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Wednesday, September 17, 2008
Gnome-o-gram: The AIG Takeover and Bankruptcy Socialism
We've now entered into the early phases of the grand liquidation of financial derivatives I wrote about last June. The most stunning—indeed flabbergasting—event so far has been the “rescue”, or more precisely effective takeover, of AIG, the largest insurance and financial services company in the United States by the Federal Reserve, which granted a two year credit line of US$85 billion secured by all of the assets of AIG. In return, the U.S. government receives a 79.9% share of AIG's equity, diluting existing shareholders' stake in the company by 4/5. To my knowledge, nothing like this has ever happened before in U.S. financial history, at least not in the last century (you always wonder about railroad deals in the 19th century, but I don't know if precedent exists there; in any case that was before the Federal Reserve was founded, and the financial system worked very differently in that era). Certainly there have been bailouts before, such as that of Chrysler in 1980, but even that deal, controversial as it was at the time, was, in inflation-adjusted dollars, less than one twentieth the size of the credit line provided to AIG and was a pure government loan guarantee: the government took no equity stake in Chrysler at all. In the case of AIG, the U.S. now has effectively nationalised the largest insurance company in the country, with not just a controlling interest but an overwhelming ownership stake of around 80%, and the whole deal was done overnight without, as was the case of the Chrysler loan guarantee, extensive debate in the Congress and the enactment of a bill explicitly granting the guarantee. Now the thing about government actions, however exceptional, is that they have a tendency to become a precedent for future actions, and what I want to discuss here is what that could mean. I'll leave to other commentators the details and immediate ramifications of this event, but here I'd like to ponder the potential consequences of the precedent created here, should this deal go through unchallenged (which is the way to bet, since there's little political benefit to be had in appearing to oppose a rescue presented as averting a financial calamity). Suppose you were a stealth candidate for the U.S. presidency who had carefully concealed your radical beliefs and connections. Suppose your election came during, and was in part due to, a growing financial crisis, perceived as spreading beyond the mortgage market and financial sector into the economy as a whole. Suppose your advisers envisioned a very different organisation of the U.S. economy than its present structure? Well, all you'd have to do after taking office is to let the economy go over the edge, which could be blamed on the previous administration, which would force many large U.S. companies, heavily leveraged and hard hit by the ongoing derivatives collapse, to the brink of bankruptcy. No problem: the Federal Reserve steps up with an AIG-style “rescue” plan for all comers, creating the credit lines out of thin air and the government picking up an 80% equity stake in each. Without a single vote being taken in Congress, large sectors of the economy are effectively nationalised, with existing shareholders seeing 80% of their equity effectively expropriated by dilution. And the whole scheme is presented by the legacy media as a grand bailout, with the government stepping in to avoid a collapse resulting from excesses of the market system. Maybe they'll call it the “Newer Deal”. Now, isn't this about the cleverest way you've heard to socialise a free market economy almost overnight? And do you want to be a shareholder of any U.S. company which would be vulnerable to such a “rescue” in the case of a sharp economic downturn? I am presenting this as a cautionary scenario, which popped into my head as I was recovering from the initial shock of learning the details of the AIG deal. I do not mean to suggest that any existing candidate or political party in the U.S. envisions such a plan, only to observe that it now appears to be possible, and hence something the prudently paranoid investor should bear in mind. Neither do I intend to imply that Barack Obama is the “stealth candidate” I refer to above. Warren Buffett is about the shrewdest investor of modern times; I don't think he'd be backing Obama if he believed Obama would contemplate such a thing. Update: Yes, I am aware that the AIG deal does not involve direct transfer of 80% of the company's equity to the government, but rather warrants which, if exercised, cause issuance of common stock with that effect. The presumption is that should AIG be able to raise sufficient funds to retire the credit line with interest, the government would let the warrants expire unexercised. But note that the Fed, in their press release, said “The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.”, and AIG, in theirs, said “In return for providing this essential support, American taxpayers will receive a substantial majority ownership interest in AIG.”, both statements treating the warrant issue as an effective transfer of equity to the government. But even should the warrants expire unexercised in this case, an administration bent on a strategy of “bankruptcy socialism” (a term for which this article is presently the number one hit on Google) would certainly exercise the warrants to obtain the outright equity stake. They could, however, strategically do warrant deals with the pretense of allowing them to expire when the “present difficulties” were over and the credit lines retired, then exercise them all as the “Next Deal” (alternative name to that suggested above) was rolled out in an address to a joint session of Congress. (2008-09-17 21:19 UTC)Posted at September 17, 2008 19:32