The AIG Gravy Train

One of the latest bailout memes going around is that maybe the government shouldn't have bailed out AIG, because an "AIG bailout" really means a bailout of the counter-parties, like Goldman Sachs, who were dumb enough to have AIG insure their transactions. Interestingly, one of the first people to voice this idea was none other than former AIG patriarch Hank Greenberg (whom I wrote about today), who's said that shareholders would have fared better in an AIG bankruptcy than in the federal bailout. Greenberg's take is odd--hey, wouldn't shareholders have been left with zip in a bankruptcy? But the more general complaint that about AIG--that it's not clear why the the government should be funding a $12-plus billion stealth bailout of Goldman--is understandable.

Understandable, but still wrong. One of the government's aims over the last months has been to separate toxic assets from good ones. If that's what you want to do, then AIG is by default a pretty good vehicle for doing it. It is in effect, a "bad bank"--one that has concentrated risk in bad CDOs that no one wanted. Backing AIG is in effect a way to get bad assets off other banks' balance sheets. It helps contain the cycle of failure.

Should AIG have been allowed to offer the derivatives that brought it down in the first place? Clearly, no. But they were. When it comes to insurance and bank deposits, the principle of caveat emptor is a bad one. Awful as the current crisis is, it would be worse if there was no assurance that the buck stopped somewhere. Take it away, and you simply create a world of ever more baroque transactions set up to deal with the uncertainty that insurance companies will pay out on their policy and banks will return money to depositors. The government's first job is to stop an insurer from writing hurricane policies if it would bankrupt it. But it's second is to backstop the insurance when it does.

The question of what would have happened if the government had not backstopped AIG, however, is an interesting one. Goldman says that their exposure to AIG was itself hedged . We don't know how effectively that could have been done--but we also have no reason to doubt it. If that is the case, then in fact we simply don't know who would have been on the hook if AIG failed. In effect, it might not be Goldman being bailed out, but still another set of banks and insurers. So that would add yet another "unknown unknown" to the crisis--reason enough to tread very carefully.