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A "Hedge Fund" Named AIG

05/08/2009 05:12 am 05:12:01 | Updated May 25, 2011

Losing $60B in a Quarter? Don't Try it At Home

Ben Bernanke is angry. "If there is a single episode in the entire 18 months that has made me more angry, I can't think of one," he is quoted as saying. "AIG exploited a huge gap in the regulatory system. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets, took huge losses." Mildly put, the Fed Chairman is indicating that American International Group wasn't what it seemed.

Bernanke, of course, is referring to one of the central causes of the current financial crisis. AIG (and so many other financial institutions) made "huge numbers of irresponsible bets" that were not visible to the outside world. These risks ended up threatening the stability not only of these companies but of the entire financial system. In the case of AIG, its scale, complexity, and global reach have made the problems especially palpable.

Responding to earnings pressures with risk and leverage.

Basic financial services have become increasingly commoditized, with their margins and fees declining. At least this has been the case for decades prior to the current financial crisis. Thus, the earnings of large and stable insurance companies have declined precipitously. Embarking on business model transformations while controlling may have been the right remedy, but it required leadership, vision, right people, and risk management discipline, certainly not an easy feat. It appears that AIG followed a different path, taking on huge contingent liabilities via structured products and credit default swaps. A $60 billion loss in one quarter speaks for itself.

The inadequacy of inconsistent, charter-based regulation.

According to Bernanke, "There was no regulatory oversight because there was a gap in the system." AIG's insurance unit was subject to stringent state regulation but the riskiness of other units fell through the cracks. Overall, obviously, the entire firm's capital and oversight were not congruent with its inherent risks. Going forward, risk-focused regulation, where capital and other regulatory characteristics are commensurate with the nature and magnitude of risks of a company - not its charter! - is desperately needed. The danger is, of course, that over-regulation that leads to narrow-line financial institutions will be enacted instead.

Lack of transparency

As has been widely said, the risks that AIG was taking were not visible to outside observers. In fact, its standard financial disclosures and accounting earnings were not capable of properly describing its exposures, with the subsequent losses genuinely surprising stakeholders, regulators, and apparently its executives and the board of directors. The insurance unit may have been large and stable, but the Financial Products unit apparently was not.

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But risk-based transparency in the financial system is needed both for the purposes of regulation as well as to inform the stakeholders about business models and risks of financial firms. Risk-based transparency involves direct, clear, and comprehensive descriptions of their sources of economic revenues, risk exposures, and the mechanisms by which they generate economic value. Had AIG conformed to these requirements the investing world would have realized just how exposed it was to almost unfathomable risks. Such disclosures would have forced the company executives to formulate a clear understanding and explanation of why these exposures were desirable and prudent, potentially resulting in a better strategic direction for the company.

The view on AIG as a "hedge fund" is bound to fuel additional arguments for the need to constrain the activities of "too-big-to-fail" financial firms. While I continue to argue for a balance between risk-based regulation and risk-based transparency, all signs point to overregulation as a more likely scenario. Unfortunately, stifled financial innovation and risk-taking that is delegated to smaller financial institutions are likely to follow, negatively impacting real economies and capital markets for years, if not decades, to come.