Should AIG be funded by the Fed?

AIG, the largest US insurance company by assets, is reported to have asked the Fed for a $40bn ‘bridge loan’ to tide it over while it sells assets and attracts new equity.  Unless such support is forthcoming, the company fears a downgrade by the rating agencies before it can shore up its capital base.  Such a downgrade could further weaken its balance sheet, leading to a downward spiral and possible bankruptcy.  While waiting for a Fed decision, AIG’s regulator, NY State Insurance Superintendent Eric Dinallo gave it special permission to access (i.e. to raid) $20 billion of capital in its subsidiaries to free up liquidity.

My first reaction to these stories was !*#\ӣ$%&?!!!

The activities of AIG that have got it into trouble are the provision of default insurance on mortgage-backed securities through a range of derivative contracts, rather like the ones that got the Monolines into trouble earlier in the financial crunch.

If an insurance company like AIG has become a highly leveraged financial institution deemed by the Fed to be too large, too interconnected or too politically connected to fail, and if it is as a result  granted access to Federal Reserve resources (through the discount window, through one of the existing liquidity facilities of the Fed or through some ad-hoc arrangement, secured or unsecured), then there has to be a regulatory quid-pro-quo.  AIG is not a bank.  It is not regulated by the Fed or any of the other banking regulators.  It isn’t even regulated at the Federal level at all.  Insurance in the US is regulated at the state level.  So a financial institution that is large enough to cast a significant global shadow is regulated by some provincial official in New York State.  I suppose it’s some consolation that AIG isn’t registered in Alaska.

I hope the Fed will tell AIG to go away, raise the money it needs from private sources or sell itself to some domestic or foreign party that has sufficiently deep pockets.  But should the Fed decide that it is now responsible for all highly leveraged institutions it deems systemically important, then significant regulatory authority and oversight of the Fed over AIG should be (part of) the price.  The bridging loan should also be priced punitively and be secured against the best assets in the AIG group.  The regulatory regime should involve serious capital requirements, liquidity requirements, reporting and governance requirements as well as the creation of a special resolution regime for AIG should it, in the view of the regulator (the Fed), be at risk of failing.  Something like the Conservatorship for Fannie and Freddie, but a bit harsher on the creditors, could be a model.

But before any money is lent by the Fed to AIG, even on the conditions outlined above, I would like to have the social cost-benefit analysis of this proposed transaction explained to me.   Where is the market failure? Where are the systemic externalities associated with requiring AIG to sink or swim on its own?   If the Fed were to provide funding to AIG, then, unless a convincing public interest/social welfare case is made (and I have not seen a single sensible argument in support of  such an act), I would have to conclude that the political economy of the US had become one of crony capitalism and socialism for the rich and the well-connected.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website