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fu aig

March 19, 2009

All I have been hearing about lately is AIG. It is all over the newspapers. It is all over the radio stations. I bet if I bothered to turn on the t.v., it would there too. I had originally wanted to write a long blog expressing my thoughts on the company, the bailout and the $165 million in bonuses that were recently handed out, but since that would be like beating a dead horse, I have decided to just note a couple of things I think are important:

1. The current financial crisis could have been avoided, and so could have AIG’s near failure.

It is rather complicated to explain exactly what happened with AIG, but the bottom line is that AIG’s financial sector was paid by investment companies to back up securities that were in turn backed by pieces of mortgages. AIG effectively promised to make up the difference if the investments failed. So where did they go wrong?

It seems that AIG, thanks in part to Gary Gorton, the finance professor who designed AIG’s risk models, figured that being paid to take on these risks was “free money” because they never thought they would have to make any payments to cover actual defaults. What they apparently did not take into consideration, however, was the potential write-downs or collateral payments to trading partners (How AIG Failed). But specific regulations dealing with these securities and mortgage default swaps could have possibly prevented all of this. This is where both the company and the government failed.

David Swensen, the person who is credited with creating derivatives or “swaps,” eventually paved the way for an entire industry to be built around creating and trading derivatives based on mortgage payments of homeowners (Inventor of the “Swap” blames regulators for Financial Crisis). In the case of AIG, they basically insured these mortgage-backed securities. But the government was seemingly reluctant to regulate these derivatives and the industries that had developed around them, and traders eventually abused them to the point of financial collapse. Part of this was due to the perceived benefit of these swaps by people like former Fed Chairman Alan Greenspan. As Bob Moon notes, “… he called credit default swaps “probably the most important instrument in finance,” because they were supposed to spread risk around and stabilize the market” (Banks deep into unregulated ‘gambling’).

The sad fact is that stricter regulations and oversight on the part of the government, plus more transparency and less greed on the part of financial institutions, could have prevented much of this from happening, including what happened with AIG. Swensen himself says that he supports “requiring swaps and other derivatives to be traded openly on an exchange” since it would reduce the risk, but surprisingly, this very proposal was “torpedoed by both the Clinton and Bush administrations.” Why? Swenson theorizes that “Financial institutions that deal in these things have resisted that because it would make the market more transparent and less profitable” (Inventor of the “Swap” blames regulators for Financial Crisis).

2. Sen. Wyden deserves and honourable mention for attempting to discourage such bonuses.

The current uproar over AIG is that $165 million in bonuses was recently handed out to execs in the same sector of AIG that helped cause this mess in the first place. Everyone is up in arms about this, and there is good reason to be.

But it turns out that, according to one article in the Huffington Post, Sen. Wyden (D) of Oregon and Sen. Snowe of Maine (R) introduced a provision during the crafting of the stimulus package that “would have forced bailout recipients to cap their bonuses at $100,000” and any amount paid above that “would have been taxed at 35 percent” (Wyden: My Bill Could Have Prevented AIG Mess). Unfortunately, the same article states that, “The language made it through the Senate, but during conference committee with the House, it was inexplicably removed.”

On the other hand, while I applaud Sen. Wyden’s initial effort to discourage these types of bonuses, I do not agree with Congress’ effort to penalize the recipients by adjusting the tax code.

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