The good news

by on September 17, 2008 at 1:32 pm in Current Affairs | Permalink

There is some.  First, it seems (knock on wood) the Fed and Treasury may make money off the AIG deal, at least over a time horizon of one to two years.  Felix Salmon explains some detail.  The company has assets and if it needs to borrow money it is paying the Fed at Libor plus 850 (!). 

Second, the size of a guarantee does not represent the cost of the bailout.  I have been getting many emails about "the cost of the bailouts" and in truth we still don’t know what those costs will be.  But think in terms of balance sheets to start on the problem, not numbers in headlines. 

Third, if the Fed needs to "print money" to make good on various guarantees (NB: this has not been the case), this need not be as disastrous or as inflationary as it sounds.  If it came to this, the Fed is creating money to protect against potentially deflationary events so the inflationary impact of that money creation is blunted.  (That said, you don’t usually want to trade in bank-created higher monetary aggregates for an increase in borrowed reserves.)

You might wonder if AIG is (possibly) a money-making deal, why no one else wanted in on the action.  Think of it as a prisoner’s dilemma among the lenders.  No one of them wants to put up money at non-exorbitant rates and so the company — which has partially illiquid assets and profit-maximizing, weakly capitalized shareholders determined to take advantage of lenders — fails.  But with the guarantee the company can borrow cheaply and the lending continues.  The company can continue and oversee an orderly liquidation.  That’s not a pretty picture and it does mean that, in the bad world-states, losses continue to stack up precisely because the guarantee was extended.  But the good world-states are there too and the expected value of the guarantee and purchase may well be positive.  To give an example, Argentina in its crisis days had net positive value but no one wanted to lend to them either.

Recent events remind me of the arguments against free capital movements for developing countries and whether those capital movements boost economic stability and growth.  Well, we have free capital movements for investment banks and insurance companies and of course the losers get hit by whipsaw effects.

Did you notice that short-term Treasuries have been trading at rates close to zero?  That’s not good news. 

In presenting all this "good news," I don’t mean to communicate a pollyannish attitude.  The bad news is indeed very bad but let’s understand it in its proper context.

I’d like to stress again that I remain worried about the rule of law in all these events.  First, the referee is on the playing field.  Second, while Dodd and others are on board, basically we have the executive branch of our government — the Treasury — operating without formal checks and balances.  (Does that sound familiar?  Would this administration do that?)  That’s why it is all being done through the Fed.  Fortunately the Fed is also a competent technocracy (as is the current Treasury) but the broader implications here are very worrying, both for governance and for the future of the Fed itself.

Maybe there is no better alternative, but these developments are a sign of just how dysfunctional American government has become.

1 efp September 17, 2008 at 2:01 pm

I wonder what MR readers (& writers) think of Josepth Stiglitz’s commentary:

Especially #6: …we should not be in situations where a firm is “too big to fail.” If it is that big, it should be broken up.

2 shrikanthk September 17, 2008 at 2:29 pm

Could you opine on how these “postmodern” bank runs of our times are different from the bank runs that reduced the money supply by a third during the Great Depression?

A hypothetical question –
Will the current episode prove to be just as disastrous as the Great Depression for the real economy in the absence of liquidity injections from the Fed?

3 meter September 17, 2008 at 2:32 pm

And yet most of your readers will vote Republican.

I think Obama – a constitutional law scholar – is far more likely to restore prior checks and balances.

4 David Heigham September 17, 2008 at 2:55 pm

Welcome aboard. I noted in the last thread but one that the Fed was likely to make money on its AIG deal; and I doubt if I was one of the first to notice.

I think that this was not a prisoner’s dilemma. The AIG management turned down a deal which – so far as I can guess – was better for AIG shareholders in most cicumstances than the Fed’s terms. My diagnosis is a touch of the Fuld syndrome; and no rational economics about it.

I agree with you on Treasuries as a class of organisation. Their competence does fluctuate from time to time; as do all human organisations – even the Vatican. Like the Vatican, Treasuries have become skilled at keeping the ragged bits behind the fold.

As for US Government, the checks and balances are built in to control planning and innovation; but the Executive branch has clear responsibility to do what it judges necessary in an emergency. It looks to me a good deal more functional at the moment than it has for the last eight years.

5 eccdogg September 17, 2008 at 3:06 pm

The more I look at this the more it looks like a pretty good deal for the FED. Which is how it should be, if the government bails you out is should be on bad terms for the bailee.

This is how I see it.

Fed provides 85B credit facility, at around 11.5% rate if used. AIG may not use it and is actually less likely to need it now that it is in place.

For this the FED gets control of the company and warrants(options) on the company stock that could take fed ownership to 80% of the company. AIG’s float is like 2.3B shares so that would mean that the FED gets 9.2 billion warrants which would put fed ownership at 80% of company if exercised.

Just to get an idea of what the warrants might be worth I took a look at AIG’s $5 strike 2010 calls. They trade at like $1.20. So that puts the value at like $11.2B. The FED gets this for free as a payment to take the dowside credit risk.

My understanding is that the company does not have a terrible book value but that the problem is that it cannot liquidate some of its assets for cash because they are in insurance subsidiaries. The problem is gettng cash. So the value of the warrants might end up being worth something.

6 Anonymous September 17, 2008 at 3:40 pm
7 alex September 17, 2008 at 4:35 pm

Maybe too early to talk about this but nevertheless…
If Obama is elected, should he keep Paulson?

