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Posted by on Sep 16, 2008 in At TMV, Economy, Politics | 6 comments

Fed bails out AIG with $85 billion loan

It was either this or a catastrophic bankruptcy that would have rippled through the economy. For the first time in US history, the Federal Reserve has placed an insurance company in conservatorship. The deal roughly calls for the Federal Reserve to assume 79.9 percent of AIG’s equity while lending the insurance giant $85 billion to continue operations under Federal control. The Feds will replace AIG’s management and will, presumably, continue to operate the firm through this period of turmoil.

As the New York Times puts it, just two weeks after the takeover of Fannie Mae and Freddie Mac, the AIG bailout is the most “radical intervention in private business in the central bank’s history.”

There are a few reasons why this is extremely controversial. First, it has never happened before. Ever. The Carter Administration helped subsidize loans to Chrysler in 1979, though the taxpayers actually earned some of the profit of Chrysler’s recovery. The Federal government bailed out the Savings and Loan industry in the late 1980s. And there was Freddie Mac and Fannie Mae earlier this month. But never has an insurance company – a single company – been bailed out in such a manner.

The second and arguably more important consequence has to do with what AIG is. AIG is no ordinary insurance company that just writes property, casualty and life insurance policies. No, AIG is MUCH more than that. It helps ensure bonds through a complex financial instrument known as credit default swaps. As a result of these swaps, thousands of bond issues receive a higher rating thanks to this extra insurance. Without AIG, these bonds would be rated lower and consequently worth less. AIG also holds as much as a trillion dollars in assets, including a fleet of airplanes.

Yes, AIG is more than just a regular insurance company. It serves as the very sinew of modern global finance. Its tentacles reach into every market around the world, and its reach touches public pensions, 401(k)s, mutual funds and more. It’s hard to find a major financial transaction of late that does not, in some way, involve AIG.

And it’s for that reason that the Fed decided it could not let AIG fail. Lehman Brothers? Sure. But not AIG.

Unfortunately, however, bailing out AIG will not be very easy. The $85 billion loan is bad enough; even in the modern world of high finance $85 billion really is a LOT of money. But much of the assets that the Federal Reserve is taking over are junk. Yes, AIG got into the same mess as Lehman Brothers – investing in the subprime mortgage market. As a result, AIG’s portfolio has plummeted in value alongside its insurance rating. And now the US taxpayers will be asked to assume ownership over AIG’s garbage portfolio under the hopes that new management will crawl through the broken glass of AIG’s asset base and find the pieces of value worth retaining. It won’t be easy.

The political fallout will be interesting to watch. I suspect both the McCain and Obama campaigns will say that this bailout is necessary given the alternative. Bad as a government takeover of an industry may be, it probably pales in comparison to a global meltdown in financial markets. But the bailout actually highlights something that Barack Obama mentioned in his economic speech at Golden, Colorado today: excessive deregulation.

It happened in the 1980s, when we loosened restrictions on Savings and Loans and appointed regulators who ignored even these weaker rules. Too many S&Ls took advantage of the lax rules set by Washington to gamble that they could make big money in speculative real estate. Confident of their clout in Washington, they made hundreds of billions in bad loans, knowing that if they lost money, the government would bail them out. And they were right. The gambles did not pay off, our economy went into recession, and the taxpayers ended up footing the bill. Sound familiar?

And it has happened again during this decade, in part because of how we deregulated the financial services sector. After we repealed outmoded rules instead of updating them, we were left overseeing 21st century innovation with 20th century regulations. When subprime mortgage lending took a reckless and unsustainable turn, a patchwork of regulators systematically and deliberately eliminated the regulations protecting the American people and failed to raise warning flags that could have protected investors and the pensions American workers count on.

Never mind the implied connection between John McCain and the S&L crisis, this passage demonstrates just how similar these two phenomena are. In both cases lax regulators given over to an ideology of deregulation encourage massive risk-taking in industries not prepared for it. In both cases greedy companies privatized the profit but socialized the risk through government bailout.

This speech could have been delivered with even more poignancy after the AIG bailout. Whereas Senator McCain waffles back and forth between ideological support for deregulation and a new-found but vague populism, Senator Obama shows throughout this speech that he has been pressing all along for newer and more effective systems of regulation to handle the 21st century economy.

In February of 2006, I introduced legislation to stop mortgage transactions that promoted fraud, risk or abuse. A year later, before the crisis hit, I warned Secretary Paulson and Chairman Bernanke about the risks of mounting foreclosures and urged them to bring together all the stakeholders to find solutions to the subprime mortgage meltdown. Senator McCain did nothing.

Last September, I stood up at NASDAQ and said it’s time to realize that we are in this together – that there is no dividing line between Wall Street and Main Street – and warned of a growing loss of trust in our capital markets. Months later, Senator McCain told a newspaper that he’d love to give them a solution to the mortgage crisis, “but” – he said – “I don’t know one.”

In January, I outlined a plan to help revive our faltering economy, which formed the basis for a bipartisan stimulus package that passed the Congress. Senator McCain used the crisis as an excuse to push a so-called stimulus plan that offered another huge and permanent corporate tax cut, including $4 billion for the big oil companies, but no immediate help for workers.

This March, in the wake of the Bear Stearns bailout, I called for a new, 21st century regulatory framework to restore accountability, transparency, and trust in our financial markets. Just a few weeks earlier, Senator McCain made it clear where he stands: “I’m always for less regulation,” he said, and referred to himself as “fundamentally a deregulator.”

This is what happens when you confuse the free market with a free license to let special interests take whatever they can get, however they can get it. This is what happens when you see seven years of incomes falling for the average worker while Wall Street is booming, and declare – as Senator McCain did earlier this year – that we’ve made great progress economically under George Bush. That is how you can reach the conclusion – as late as yesterday – that the fundamentals of the economy are strong.

Agree or disagree with Barack Obama’s approach to reforming Wall Street, he’s clearly been advancing a plan to change the regulation mechanism. Obama rightly mocked the “blue ribbon commission” from McCain, knowing full well that it’s a poor substitute for a plan. Expect to hear the specifics of these reform plans spelled out in sound-bytes over the next few days.

Barack Obama has gone right after the conservative economic philosophy that’s guided Washington since 1980: deregulation at all costs. Both parties participated in this; in fact, the law that encouraged the current crisis was written by McCain adviser Phil Gramm but signed by Bill Clinton. But the ideology has run its course. De-regulation and small government conservatism is reduced to farce and irony: the Bush Administration must intervene to take over a private insurance company, effectively-nationalizing a major portion of the insurance industry.

The economic fallout from this is hard to measure. Wall Street will undoubtedly respond with relief. Once again they learned their lesson the easy way. But the American taxpayer will get saddled once again with the detritus of Wall Street’s greed and the government’s negligence. It seems high time for a new approach.