Wednesday, September 17, 2008

AIG Bailout Opens The Floodgates

Last night the government of the United States acting through the Federal Reserve officially drove the final nail in the coffin for free market economics in this country. And so marks an extremely sad day for the U.S. economy. It was a mistake to bail out Bear Sterns. It was a bigger mistake to bail out Fannie Mae and Freddie Mac, and while Wall Street may breathe a collective sigh of relief it will prove a particularly fatal mistake to have bailed out AIG.

With this transaction the government has crossed the tipping point. It has abandoned a key underpinning of capitalism – the right to fail when you screw-up. That we have adopted what essentially amounts to European style socialism under a Republican administration makes these times all the more surreal. Having once again come to the rescue of the fat cats in New York, there’s simply no way the politicians can or will say “no” to the blue collar auto workers in Detroit or the airline mechanics in Minneapolis. Thus we should anticipate a flood of similar bailout adventures.

To over simplify, AIG employed a classic cash flow underwriting scheme. It undercut less sexy competitors to rake in premiums, which it then invested in an array of high yield mortgage securities. To the extent housing prices continued to sky rocket and homeowners paid their mortgages the scheme worked fine. For a period AIG’s investment earnings more than offset the cumulative impact of its sloppy underwriting. However, when housing prices started to fall and homeowners began to forgo mortgage payments AIG's investment returns took a dive. Not long after, the write downs began. Soon all that was left of AIG was an illiquid investment portfolio and an illogical underwriting culture – not exactly a winning formula for an insurance company. When the market finally figured this out it turned on AIG’s stock with a vengeance. Rumors abounded of a pending bankruptcy. Who knows how it might have all played out? Certainly an AIG bankruptcy would have spooked global markets. However, it would also have created some splendid opportunities for all those less sexy insurers to regain some business.

Unfortunately, once the government stepped in, the whole matter became moot. Thus we’ll never know how our financial system would have coped with this disruption. Presumably now the AIG party will continue - this time with taxpayer sponsorship. Strangely, that bastion of free market economics, The Wall Street Journal, characterized this transaction as a potentially lucrative one for the Feds. The theory goes if the housing market comes back AIG’s liquidity problems go away, and the government emerges unscathed with 80% of the largest insurance company in the world. Excuse me? That’s a good thing? Can you imagine the mischief the politicians will wreak with a toy of this size? AIG will soon become nothing more than a social tool for the political class. It will forever prove a net drain on the Treasury. Mark my words; you can kiss that $85 billion loan from the Fed goodbye. Barney Frank is no Hank Greenberg.

So keep your fingers crossed that this latest installment to the national debt will not cause the Ponzi scheme also known as the U.S. budget process to implode just yet. Ironically the government justifies each bail out as necessary for staving off a financial meltdown. But each bail out only brings us closer to that exact same point. The dollar gets trashed. The national debt grows. Something looks to give eventually. I would have preferred AIG over the Federal Government.

Incidentally the market closed down 450 points today. So much for small favors…

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