Fifty Chimpanzees or One Toothless Gorilla
AIG has several incredibly warm and cuddly commercials. One features a hysterically laughing baby (one has to ask the question this past week--is that baby still laughing?). The message--policyholders, you are safe, secure and happy being AIG customers. But after last week's takeover, are AIG insurance policyholders safe? With a sigh of relief, the answer is yes.
In the flurry of words on the Sunday talk shows it has been suggested again that the current crisis on Wall Street shows that insurance should be regulated by the feds and not the states. A commenter on my previous blog posed the question: do you want fifty chimps or one gorilla?
We all have a stake in how AIG treats its policyholders, and a stake in how the whole industry works too. Without the atmosphere of trust and good faith that surrounds insurance, no one could get a loan to buy cars or homes. Imagine where the economy would be without credit and the insurance industry.
AIG's financial meltdown this past week was not the result of failed insurance regulation. (Go ahead. Read that one more time, real slow.) AIG has about seventy insurance company subsidiaries. Each and every one is under the jurisdiction of a state insurance regulator. Not a single AIG insurance subsidiary is insolvent. Not a single one, or all of them together, is the cause of AIG's difficulty. The fault for AIG's woes lies in two federal laws that hurled us headlong into financial services deregulation. As a result of this deregulation, AIG's non-insurance parent company is not held to the same investment, accounting and capital adequacy standards as its state-regulated insurance subsidiaries.
According to the first one, the 1999 Gramm Leach Bliley Act, state insurance regulatory authority is limited to actual insurance entities and transactions with those entities. Senator Phil Gramm (the guy who thinks we are a nation of whiners and having a "mental recession") led the Senate Banking Committee that sponsored the act that bears his name. He later joined UBS Warburg, the investment banking arm of a large Swiss bank as a lobbyist. The second piece of deregulation legislation Phil Gramm deserves to be known for is the Commodity Futures Modernization Act of 2000. The act specifically banned regulation of something called "credit default swaps." And it is precisely the creation and trading of these unregulated CDS's that led to AIG's downfall.
In a nutshell, here is how a CDS works. Imagine lending money to your brother-in-law whose creditworthiness is only so-so. You would be reassured to find someone who would guarantee repayment of the loan -- even if you had to pay a premium for the guarantee. This arrangement is a "credit default swap." Now, further imagine that your brother-in-law defaults, and the guarantor of the loan doesn't have the capacity to pay off either. In the unregulated world of credit swaps no one has really paid attention (and the hands of state insurance regulators were tied) to whether the sellers of were capable of meeting their obligations. As a result of a wave of bad home mortgage loans threatens to capsize our whole financial industry, including a number of "unsinkable" giants like AIG.
As AIG was floundering last week, insurance regulators were concerned that the company might raid the funds of its insurance subsidiaries. The regulators were fully prepared to seize the subsidiaries in order to protect policyholders - literally, to throw out management and change the locks. Fortunately for AIG, it didn't come to that.
In the aftermath of the AIG and other bailouts, people are asking what permanent reforms are needed. So what about the suggestion that federal regulation of insurance is needed because having the fifty states regulate insurance is too disjointed? I would strongly disagree. State regulators can be faulted for many things (including being ardent and mistaken supporters of Gramm Leach Bliley) but they did the job they are supposed to do by protecting AIG policyholders. However, I would suggest at least two reforms. First, we should re-create the Depression-era wall of separation between insurance and banking that was torn down by the Gramm Leach Bliley Act. (Some provisions of GLBA are arguably beneficial, so I don't suggest a total repeal.)
Second, credit swaps and other exotic financial securities need oversight. Insurance regulators faced a similar challenge in the 1990's when insurers were investing heavily in junk bonds. At the request of insurance regulators, state legislators in many states acted to limit exposure to these risky investments. Congress needs to similarly rein in the use of risky credit default swaps.
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"As a result of a wave of bad home mortgage loans threatens to capsize our whole financial industry, ."
No, you need one more step to set up this result.
The dot-com bubble like other bubbles was the result of the over-valuation of by banks, funds and insurers of assets for which there was no real or liquid market - because the shares in one dot.com company might show huge increases in value on the market, shares of other dot.com companies were often revalued upwards in step
So to correct this accountants introduced the 'mark to market' rule which requires regular revaluation of assets to their real market value.
As a consequence a few bad loans led to the devaluation of the securities they were tied in with, but this forced accountants to write down the value of similar assets because that became the market price regardless of the actual financial security of the underlying assets and no-one could establish the actual value of the security as this needs tracing the actual dollar value of the underlying mess of securities. Hence rather than a 'bubble' of prices leapfrogging upwards we have an implosion of write-downs which deter buyers and force further write downs.
It doesn't mean the securities are worthless - potentially much of the interest and eventually the capital underlying them will be repaid to the holder but they have virtually no 'market price' and this is the value they have to be given.
Excellent analysis. I agree that the AIG loan is completely different from Paulson's 'Blank Check' to Wall Street. You, and other commentors have elicited the facts in this case.
