crappy insurance policy. A CDS is an insurance policy for investors holding a lot of CDOs. The key here is the Morgan Mafia convinced the Fed that this insurance on their loan effectively lowered their risk, and paved the way for banks to issue MORE loans, though they had technically reached their legal leverage point.
Third, combine AIG and CDSs. A man named Joseph Cassano became the head of the small AIG Financial Products group. Cassano learned the tools of the trade from a man named Mike Milken, the guy responsible for creating a junk-bond market in the 70s and 80s, who yes, was eventually indicted on 98 counts of racketeering and securities fraud in '98. The board of directors at AIG didn't really understand the investment strategies that Cassano pursued, so they let him run amok and got all happy when he brought in tons of money. He would sell $billions of insurance in CDSs without ever having to pony up assets from AIG. In addition, he sold "naked" CDSs, in which AIG would sell insurance to Bank A for its CDOs, and would turn around and sell insurance to Bank B for Bank A's CDOs. Yes, gambling. Bank B was betting that Bank A's CDO would fail. So were Banks C-Z.
The result was AIG held $500 billion in CDS protection after 7 years of Cassano's work, but with no assets to back it, and Cassano pocketed $280 million in compensation.

The problem here is basic - when the money is flowing, nobody cares where it is coming from. The senior management team of a publicly traded company is supposed to increase profitability and long-term profit growth to the advantage of all stake holders - the board of directors, the creditors, the stock holders, the employees, the community that provides their infrastructure, etc. But so long as the money was coming in, so long as the creditors got their money and the stock holders got theirs, and the employees got theirs, and the community got theirs (through taxes), nobody stopped and said, "Will you please explain to me where this money is coming from?"

There are a ton of small banks out there that did not participate in this crap. What we need is a revolution. The banks that are "too large to fail" need to fail. They should declare bankruptcy (they are technically bankrupt), which would nullify these big-bucks contracts. The people who made bad decisions, including the corporate execs who have already taken their golden parachute, need to pony up all the money they can to pay back the defaulted loans the bank could not afford to sell. Then, the small banks will have the opportunity to rise into something great. This is how free market works, and we should let it work.

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