Bailout Nation (32 page)

For those who have a hard time conceptualizing the differences between Bear Stearns, Lehman Brothers, and AIG, consider the Naughty Child Index.

Lehman Brothers is like the little kid pulling the tail of a dog. You know the kid is going to get hurt eventually, so no one is surprised when the dog turns around and bites him. But the kid hurts only himself and no one else. No one really cares that much.

Bear Stearns is the little pyromaniac—the kid who is always playing with matches. He could not only harm himself, but burn the house down and indeed burn down the entire neighborhood. The Fed steps in to protect not him, but the rest of the block.

AIG is the kid who accidentally stumbles into a biotech warfare lab and finds all these unlabeled vials. He heads out to the playground with a handful of them jammed into his pockets.

T
he decision to allow Lehman Brothers to go belly-up has been roundly criticized by many people as a mistake that cost AIG dearly. That turns out to be an incorrect conclusion, a classic correlation-versus-causation error. It is much more accurate to observe that the same factors that drove Lehman into bankruptcy also drove AIG to the brink.

It began with rates so low that everyone in the nation decided they wanted a house (and the bigger, the better). This included many people who could not afford one. So these folk applied for mortgages from a new kind of lender, one that operated with little regulation and even less supervision. These lenders were able to give loans to these people—bad credit risks, too little income, no equity—due to their unique business model. They could ignore traditional lending standards because they did not plan on holding these mortgages very long. They could specialize in higher-commission subprime loans because they were so-called lend-to-securitize originators. They made higher-risk loans, then flipped them to Wall Street firms, which repackaged them into complex mortgage-backed securities.

These same investment banks had too little capital and used too much leverage, but that didn't stop them from buying too much of this paper from each other. It didn't matter much anyway; since it was rated triple-A by S&P and Moody's, there wasn't anything to worry about. Underlying all of these transactions was the assumption that home prices in the United States never went down.

Oh, and this entire series of events took place at a time when the dominant political philosophy was that it was impossible for this to go wrong—the self-regulating markets, you understand, would see to that.

Plenty, as you might imagine. The teetering insurance giant lost $13 billion in the first half of 2008, but the real trouble was about to hit. It wouldn't be long before AIG would need a lifeline from Uncle Sam—or, as it turned out, Uncle Ben.

When Lehman went down, there was all manner of bad mortgages on its books. Dick Fuld, Lehman's CEO, had already given these assets a substantial haircut. Lehman was carrying its subprime mortgage securities on its books at 34 cents on the dollar, and its Alt-A holdings at 39 cents. Lehman had written down about two-thirds of their value.

AIG had not had its
come-to-Jesus
moment yet—not when it came to its housing derivatives, anyway. It had over $20 billion of subprime mortgages marked at 69 cents on the dollar and more than $24 billion in Alt-A securities valued at 67 cents on the dollar.
¹²

Forget “mark to market.” AIG was carrying these assets at values that were double what Lehman was. You can call that bookkeeping “mark to make-believe.”

The Lehman bankruptcy occurred on September 15, 2008. Two days later, the Federal Reserve stepped in. AIG was effectively nationalized on September 17, 2008, with Uncle Sam picking up 79.9 percent of the former Dow component.

T
o anyone who believed in the doctrine of “too big to fail,” AIG was a must save: almost a century old, with tentacles reaching everywhere. When the world's largest insurer collapses, it is every Fed chairman's nightmare. Hence, the massive effort policy makers have engaged in to keep the firm quasi-solvent as it is wound down. As of March 2009, more than a $173 billion in loans, lines of credit, direct capital injections, and purchases of stock have been made by the government to AIG. No private capital was willing to step up to 70 Pine Street in lower Manhattan.

Some cockeyed optimists believe this will be a profitable transaction for taxpayers, but I find that hard to believe. Not because AIG doesn't own some fine assets. Rather, because of the extent of the damage done by the structured finance half of the firm. At the end of Q1 2009, AIG announced a staggering $61.6 billion fourth-quarter loss. Even more AIG-related risk was moved to the Federal Reserve (a private institution), and to the Treasury—which is to say you and me.

Understanding how AIG went rogue and what happened since is critical, not only because it's one of the biggest single bailout beneficiaries, but because AIG encompasses all the elements that led us to the brink of financial catastrophe. These include:

Once you can wrap your head around AIG, the mess that is Bailout Nation becomes much clearer. AIG was a fearsome combination of too many bad factors converging together. As is so often the case, these risk elements came together at precisely the wrong time.

“It's a terrible situation, but we're not doing this to bail out AIG or their shareholders,” Bernanke declared. “We're doing this to protect our financial system and to avoid a much more severe crisis in our global economy.”
¹³

Bernanke's comments about AIG were eerily similar to what former Treasury Secretary Paulson said on September 7, 2008, about Fannie Mae and Freddie Mac: “Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe.”
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As with Bernanke's statement about AIG, Paulson statement was accurate, concise—and wholly irrelevant. Neither man specified the real reason AIG, Fannie, and Freddie were nationalized: to protect their counterparties and debt holders, including major financial firms and foreign institutions, such as Japan's central bank, China's sovereign wealth fund, and Saudi Arabia's holdings, among others.

Why? The short answer is that foreigners have been funding the profligate ways of the American consumer for decades. Once you begin to depend on the kindness of strangers, it's best not to make those strangers too angry. We in the United States have lived beyond our means for many years. We consume far more in goods and services than we produce, and that net deficit has to be funded somehow. The global economy has come to depend on the excessive consumerism of the United States. In return, we finance our massive deficit via the constant flow of capital from foreigners. As of June 30, 2008, that capital flow was $1.65 billion per day, every day.

How much kindness would these strangers offer if we allowed our paper that they held to default? Think about the $2 trillion in Treasury securities expected to be issued in 2009—who would be the takers?
¹⁵
How about any appetite for holding the $4.25 trillion of U.S. government and agency debt already owned by foreigners as of Q3 2008?

Forget going nuclear: These foreign treasury holders could all but destroy the U.S. economy by selling this debt on the open market at once. The only thing that prevents them is the same doctrine that precluded nuclear war during the Cold War: mutually assured destruction (MAD). They'd destroy themselves as well as us.

Why bail out overseas counterparties and debt holders? One gets the sense Uncle Sam had little choice in the matter.