I can only hope that our congresscritters do not jump to the whistle and agree to this current - or even marginally modified - plan. Any bailout should be on similar terms to AIG, with, I would suggest, even firmer requirements on the loan recipients regarding conduct of business, compensation practices, and settlement terms.
You are absolutely right, Ms Senn. The push for federal regulation of insurance has always been motiviated by a desire to avoid state regulation, which the industry sees as unduly protective of consumers. In other words, it is an effort to deregulate insurance. A number of states regulate the rates that insurance companies may charge their customers--a switch to federal regulation would do away with that. State regulators routinely conduct examinations of the way insurers treat their customers--a switch to federal regulation would mean the end of that as well, unless a huge federal bureaucracy is created, which no one supports.
It is ironic, to say the least, that in light of failures in the parts of the financial services industry that are under federal jurisdiction, the cry is being heard that we should take the insurance industry, which under state regulation is doing relatively well, and subject it to federal regulation. The industry wants to take advantage of this crisis to achieve a goal that it has been unable to achieve thus far. Congress should resist.
of all the loans, looks like the AIG loan is the safest one. let me explain before you angry libs kill me :).
1) Govt doesnt have 80% equity yet in AIG. it has warrants that could be excercised if AIG doesnt make good on its loan. So a lot of shareholders are pressuring the CEO on asset sales to pay the govt its loan back ASAP.
2) AIG CEO is announcing in 7-10 days what divisions of AIG will be on the chopping block. on the line are US insurance business and airline leasing business. along with a few other divisions, there is a huge chance that the govt. wont even have to wait 2 years to get that principal+interest back.
3) Even though AIG was insolvent, it still has assets worth north of 100 billion. Remember that line
"sum of parts is more than the whole". Well selling off some of the good assets of AIG will pay off the govt loan pretty fast.
Lets hope the shareholders (by that it means big mutual fund managers and institutional investors) of AIG pressure/armtwist to hold asset sales asap. thats the only way , govt doesnt get to excercise its warrants and dilute their stake.
any further questions?
Yes. When is the CEO announcing his resignation?
sorry I am not the ceo or the management (heck i am not even shareholder of AIG). so dont know when the ceo is leaving.
all i did was analysis based on Govt.'s warrant stake in AIG, news on asset sales, nature of the transaction between AIG and govt.
watch out for the news of AIG asset sales in next 2 weeks. I hope you understand the criticality of the situation AIG is in. The loan it got is a floating rate loan (LIBOR + 8%). So govt. didnt give the money to AIG to let it survive in the way it is. :).
Govt. will make out fine with the AIG deal. I cant say the same for the other ridiculous bailout though.
actually, several top folks are/will be gone. There was an interview of Hank Greenberg, the papa of AIG, who was VERY UNHAPPY at what they did to his company. And he laid it out, in different terms, but with the same conclusion as the original post.
They went for the free money, got their fingers burned, and ran to Uncle Sam for a bailout. That only works if you are huge, and while the US Constitution (remember that piece of paper that BushCo ignore all the time?) Article 1, Sec 8, requires congress to create unform laws for the bankruptcy protection of its citizens.
Our Congress has done just the opposite. It created laws that support credit card companies, removed bankruptcy protections from the little guy, and institutionalized financial serfdom for 250,000,000 of us.
"of all the loans, looks like the AIG loan is the safest one. let me explain before you angry libs kill me :)."
Why do you think someone, left or right, would "kill" you for accurate analysis. Remember, facts have a liberal bias :-)
Thank you, Ms. Senn--brief and clear (and partisan, but aligned with my predilections).
Please feel free to provide another such discourse daily, with gradually increasing detail as you lead us through the arcana of high finance and the insurance racket. I note that your expertise extends to health insurance; if you want abundant posted replies, writing on that topic is the way to attract them.
I have long felt (that is, for decades) that real business owners favor regulation as a way to avoid a race to the floor on all matters related to fair dealing, honor toward your employees, and an ability to take a long view (beyond the end of the current quarter). The business owners that don't want regulation think they are smarter, tougher, more ruthless, quicker, etc. than the next guy, and, being willing to do "whatever it takes" to prosper, they are superior beings. This attitude generally persists until (a) they have driven all of their competitors out of business (proving their own superiority), (b) they have ruined the lives and/or businesses of employees and suppliers alike (proving these folks' weakness), (c) they have destroyed their own business (proving that the world is not ready for true greatness), and/or (d) they have been indicted (proving the core rot of the culture). I suspect this is an oversimplified dichotomy, but I would appreciate your view.
Thanks for your comment and I will be addressing health insurance issues in the future.
I suppose you could draw the analogy to 'policyholders, you are safe, secure and happy being AIG customers.'
Voters, you are safe, secure and happy with a Republican Administration.
Before Phil Gramm take the oath as McCain's treasury secretary it would be nice if he repaid the taxpayer the trillion dollars he owes us.
He could always find new ways of losing those trillions when McCain puts him back in the saddle.
I'd like to hear what Gov. Palin has to say on this -- what's that you say? She's in her bunker with Cheney? Never mind, then...
Since the McCain/Palin campaign is stonewalling the MSM & limiting Sarah's appearances, don't expect to hear from her on anything.
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