David Stockman (1) AIG

I can remember when David Stockman was Ronald Reagan’s budget director. At that time, I was impressed with his stand for economic principle over political expediency, so I was interested when I picked up a copy of his latest book from my local library. The book is called The Great Deformation: The Corruption of Capitalism in America.

The book is very long, rambles in places, and it could have benefited from a thorough editing, but he has some intriguing thing to say. His overall theme is crony capitalism and the harm it has done. He begins by explaining why the bail out of the insurance giant called AIG was unnecessary.

In the previous decades, Hank Greenburg had grown AIG through a series of mergers and takeovers of insurance companies all over the world. AIG had taken over a string of large life and casualty insurers including Western National, SunAmerica, Hartford Steam and Boiler, and American General. AIG’s total assets went from $140 billion into $450 billion in three years.

When Lehman Brothers collapsed, AIG went to the government requesting a rescue, Hank Paulson claimed that AIG had to be saved, or insurance policies all over the world would be worthless, and ordinary people would be left at risk of disaster with no insurance cover. Paulson claimed that AIG was entwined with the global system touching business and consumers alike. Stockman says this was a lie designed to scare Congress into action to benefit the investment banks.

The reality was that AIG had become a glorified insurance mutual fund. It had grown to be a giant by acquisitions and investments, but it did not have automatic access to the assets sequestered in its far-flung subsidiaries. They were protected by by state insurance commission rules designed to protect policyholders and ensure solvency.

At the time of the crisis, 90 percent of AIG was solvent and no danger to the financial system, or anyone else. Its $800 billion balance sheet consisted mostly of high-grade stocks and bonds that were domiciled in a manner that prevented contagion. Its massive high-grade assets were parcelled out into scores of insurance subsidiaries subject to legal and regulatory jurisdictions scattered all over the globe. These lockups protected policyholders and ensured that there could be no asset stripping action by the liquidators of the AIG holding company. The insurance subsidiaries were asset rich. The liabilities of these companies were the future claims of the policyholders, which come slowly over time. There could not be a panic “run” by policyholders, because their claims would mature over months and years.

The real problem with the AIG holding company was that it had been guaranteeing some of the toxic derivatives created by the big five investment banks. These were domiciled exclusively in the AIG holding company. These obligations could have been readily liquidated in bankruptcy without any disruption to the insurance companies, their solid assets, or their policyholders. Instead of allowing this to happen, AIG was given $180 billion dollars of taxpayer’s money.

Congressional investigators later found that the $400 billion of Credit Default Swap (CDS) insurance issued by AIG were held by a small number of the world largest financial institutions, but virtually none of it was held by main street banks, so they were shielded from an AIG collapse. For the financial institutions that did hold the CDS insurance, the worst-case loss would have been only a few months bonus accrual. AIG was not a risk to the financial system. What was a risk was the bonuses of the staff at the big fie investment banks. Not surprisingly, nearly $20 billion was paid to Goldman Sachs, where Hank Paulson had previously worked. This was the equivalent of eight months profit and bonus accrual for the company.

Washington threw stupendous amounts of money at AIG in a great panic, pretending to save the world, but the main beneficiaries were their mates in the investment banks.

Scary stuff.

David Stockman cover AIG in this talk at the Metropolitan Club.