AIG is Left Holding the Government’s Bag

by | Mar 23, 2009

On March 16, Obama said this about AIG:  I do want to comment on the news about executive bonuses at AIG. … This is a corporation that finds itself in financial distress due to recklessness and greed. Under these circumstances, it’s hard to understand how derivative traders at AIG warranted any bonuses, much less $165 […]

On March 16, Obama said this about AIG:

 I do want to comment on the news about executive bonuses at AIG. … This is a corporation that finds itself in financial distress due to recklessness and greed. Under these circumstances, it’s hard to understand how derivative traders at AIG warranted any bonuses, much less $165 million in extra pay. I mean, how do they justify this outrage to the taxpayers who are keeping the company afloat?

In the last six months, AIG has received substantial sums from the U.S. Treasury. And I’ve asked Secretary Geithner to use that leverage and pursue every single legal avenue to block these bonuses and make the American taxpayers whole.

Yes, AIG and other financial institutions indeed were reckless. The essence of their recklessness was that they trusted and unwittingly bailed out the US Government. Now the US Government has returned the “favor,” with strings—tied into a noose—attached.

Let us review the sequence of events, which began with the Government’s creation of Fannie Mae (in 1968) and Freddie Mac (in 1970):

1. The U.S. Government, armed with the Community Reinvestment Act of 1977, forces banks to make home loans to people who cannot afford to repay the loans. At the same time …

2. Fannie Mae and Freddie Mac—Government-sponsored enterprises (GSEs)—create a credit-scoring formula with a very low qualifying score. They tell banks and other lending institutions, “If you make a home loan to anyone who meets our low qualifying score, we will buy the loan from you at a profit to you.” The lenders play along and make more bad loans. The GSEs play along too and buy the bad loans from the lenders. The GSE’s create a portfolio of about $6 trillion (half the mortgage market) in this manner.

3. At this point, the mortgage crisis is unavoidable, because this mortgage portfolio that is nominally worth $6 trillion is really worth much less, because the people who took out the mortgages will not be able to pay them back. Many of these people would not have gotten a mortgage in a free market. Others would have gotten a smaller mortgage, to buy a home for a much lower price than the  price they had to pay; the artificial demand created by the GSEs has caused home prices to skyrocket.

At this point, much of the wealth thought to be in the GSE’s $6-trillion portfolio is gone; this wealth has gone to those who sold the homes and then bought things that they never before thought they could afford and that they did not really need. The wealth no longer exists. A crisis is inevitable, though most people don’t know it yet.

And so, at this point in our process, the GSEs are holding the bag. But they get bailed out by unwitting investment firms and insurance companies, through the following scheme that has been going on concurrently with Steps 1 and 2 above.

4. For years, Government employees have hinted, suggested, implied, and never denied (except in the fine print of securities prospectuses) that the Government stands behind these dicey mortgages. Private investment firms, foolishly, are inclined to believe this. After all, these loans serve the Government’s social goal of affordable housing (i.e., robbing from the rich to give to the poor); surely the Government would not let such a “noble” program fail.

5. So, the GSEs package these loans into large bundles, and private investment firms buy the bundles—thereby bailing out the GSEs. Now the private investment firms are holding the bag. And these firms create even larger bundles of mortgages, classified by degree of risk, and sell them to other private firms. Now those private firms are holding the bag.

6. The private firms still trust that the Government will stand behind these loans if too many of the loans go bad, but—just to be safe—they want some insurance. And so they make a deal with firms such as AIG. AIG sells insurance (called “credit-default swaps”) that promises to reimburse the private firms in case the mortgages go bad. AIG is not worried because, after all, the underlying assets—the mortgages—were created by the Government to carry out noble social policy; if anything goes wrong, surely the Government will stand behind these securities and “bail us out.” And so AIG bails out the holders of mortgages created by the Government and held by investment firms. Now AIG is holding the bag.

7. Eventually, people realize that many of the mortgages are worthless. Moreover, the Government changes the accounting rules to something called “mark-to-market”; this means that, even if a borrower can pay the mortgage, the mortgage is down-valued to the current market price of the mortgage. The result is that AIG has to pay up on the insurance it wrote.

Barney Frank, Chris Dodd, Barack Obama and the rest of the Government say to AIG and investment firms: “You reckless, greedy, incompetent fools [for having bought and insured what we were selling]! Okay, we will bail you out [just as you always expected, and just as you did for us and the GSEs], but it will cost you a little something extra: From now on, we own you. And we’ll decide your salaries.”

Memo to owners of US Treasury instruments: You could be next.

An earlier version of this article was published on Ron Pisaturo’s Blog.

Ron Pisaturo is a writer and philosopher. He has written a screenplay, The Merchant of Mars. Ronald Pisaturo is the author of A Validation of Knowledge, The Longevity Argument, The Merchant of Mars, and Masculine Power, Feminine Beauty.

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