The Return of "Know-Nothing" Politics

AIG was bailed out for one reason, and one reason only. It was not bailed out because it was a flagship insurance company. It was not bailed out because it employed many people. It was not even bailed out because of its long-standing cozy relationship with the American intelligence community. It was bailed out because, in the judgment of the Fed and the Treasury, its failure would have posed a “systemic risk”.

What is meant by “systemic risk”? Simply that AIG was so interconnected with other financial institutions, through various and myriad counter-party relationships, that its failure would trigger a cascade of losses which might cause other institutions to fail, which, in turn, would bring down more institutions, and so on.

The mechanism of transmission here is breach of contract. If AIG had gone bankrupt, institutions that had open contracts with AIG would have found those contracts dishonored. What kind of contracts were these? They were insurance contracts against the risk of default of other institutions, for example, Lehman.

So what is the difference between a bankrupt and a bailed-out AIG? The bailed-out AIG honors the contracts and therefore pays out to its counter-parties on the default swaps.

So the sleeping giant of American politics, “know-nothing protectionism”, having awoken, finds it shocking that a majority of the funds injected into AIG have been “funneled” to various financial institutions and municipalities throughout the world. In order to turbo-charge the outrage factor, the reporting of this fact is conflated with the news that lots of money was also paid out by AIG as bonuses.

The only thing these two facts may have in common is that they may both involve honoring the terms of pre-existing contracts.

If a financial institution, which was bailed out on the theory of preventing systemic risk, did not pay out a majority of the Government funds to other institutions pursuant to the terms of pre-existing contracts, then the bailed out institution did not represent a systemic risk and was bailed out in error.

One can argue about whether the bail out of AIG was wise, necessary or fiscally prudent. One can ask whether it enhanced "moral hazard" to an unacceptable degree. One can even take issue with the notion that its failure would pose a systemic risk. And finally, one can ask whether it was wise for a regulated industry to be allowed (by the regulation and the implimenting regulators) to make risk bets that were of "bet the ranch" magnitude. All of these questions could be discussed intelligently.

What can not be intelligently discussed is the notion that "AIG paying billions to other financial institutions" is evidence of wrong doing.