The Big Rip

Who exactly, is all that bank bailout money going to, and why? For me, that's the central mystery of the TARP.

George Bush, the Republican Congress, and their market fundamentalist allies apparently enabled the greatest financial swindle in world history. What they did was to recklessly and egregiously fail to carry out their legal responsibilities to oversee and regulate American financial markets. Instead, they tolerated and cheered on a culture of dishonesty and theft. Joe Nocera, writing in the New York Times, looks at how it worked at AIG, which he calls ground zero for the mortgage backed securities scam. (Hat tip to Arun G)

So far, the US government has poured $150 billion dollars into this one company, money that the taxpayers are unlikely to ever see again. AIG lost all this money by selling a type of insurance called a credit default swap, insuring banks, hedge funds, and others against the risk that the vast pile of toxic assets in mortgages would not go bad. Unlike other types of insurance, AIG failed to keep realistic reserves to pay claims on this insurance and in addition, very dishonestly evaluated the risks of those securities.

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.

That 150 billion amounts to about $500 for each American man, woman, or child - thousands for each American family. Why should I want to put up that kind of money to pay the debts of one American company? Who exactly, again, is that money owed to, and why should I have to make them whole?

Nocera offers some hints:

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.

Bailing out nice European banks, pension funds, hedge funds, and others sounds very worthy, but why again should I have to take the loss? Wouldn't it have been fairer to simply apportion the losses to all those worthy banks, rich people, hedge funds, pension funds, widows and orphanages who bought the rotten assets and the phony insurance? Isn't that what a bankruptcy would have done? After that, if the taxpayer's representatives thought that some of those widows and hedge funds looked pitiful and worthy enough, wouldn't that have been the time for us to put up the cash?

I realize that there is a counter argument that such a course would have irretrievably have collapsed the world financial system, but how exactly would that have happened? And why, again, is there no fix that doesn't leave all the perpetrators of this catastrophe with their own personal jets and even bonuses intact?

I really don't approve of torture, but if water boarding Hank Paulson and the CEOs of Citi, Lehman, AIG, etc could clarify this point, I might be willing to make an exception.

UPDATE: Tyler Cowen tells us why the banks are hard to fix. The final wordbite:

The outlook is bleak. Perhaps true and irrevocable insolvency will force the hand of the regulators to act more decisively. In the meantime, the banking system will be very hard to fix.

Also, via Cowen, Megan McCardle:

It's easy to blithely say "Why don't they just make the bondholders take a haircut?" Harder when you think about who those bondholders are: insurers. pension funds. the bond component of your 401(k). Financial debt makes up something like a third of the bond market, and the largest holders are pensions and insurers.

The insurers are the biggest problem, because they're just so heavily regulated. They're not allowed to hold risky assets. Convert their bonds to equity and they will be forced to dump that equity at prices that will trend towards zero. Many insurers will see their capital impaired below the regulatory limits, requiring a government bailout.

Pension funds are the next biggest problem. They're already in big trouble because of stock market declines. The bonds are the "safe" portion of their portfolio, the stuff that's supposed ot be akin to ready cash. Convert their bonds to equity--or worse, default--and suddenly they're illiquid and even further underwater.

Nor is the 401(k) problem small. Bond funds are typically held most heavily by the people closest to retirement; they're for income, not capital gains. What is your mother going to do when a third of her mutual fund income gets converted to equity that produces no cash and can't be sold because the insurers have all had to dump their shares on the market at once? Or simply disappears into the land of bankruptcy lawsuits

Ah yes, the widows, orphans and hedge funds.

My favorite part of her article though:

Why is the government so reluctant to hand losses to the bondholders? The standard explanation on both far left and far right is that Treasury and the Fed are in the pocket of the banking industry, and Geithner et. al. are simply bailing out their corporate masters. I don't entirely discount this theory, though I would (and did) put it more nicely: all the information the regulators has comes from the people they are trying to regulate. This naturally biases them towards the regulated. Every time I am tempted to get outraged about this, I think through the alternative: regulators who don't have much interaction with those they oversee. I'll take Tim Geithner over Maxine Waters any day of the week, and twice on Sunday.

The dismissal of the "standard explanation" looks pretty weak to me. It's sort of like saying that the greatest expertise on cat burglars is among cat burglars, so only they can be trusted to make laws concerning cat burglary.

UPDATE II: Tyler Cowen (the-banking-crisis-as-a-foreign-policy-issue) says it in print:

No one wants to say it, but essentially the Fed has been bailing out European banks.

The inflation-adjusted cost of the Marshall plan has been estimated at about $115 billion in current dollars. If we end up spending $250 billion on AIG, how much of that sum will go to European financial institutions and might it someday exceed the scope of the Marshall plan? (I do not, by the way, think that central banks ought to treat foreign creditors differently.)