A Big Lesson From AIG

Lost in all the huffing and puffing over the Geithner Plan and those bonuses is the simple but certain problem that the regulators faced back when AIG tottered towards failure: the US, unlike most other countries, has no legal framework for dealing with the public winding up of a non-bank financial company at the Federal level. That’s why both Geithner and Bernanke argued strongly today for those powers to be granted to the Treasury department.

The FDIC can force a failing bank through a publicly run reorganization and dissolution. This mechanism works well, and as I have pointed out many times, is used constantly. The US has nationalized almost three banks a month since the crisis began using these powers.

AIG represented a problem because it is not a bank. None of the US regulatory authorities has the legal power to force AIG to reorganize. As a result everything had to be done in an ad hoc way with the consent of AIG. A major consequence of this regulatory gap is that those infamous bonus contracts still had legal standing even after the government ended up with an 80% shareholding in AIG. Had the FDIC model been available as a method for winding down AIG’s operations the contracts could have been voided without recourse by the employees affected. Not only this but the furor over counter-parties receiving full payments from taxpayer bailout money would have been avoided: creditors would have bee forced to take a ‘hair-cut’.

The issue with the counter-parties still roils Congress.

Here’s the problem: in the absence of the correct legal powers the government cannot pick and choose which creditors it pays off in full and which it forces a ‘hair-cut’ on. We all forget that AIG is also the world’s largest insurance company and since it fell into government ownership it has faced having to pay up on tons of regular people’s insurance policies. When someone makes a claim against an AIG insurance policy they become one of its creditors. Just like the famous counter-parties such as Goldman Sachs. Since the government had no legal way to pay regular insurance claims in full while sticking it to the Wall Street firms it was forced to treat them all equally. Hence they all were paid in full, with most of the money going to Wall Street because they were owed the most.

That’s why Geithner and Bernanke are right to argue for being given FDIC like powers over non-bank financial companies. There is a gaping hole in the US regulatory system that needs filling. Had the right system been in place neither of the last week’s hot and embarrassing issues would have arisen. And the bail out of AIG would have been a lot less expensive and painful.

I hope we get strong regulatory reform soon.