8 Angus Hendrick September 17, 2008 at 5:03 pm

Tyler, can you comment on 3-month treasuries trading near 0%? If the interest rate is the price of money for the government, why are people willing to loan to the U.S. government for free? Especially now…

9 guam dentist September 17, 2008 at 6:17 pm

What happens to bonds at American General Finance and International Lease?
Both AIG companies

10 Methinks September 17, 2008 at 7:12 pm

Think of it as a prisoner’s dilemma among the lenders. No one of them wants to put up money at non-exorbitant rates and so the company — which has partially illiquid assets and profit-maximizing, weakly capitalized shareholders determined to take advantage of lenders — fails.

This is the clearest difference between an academic economist and someone who actually has to make these decisions in “real life”.

The reality is that these prisoner’s dilemmas are easily solved on Wall Street all the time. If nobody is willing to lend the money by themselves AND it actually IS a good deal, then all the possible lenders know this. Fixed income is quantitative, it’s easier to price than stock – that’s why the edge is so small. The prospective lenders will form a consortium and each will lend a portion of the total to the company in question. Thus, they spread their risk and the reward. If nobody wanted to touch AIG it’s because the reward was too small for the given level of risk (Wall Street suddenly cares about risk adjusted returns again, in case you haven’t heard).

The exorbitant rates that non-taxpayer backed institutions would charge AIG reflect the very real risk of lending to a company like AIG, which is filled to the gills with illiquid assets. The fact that nobody was willing to join such a consortium means that the risk adjusted returns are incredibly low and the only poor sucker “willing” to accept such terms is a taxpayer – as the Fed and Treasury holds a gun his head.

11 Frank Miller September 17, 2008 at 9:29 pm

Another piece of bad news and more is coming with WAMU. Everyone should recognize this as the time to protect your money. I personally use offshore bank accounts and they have helped me with asset protection and diversification. If you would like to learn more, you are welcome to visit my site.

Frank Miller

12 Jason Armstrong September 17, 2008 at 9:48 pm

“What we need to do is severely limit immigration (1924), seize gold (1934), increase tariffs (1930), curtail margin (1930), raise taxes (1932, 1935), sponge the labor pool with make-work projects, employ overcontrol and generally assault the free expansion of the division of labor through various regulations…We can still make this a real hum-dinger.” -Andrew

YEE-HAH! New Deal III & IV, here we come!

13 Buck September 17, 2008 at 10:19 pm

This good news doesn’t change the fact that, because we couldn’t make our mortgage payment due to dropping wages of the middle class, our overvalued houses are now owned by china, India, and are insured by the U.S. Federal reserve.

How does this good news bode for interest rates? Increasing demand for suburban housing?

14 Ricardo September 17, 2008 at 11:25 pm

At what point to people recognize that the “illiquid assets” are illiquid for a reason?

Even in normal times, corporate bonds are less liquid than common stock despite the fact that determining the value of the former is easier than the latter.

In abnormal times, such as the liquidity crunch we’ve found ourselves in for a while now, borrowing constraints can become binding in a very unpleasant way. So no one is going to lock money away in an illiquid asset since such a move could force bankruptcy. The only institution in the U.S. that does not face such borrowing constraints is, of course, the Fed.

Remember when the market for auction rate Port Authority of New York and New Jersey munis came to a halt when no one was willing to buy these securities except at a ridiculous discount? Was that an indication of true value?

15 meter September 18, 2008 at 5:42 am

I know this kind of rhetoric is expected from the government-expansionist left (my, what irony) but here’s fiscally responsible McCain pandering to autoworkers for bailouts of (oops, “loans to”) GM:

“”It’s great to be here today with the assembly workers of this GM plant,” he said. “I’m here to send a message to Washington and Wall Street: We are not going to leave the workers here in Michigan hung out to dry while we give billions in taxpayer dollars to Wall Street. It is time to get our auto industry back on its feet. It’s time for a new generation of cars and for loans to build the facilities that will make them.””

There’s no slippery slope here.

16 Methinks September 18, 2008 at 8:50 am

Remember when the market for auction rate Port Authority of New York and New Jersey munis came to a halt when no one was willing to buy these securities except at a ridiculous discount? Was that an indication of true value?

Yes, it was. New York City was a much bigger socialist disaster than it is today and potential investors had no confidence at all that the return was worth the risk. Instead of crying to mommy, NYC needed to change its policies.

In abnormal times, such as the liquidity crunch we’ve found ourselves in for a while now, borrowing constraints can become binding in a very unpleasant way.

The abnormal times are not now. The abnormal times were when the risk premium was close to zero. Not expecting compensation for risk is NOT normal. The “liquidity crunch” simply means nobody is willing to take risk for free anymore. Part of management’s job is to imagine tail risk and to understand how his portfolio of assets will behave under the worst circumstances. This is not an unforeseen event like 9/11. A widening of credit spreads to historical averages should have been factored into every portfolio manager’s decision (and a ceo is a portfolio manager, btw).

What you’re saying is that it’s A-okay to mismanage a portfolio and force someone else to pay the price. How about we divide the taxpayers who believe this is true into their own little group and have them put their money where their mouth is? I’m betting we’ll get no takers.

17 Andrew September 18, 2008 at 1:29 pm

Hypothetical: If GS goes down, should there be a claw-back on Hank Paulson’s compensation?

18 green May 15, 2009 at 3:03 am

so many different opinion

19 miky May 15, 2009 at 3:05 am

we can read more

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