Streetwise Professor

March 18, 2009

Bills of Attainder, AIG Edition

Filed under: Derivatives,Economics,Politics — The Professor @ 8:45 pm

In Britain, a Bill of Attainder was a private bill in Parliament which imposed a punishment on a specific person, or group of people, without any trial.  Their abuse was so notorious, that they were specifically proscribed in the US Constitution.

Perhaps there are legal nuances that distinguish the many of the legislative and administrative proposals being bandied about to strip AIG employees of bonuses (some already paid) from Bills of Attainder, but there is plenty of family resemblance.

I say again.  There are legal provisions under which contracts can be modified (e.g., bankruptcy). If they apply here, then by all means proceed.  Unlike the attainder-like proposals ricocheting around Capitol Hill, these mechanisms embed various procedural protections, require rigorous fact-finding, and can draw upon a variety of precedents.  All of these reduce the likelihood of legal error.  If these do not apply, then let’s speak no more about it.

And by all means, every one of the Capitol Hillbillies that has been running his or her mouth on the subject should STFU.  As should pretty much everybody in the administration.  The grandstands are closed.

One sentiment (I won’t dignify it with the words “thought” or “idea”) that I’ve heard is that since the government now owns AIG, it can do whatever the hell it wants.  Uhm, no.  A firm is a nexus of contracts, and if you acquire it, you acquire the entire bundle.  Not just the contracts you feel like living up to.

But the ownership issue does raise a set of questions relating to the bailout, and the “logic” behind it.

The story of the bailout in a nutshell goes: AIG did massive trades without having to post any collateral, due to its sterling credit rating.  (Given the UK’s current condition, that phrase may be obsolete.)  However, the mark-to-market losses on its derivatives and securities lending business became so large that the company’s credit rating was cut to below investment grade, triggering huge collateral calls.  The mark-to-market hole was so deep firm couldn’t make these calls, and fearing a meltdown, the Treasury stepped in.  The bulk of the cash it supplied the firm went to meet collateral calls to various counterparties.

Now, if these counterparties viewed the government-owned AIG as being backed by the full faith and credit of the US government, there would be no need to post collateral.  The fact that government cash went out the door to meet AIG’s collateral requirements means either (a) counterparties don’t view AIG’s credit as good as the Federal government’s, or (b) the AIG bailout is really a disguised lending program for the counterparties, or (c) the government is clueless.

Now, insofar as (a) is concerned, there is good reason to believe that even in government hands that AIG’s credit is bad, and it poses a substantial risk of default.  After all, the government has a limited liability equity stake.  It can still walk away.  Given that fact, perhaps the counterparties are operating under the motto “In God We Trust.  All Others (including Uncle Sam) must pay cash.”  Presumably, the howling over the bonuses only encourages those now holding AIG collateral to think that keeping their hands on that cash is a far better alternative than to rely on the hope that the government will come through when the contracts at issue actually must payoff.  (Whether it should is another issue.)

This illustrates one of the absurdities in keeping AIG in its current Living Dead state.  If the government really intends to guarantee that AIG’s obligations will be paid off (in order to avoid a systemic crisis) then it can do so without having any cash go out the door as collateral to ease the fears of jittery counterparties.  The government could provide an explicit guarantee of the contracts in question.  It could novate the trades, and substitute itself for AIG as the counterparty.  (Or perhaps the Fed could do this.)

Now, from a mark-to-market perspective, either would be a wash.  The liability is worth what it is worth.  But they would not require the government to pony up tens of billions in cash to provide to counterparties.  Just like AIG’s counterparties effectively extended credit to the firm by allowing it to hold underwater positions without collateral, the government should be able to do the same thing.

Indeed, if Treasury and the Fed really believe what they’ve been saying since the crisis broke in the late summer, the mark-to-market loss on the position is far greater than the present value of the loss that the AIG portfolio is expected to suffer.  After all, Bernanke and others have argued that the market prices of these positions are artificially depressed as a result of the lack of liquidity, and the potential for fire sale liquidations of troubled assets.  So, according to this logic, if Treasury (or the Fed) took these positions onto its books, the eventual cost to the taxpayers would be expected to be smaller than the current mark-to-market loss–and hence smaller than the amount of government cash paid to counterparties as collateral.  (Of course, if this is right, then eventually some of that collateral will be paid back as liquidity improves and market prices rebound as a result.  But, since the government doesn’t own 100 percent of AIG, it will only capture a fraction–80 percent, if memory serves–of that rebound.   But note that this means that the government could potentially face the risk that the counterparties would not pay back the collateral.   Which raises another question: is this truly collateral, held in a particular account, not commingled with the counterparty’s funds?)

This all raises questions in my mind as to why the government is persisting with this indirect way of absorbing the risk on the AIG positions.  If the powers that be consider it essential that the government absorb this risk because (a) AIG cannot, and (b) doing so is necessary to maintain the stability of the financial system, then why do it in a way that (c) requires a lot of cash, and (d) incurs the agency costs and other frictions that arise when working through a firm with incentives that are not necessarily well-aligned with those of the taxpayers.

Thus, I hold open the possibility that there is an ulterior motive for the convoluted structure of this intervention.  The difference between the intervention as it is, and the alternatives I’ve sketched above, is that the existing structure puts a lot of cash in the hands of large financial institutions, whereas the alternatives would not.  It effectively monetizes the mark-to-market values of the positions these institutions had with AIG.  This suggests that the reason for doing it this way is that it effectively extends credit to these institutions.

But, this just kicks the can down the road.  If these institutions need injections of government credit, why not do it in a more straightforward, transparent manner?  Or is this indirection part of the plan, an effort to conceal the liquidity needs of these institutions?

I dunno for sure.  What I am pretty sure of is that the “collateral” narrative does not make a lot of sense.

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