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Why You Should Ignore the AIG Inquiry


Unfortunately, television drama does nothing to advance public policy.

Today, all eyes are on Washington as the Congressional inquiry on AIG (AIG) begins. And the financial media have all made it out to be the daytime equivalent of West Wing meets CSI.

Cue the dramatic music -- "Back door bailouts? Tune in to see!"

Or, if you want my advise, don't.

While I'm sure all of these inquiries make for interesting television, I'm afraid that yet again, Congress and the media have missed the forest for the trees.

In the context of the total amount of monetary and fiscal stimulus thrown at the banking crisis, AIG was a nit. And even if it was through the back door, the AIG "bailout" pales in comparison to the total subsidies that entered the banks through the front door, the windows, if not down the chimney in Santa Claus' sacks.

The government bailed out the banks.

And it did it through a near-zero percent Fed Funds rate, the expansion of the Federal Reserve balance sheet, the rescue of Fannie Mae (FNM) and Freddie Mac (FRE), unlimited FDIC insurance on transaction deposit accounts, conversion of investment banks to bank holding companies, the TLPG, TARP, Cash for Clunkers, home purchase subsidies, and I could go on and on and on.

It was "Shock and Awe" meets "Whatever It Takes."

As it was designed to be.

Rapidly falling asset prices coupled with too much systemic leverage forced a dramatic public policy response (and not just here in the United States, but around the globe) with the clear goal to inject capital into the banks and liquidity into the system. And, putting Lehman Brothers aside, everything the government did was aimed at achieving those two principal goals.

Stable economies require strong banks.

But underlying the public policy response to the banking crisis was a trillion dollar catch-22.

Mechanically, there are only two ways to get capital into banks. The first is by issuing additional shares of common stock and diluting current shareholders. The second is through "enhanced" earnings. With the exception of the TARP warrants, as best as I can tell, every action that the US federal government and the Federal Reserve took opted for the latter solution.

I'm sure that behind this strategy was the simple thought that whether it was labeled outright "nationalization" or just simply "dilution," the sale of tens if not hundreds of billions in bank common stock to the government would have caused a significant further decline in overall stock prices.

So, instead, capital flowed into the banks through non-dilutive TARP preferred stock and artificially enhanced earnings -- of which AIG is just one example.

In fairness to Messers Bernanke, Paulson, and Geithner, it's very easy to sit back today and suggest that they made a poor choice on AIG. I'll leave that for others. (And for what it's worth, I think the far poorer choice was the decision that many leaders on Wall Street made to pay out bonuses on earnings that were clearly either directly or indirectly attributable to government subsidies.)

But rather than wasting time on AIG, where I wish the public policy debate would go instead is into a thoughtful discussion regarding how we handle future bank crises, since, unlike many others, I don't think bank crises can ever be regulated away.

Two weeks ago, the Obama administration suggested a bank levy -- effectively trying to recover some of the "value" the government created through an "after the fact" tax.

As a different solution, a year ago I proposed that all TARP preferreds be converted to common. My thinking then -- see Open Letter to Timothy Geithner -- was that the market assumed that in a worst case scenario that would happen anyway. (And, in fact, in Citigroup's (C) case that is exactly what happened.)

And in the UK, "end of life" plans for failing banks has been proposed as yet a third alternative.

But what's clear from all of these alternatives is the fact that the days of "free" government bank bailouts needs to end. And the consequences to shareholders, employees, bondholders and depositors need to be clear -- irrespective of the size of the institution.

As someone who believes that we may need to know this sooner than later, I'd sure rather see our government focused on what's potentially ahead, versus spending time arguing over the past.

We need to accept that we bailed out the banks. Learn from it. And we need a better plan for the next time it happens.
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Position in SPY, SRS, and JPM.
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