Second in Series
This is the second in my guest blogger series for students enrolled in my new Georgetown University Law Center course, Contemporary Issues in Economic Justice: The Subprime Crisis.
By Yeon Yoon, Third year student, Georgetown University Law Center.
The most recent expansion of the AIG bailout suggests that perhaps AIG does not need anymore bailing out. The US government contributed more than 170 billion dollars so far and the last expansion was only thirty billion dollars. If the bailout of AIG continues in a linearly proportional manner, I suspect we will be done bailing out AIG by the end of this year. Huzzah for all!
Some critics complain that we are giving money to bad managers, that the very educated and highly experienced executives at AIG and other Wall Street firms performed horribly, so horribly that they needed a bailout. One critic went as far as calling them "idiots"for awarding themselves multimillion dollar bonuses. Judging the performance of these executives, however, on an after-the-fact basis seems a bit unfair.
The first rule of finance, at least in the early 2000s, is that there is no such thing as a free lunch. AIG thought they had found an exception and called it ratings arbitrage. Essentially AIG used its high credit rating for its insurance line of business to guarantee mortgage backed securities. AIG received a fee for what was perceived as a negligible risk, the issuer got a better interest rate, and AIG's counterparties got a guarantee on their investment from a highly regarded insurance company. Alas it seems our rule is broken--AIG's counterparties are having a free lunch on us all.
Considering what we now think of AIG's business transactions, you would think that ratings arbitrage is dead. Considering our government is the one publicly wringing its hands and paying for these free lunches you would think that our government would not participate in any of this ratings arbitrage rubbish. Unfortunately ratings arbitrage is very much alive, and from our government no less.
The bailout and federal budget require borrowing a lot of money using the United States' high credit rating and giving it to those who need it, the bad managers. The bad managers get a free lunch, the United States gets a low rate of interest, and those who are financing the budget and the bailout get treasury bills, which are considered a very safe investment. Essentially the US government is using its high credit rating to borrow from other nations to invest in bad managers.
A sense of optimism underlies both schemes of ratings arbitrage. AIG thought that housing prices would continue to increase indefinitely, and the US and its creditors believe that the US economy will continue to grow indefinitely. Indeed the new federal budget projects a 4.6% growth in GDP in 2012, and a 15.6% net growth in the next five years. This is despite the D word being thrown about amongst the hushed voices of fringe economists.
I am also an optimist. Someone bailed out AIG and its counterparties, and if worst comes to worst, someone will bail out America and its creditors. Phone home ET.
The views expressed here do not represent my own views or those of Georgetown University. They are the sole responsibility of the author.