naked capitalism

Why is AIG being permitted to continue to give the finger to the government, and ultimately, the US public that saved its bacon?

The sort answer, is that the US government’s need to resort to accounting fictions is being used skillfully against it.

The latest AIG stunt is that it is refusing to sell its derivatives business. Remember that AIG owes the taxpayers a mind-numbingly large amount of money, but intransigent CEO Robert Benmosche has refused to execute on the agreed-upon plan, and instead is off on his own mission.

And why might that be? This is yet another, classic management favoring “heads I win, tails you lose” bet that is given more respectful treatment than it deserves by the Financial Times:

AIG has shelved plans to sell the whole of its derivatives portfolio, which nearly destroyed the insurer in 2008. It believes that keeping up to $500bn worth of complex positions could help it to survive as an independent entity and repay US taxpayers….

Yves here. Having AIG survive as an independent entity was NEVER an objective of this exercise, never. The fact that that management/company flattering notion is given any credence at all is appalling. Many storied companies are dead or very much diminished due to poor management decisions: A&P, Woolworths, Polaroid, U.S. Steel, Pan Am, TWA. AIG has no God-given right to exist.

The logic of the “let us hang on to the money” is that AIG can improve returns by keeping the money longer. But that was never the purpose of this exercise. The intent was very clear: that AIG was to be dismembered. And that is a fine outcome. Taxpayer money recouped, systemic risk eliminated. And AIG is hardly a deserving candidate for any kind of break. It was extraordinarily badly managed from an operational standpoint; Sorkin’s Too Big Too Fail makes it clear than the company had antiquated accounting systems and was unable to gauge its cash needs (another sign of how badly the company was run: I am told a Greenberg relative was buying the stock all through 2008 through the bailout on insider reports that everything was fine, the concerns were way overblown). As important, AIG has never been a good corporate citizen. It is a master of loophole-bending, aggressive lawyering to avoid claims payment, jurisdiction shopping, bribes (see here and here), kickbacks and dubious accounting.

Let’s return to the Financial Times:

Gerry Pasciucco, who joined AIG after it was rescued by the government in September 2008 to wind down AIG Financial Products, said the troubled unit would still be out of business by the end of this year….

The original plan…was to sell off all the positions and close down AIGFP as soon as possible. But Mr Pasciucco said that derivatives with a notional value of between $300bn and $500bn – or between 15 and 25 per cent of the derivatives portfolio’s original size – would not be sold. The assets could either be managed by AIG or outsourced to an external fund manager, he added.

AIG’s management, led by chief executive Robert Benmosche, believes that such a move reduce the need for fire sales and enable AIG to reap the benefits of rallying credit markets, Mr Pasciucco said. AIG recorded billions of dollars in paper profits on its derivatives in the third quarter of 2009…..

AIG executives said the Treasury and the New York Federal Reserve, which took an 80 per cent stake in the insurer in return for more than $80bn in federal funds, had been consulted on the decision to keep the derivatives. Peter Hancock, the derivatives expert who has just been hired to oversee AIGFP, among other responsibilities, is also believed to back the move.

Yves here. I prefer Rep. Brad Sherman’s take on this matter:

If [Benmosche] holds onto [the assets] and their value goes down, the taxpayer loses, and if they go up, he and AIG’s shareholders win… “It’s heads he wins, tails we lose.

Yves again. This is basically a market timing bet. And how seriously ought we to take this?

The Fed’s massive securities purchases had the effect of suppressing volatility, which would be particularly flattering to derivatives positions as AIG has found. As the Fed stops its market interventions, AIG will no longer have this wind in its sails. As Nouriel Roubini noted:

… the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low…. the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring.

Yves again. Now AIG claims to have in fact reduced its portfolio’s exposure to changes in volatility (known as vega) considerably. But if that is indeed true, that AIG has been unwinding its riskiest trades (riskiest measures in volatility terms) one might think what remains would be easier to value (I’d be curious for reader input on this notion, plus whether “gross vega”, the measure that AIG keeps citing, is really the best way to look at portfolio-wide exposure to vol).

