Pundit Interviews

Pundit Letters





Perishable Pundit
P.O. Box 810425
Boca Raton FL 33481

Ph: 561-994-1118
Fax: 561-994-1610


email:
info@PerishablePundit.com

a

Produce Business

Deli Business

American Food & Ag Exporter

Cheese Connoisseur



AIG Bailout Gives Short-term
Relief Many Dangers Long-term

Jim Prevor’s Perishable Pundit, September 18, 2008

The Fed’s decision to lend $85 billion to AIG in exchange for an ownership stake just under 80% is very dilutive to shareholders, and with the terms of the loan precluding common and preferred dividends and the interest rate being about 10 percentage points over what the government is paying for funds, the most likely outcome is that AIG will sell off virtually everything to pay off the US government.

What the government is basically doing is putting the company into bankruptcy but in an orderly way so that its obligations will be honored and its assets do not have to be sold at fire-sale prices.

It is quite possible that common shareholders will be wiped out and so the moral hazard of the action is reduced — at least as far as owners go. Shareholders will realize that even if a company is considered “too big to fail,” shareholders should not think that their investments can’t be wiped out.

Still, the bail out was a bad idea for many reasons:

First, the government is either wrong about the consequences of an AIG failure or it got snookered by Wall Street hot shots. The basic justification for an AIG bailout is that it is so big that its failure would create systemic risks which would bring down Goldman Sachs, The Bank of America, etc.

Yet if this were true, these institutions and others had the capacity to put together an $85 billion bridge loan as well. That they didn’t do so indicates either that they didn’t feel as threatened as the Fed and the Treasury thought or that they were playing a massive game of chicken with the government. The government employees simply folded first.

Second, the bailout will create enormous risks for the future. Moral hazard is what it is called when doing something creates the incentive for the thing you would like to prevent. The classic example is fire insurance. It is the very existence of fire insurance that creates the crime of arson for profit.

Although the bailout is structured — as was the Bear Stearns bailout before this — to reduce moral hazard for owners — it increases the likelihood of reckless behavior by lenders and investors.

For example, one of the big concerns that doubtless led the Fed to act is that AIG sold lots of paper that wound up in money market accounts all across the country and around the world. Now every time one buys a money market instrument, one has a choice: either invest in a money market that solely invests in US Treasury securities or invest in money market funds that stretch for a higher yield by including lesser paper.

By bailing out AIG, the government has avoided millions of people suffering losses as their money market funds would have “broke the buck” — that is, lost value.

But the consequences are far beyond that. The government made into suckers all those people, millions and millions of them, who invested in government-guaranteed money market funds or in FDIC insured CDs or passbook accounts — thus accepting lower yields, sometimes for decades, precisely because they wanted to avoid the risk of having their cash backed up by AIG as opposed to the federal government.

Now the Secretary of Treasury has basically said to all those conservative investors: “Man, were you guys chumps!” This will encourage more risky behavior in the future and is fundamentally immoral.

Third, by not compelling the sale of assets, the Treasury’s bailout will avoid a speedy reckoning. What was needed was a quick liquidation so valuation could be clearly established. What the Treasury is doing is going to do nothing but prolong the suffering — it is like removing a sticky bandage painfully slowly when we really needed to have it ripped off instantly. The pain might be acute, but it would be over and we could start growing from a sounder base.

© 2017 Perishable Pundit | Subscribe | Print | Search | Archives | Feedback | Info | Sponsorship | About Jim | Request Speaking Engagement | Contact Us