AIG is one big taxpayer IOU

In the years ahead, whenever economic conservatives and market absolutists point out the wonders of the market, just mention a popular four-letter word. Actually, this particular word has only three letters: AIG.

And the issue is not the bonus controversy -- far from it. While the public voices understandable anger at the prospect of the federal government rewarding professionals working at under-performing AIG with large bonuses, a matter of far more importance to taxpayers, the economy, and the financial system alike concerns the ultimate cost for the AIG (AIG) bailout.

Or in other words, the popular media has gotten it backwards (or upside down) again. It's devoting tons of news space and broadcast time to AIG's bonuses, while allocating only a scant amount of coverage to the bailout costs for AIG. The AIG bonus issue merits an systematic Congressional review, but it's not worth anywhere near the media time being dedicated to it.

A gargantuan bill . . . for one company

The AIG bailout's cost does merit more attention, however. No one can state with certainty how much AIG's bailout will cost. AIG, which sold credit default swaps -- really, a form of credit default insurance -- faces claims from banks and other financial institutions, as they seek payment for swaps and insurance purchased for investments, including many mortgage backed securities that are now worthless. AIG did not have adequate capital to pay claims, which is why, given the company's vast and complex linkages to the global financial system, the U.S. Federal Reserve intervened last year to save AIG, with the U.S. government purchasing a nearly 80 percent stake in the company. To date, the U.S. government's investment in AIG exceeds $200 billion.

Economist David H. Wang, whose specializations include credit analysis, said the likely bailout bill for AIG will exceed $400 billion. Still, Wang underscored that the $400 billion estimate assumes that the U.S. and global economies will recover by late 2009, and that the recessions don't deepen. If the latter occurs, AIG's losses will increase, and the AIG bailout will exceed $500 billion, he said.

Imagine that: a $500 billion U.S. government liability for one company -- staggering.

Economic conservatives will no doubt quickly point out that federal cash infusions for Fannie Mae (FNM) and Freddie Mac (FRE) will exceed AIG. The counter to that critique is that Fannie and Freddie had and have a designated public policy function: to buy mortgages to free-up capital so that banks could make more mortgages, facilitating home ownership.

Conversely, prior the financial crisis, AIG had no public policy role. "Then, due to a changed financial climate – bang! A bill is issued to the U.S. government for $200 billion," Wang said. "It's a stunning and costly turn of events, when you think about, from a taxpayer burden standpoint, and one that can't be replicated. In the future, the federal government can't be faced with these 'Saturday night surprises' where all of sudden we're writing checks for $200 billion and $300 billion."

New powers sought

Moreover, U.S. Federal Reserve Chairman Ben Bernanke, in testimony delivered Tuesday before the House Financial Services Committee, recommended that Congress provide new powers to the Fed and / or U.S. Treasury to take over and wind-down failing institutions, including those, like AIG, that pose risks to the financial system. Bernanke also said municipalities and other institutions, not just financial institutions, could conceivably pose a systemic risk.

"If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. AIG highlights the urgent need for new resolution procedures," Bernanke said Tuesday.

U.S. Treasury Secretary Timothy Geithner also said existing federal financial regulations should be revised to eliminate gaps that prevent regulators from reining-in companies posing systemic risk.

"All institutions and markets that could pose systemic risk will be subject to strong oversight, including appropriate constraints on risk-taking," Geithner said, Bloomberg News reported Tuesday. "Regulators must apply standards, not just to protect the soundness of individual institutions, but to protect the stability of the system as a whole."

Monetary Policy Analysis: Clearly, overnight bills to the U.S. taxpayer for $200 billion can't be repeated. Hence, in addition to broader power for the Fed and the U.S. Treasury to identify, intervene in, and if necessary, decide to wind-down institutions that pose systemic risk, look also for Congress to create a System Risk Regulator -- a critical, powerful new institution in the federal government. Most likely, the SRR will report to the Chairman of Fed but have independent investigatory powers: at this juncture it's unclear whether Congress wants the Fed of the SRR to have the ultimate authority to intervene. A second position would also be created to implement the wind-down process or resolve the institution, possibly inside the FDIC.
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