There is another possibility, that now that AIG has wound down the portfolio by a bit more than half, that, what is left is utter dreck, so this is a kick the can down the road exercise, to camouflage the full extent of the losses as long as possible. But even in that case, there is still a market bet operative.

Ultimately, this incident is yet another symptom of the problematic governance arrangements in place with AIG. The authorities find it necessary to pretend that AIG is a private company when it never should have been afforded that privilege. AIG was unquestionably bankrupt. The Swedish model, which most experts consider to be best practice, is to fire top management and the board. Their replacements are given specific targets and timetables, are required to report on their results and progress pretty frequently. and have considerable latitude in how to meet their goals,. This is similar to the way private equity investors manage portfolio companies.

But what do we have with AIG? Rather than take 100% ownership of AIG, it has taken only 79.9%, which was a bit of a fiction, since the original Fed loan was secured by all the assets of AIG. But the not taking full ownership was to avoid consolidating AIG debt on the Federal balance sheet (that’s is why the Feds similarly own 79.9% rather than all of Freddie and Fannie). So that means AIG is still subject to an SEC reporting regime, with minority shareholders. That still might have been workable had the government demanded letters of resignation from all board members as a condition of the bailout (the idea being they would leave as soon as replacements were found; two stepped down after the bailout, and three did not stand for re-election last May). Uncle Sam has installed three trustees to oversee AIG, but they did not make much of an impression on Ed Liddy, Benmosche’s predecessor, and Benmosche seems impervious to outside influence.

As we noted last August, which started with a remarkable quote from Benmosche, then AIG’s new CEO:

Benmosche told employees that he “had the luxury to say to the government, I’m not going to rush to do this. I’m appalled at how much pressure has been put on all of you to just sell it no matter what, because the Fed wants out, or the Treasury wants out. If they want out in a hurry, they shouldn’t have come in in the first place.”

For anyone who followed the rescue, this is a staggering bit of hubris and revisionist history. First, the idea that the government “came in” implies that this was some sort of normal investment process, as opposed to AIG begging the Federal government for a rescue, even though states, not the national government, are the main regulators of insurance business (the AIG Financial Products business was overseen, if you can call it that, by the Office of Thrift Supervision. AIG structured its operation so as to get them as supervisor precisely because they were guaranteed to do next to nothing).

Next, the original deal called for AIG to pay back the money in two years. That inconvenient fact has been airbrushed out of the story Benmosche tells us. AIG made great assurances that the operating units were worth a lot of money and paying back the loans would be no problem. They accepted a high rate of interest given the riskiness of the loans and the desire of the Federal government to keep the heat on AIG. This original deal in theory fit Bagehot’s rule: lend generously, at a penalty rate, against good collateral.

But AIG fooled itself, or maybe just everyone else. Those supposed crown jewels were worth a lot less than AIG thought.Once they had established they would not be permitted to fail, they started retrading the deal. When AIG realized it couldn’t sell some operating units, pronto, suddenly it started complaining the interest rate (I think Libor plus 8 1/2%, forgive me for working from memory) was too high. Oh, and they happened to need more money too, a wee oversight in their initial demand. So the deal was reworked to give them better terms, a bigger commitment, and NOTHING ADDITIONAL was obtained. This was a free concession, a very bad move in deal land.

The government owns 79.9% of AIG. Any private sector owner who had an overwhelming majority interest and got that kind of attitude from a CEO would fire him immediately. But no, we live in a world where arrogant members of the financial services industry engage in looting, dictate terms to the government, and try to rewrite history to make baldfaced lies seem plausible. Why shoudn’t the government pressure AIG? The idea that owners don’t pressure companies (the subtext of this remark) is an absurd misrepresentation. Go talk to the management of any underperforming company owned by a PE or venture capital firm. For the most part, they do not play nice, and would never tolerate Benmoshe’s posturing, and he knows that. He is simply playing the media and the public for fools.

When you think this AIG drama can’t get any worse, predictably, it does.