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October 2, 2017

Special Financial Reform Newsletter: Deregulating AIG Is an Historic Mistake That Sends a Terrible Message

Deregulating AIG Is An Historic Mistake That Sends a Terrible Message — That Recklessness and Lawbreaking Pay – and Will Once Again Leave American Taxpayers Unprotected from a Dangerous Shadow Banking System

President Trump’s Financial Stability Oversight Council (FSOC) voted last Friday to de-regulate AIG, the gigantic global financial firm that was at the center of causing and spreading the catastrophic 2008 financial crash.  This “landmark move
(technically, de-designating AIG as a systemically significant nonbank) is the first major financial regulatory decision of the Trump administration and makes clear that the Trump administration’s de-regulatory rhetoric is going to become a reality.  For many reasons that should have been obvious to those unwisely voting to de-designate, that is very bad news and makes another costly financial crash more likely and sooner rather than later.

First, designating systemically significant nonbanks is the critical reform in ending the dangerous pre-crisis two-tiered regulatory system that enabled massive risks to build up unregulated and unseen in the shadow banking system until they blew up and required taxpayer bailouts to prevent the collapse of the global financial system and a second Great Depression.  Pre-crash, banks were heavily regulated, but financial firms engaging in very high-risk bank-like activities were lightly regulated, if they were regulated at all.  Unsurprisingly, risk then migrated from the regulated banking system to the unregulated shadow banking system, which is where much of the crash was spawned.  Making systemically significant banks and nonbanks alike internalize the costs of their high-risk activities via heightened regulation was intended to end these misaligned incentives and regulatory arbitrage.

There was bipartisan and industry support in 2009-2010 for creating an entity to make sure that didn’t happen again.  FSOC was the result and it is the only governmental entity with the power and duty to analyze and regulate systemically significant nonbanks.  The Trump administration appears committed to neutering FSOC and using it as a mechanism to deregulate finance.  This will lead to the recreation of the two-tier regulatory system and the revival of a dangerous and fragile shadow banking system as regulatory arbitrage incentivizes risk to again move out of the regulated banking system.


Second, the criticisms of FSOC and its regulation of systemically significant nonbanks doesn’t match the reality.  FSOC has been cautious to a fault in using its designation authority, particularly in light of the dozens of nonbanks that had to be bailed out in 2008 and 2009.  Yet, during the entire Obama administration, FSOC only designated four nonbanks as systemically significant:  AIG, GE, Prudential Insurance and MetLife.  Two of the four (50% of the designations) should be entirely noncontroversial: AIG, given its role in the 2008 crash (more on that below), and GE, which would have gone bankrupt in 2008 if it had not been bailed out by the government.  Such minimal action proves that FSOC has not been some out-of-control, designation-happy entity, and that was before the Trump administration!


As for the Trump administration, Treasury Secretary Mnuchin said when announcing FSOC’s AIG action that “this action demonstrates our commitment to act decisively to remove any designation if a company does not pose a threat to financial stability.”  The real question is whether the Trump administration will show equal zeal and speed in regulating systemic risks from nonbanks when they do exist or if they will even undertake the analysis.

Third, AIG is not a run-of-the-mill systemically significant nonbank.  Unsupervised in the years 

before the 2008 crash, AIG was one of the most reckless financial firm in the world and a leading cause of the crash.  Indeed, there’s a good case to be made that the crisis and crash would have been less severe, shorter and more manageable if AIG’s actions hadn’t enabled the fraudulent subprime bubble to be supersized: by the end of 2007, AIG had written $527 billion of insurance (called “credit default swaps” or CDS) on collateral default obligations (CDOs) and other subprime mortgage related derivatives and structured products, among other toxic assets.  Every time AIG sold a CDS, it enabled other reckless market participants (the buyers of the CDS) to keep packaging, selling and distributing worthless toxic assets because they were able to shift their risk of loss to AIG.  This in turn created artificial demand for subprime mortgages, which kept the fee-based originate-to-distribute predatory mortgage mills running long after they should have collapsed.  For accepting all this risk, inflating an historic subprime bubble and, ultimately, ruining so many lives, AIG collected billions in fees, virtually all of which dropped into the bonus pool for AIG’s executives because it failed to set aside reserves for this CDS insurance, insanely claiming that it was inconceivable that it could ever lose “one dollar.” 

Of course, what really happened was that all these losses were not shifted to AIG, but were shifted to taxpayers and the American public.  AIG and the other market participants enriched themselves, their shareholders and executives at the expense of the American people, who were forced to provide AIG with an unlimited bail out, which ended up being more than $180 billion.  Brazenly, AIG used some of that bailout money to pay bonuses to some of the very executives who engaged in the reckless activities that bankrupted the company in the first place.  Indefensibly, there was no accountability for a single AIG executive (or any other executive or supervisor on Wall Street for that matter).  The guilty pocketed their bonuses and victimized Americans paid the bill.

None of that is to deny that AIG has reduced its systemic footprint.  But, that alone should not lead to de-designating AIG, which would require ignoring AIG’s uniquely critical and despicable role in the 2008 crash.  It would also require ignoring AIG’s egregious recidivist history, which was detailed by famed author William Cohan in “The Fall of AIG: The Untold Story” (Institutional Investor, April 7, 2010) as well as in two terrific books: Roddy Boyd’s “Fatal Risk” and, more recently, in Jesse Eisinger’s new book “The Chickenshit Club” (which everyone should read). 


Fourth, the issue isn’t de-designation or having a so-called “off ramp” once designated.  There is no “Hotel California” problem where you can check in, but you can’t check out.  Given GE’s high risk financial activities before the crash and its 2008 bailout, it was appropriately designated as a systemically significant nonbank, but it dramatically and comprehensively de-risked, which led to it being de-designated.  That was appropriate.  However, GE, unlike AIG, didn’t have a history for taking enormous reckless risks, abysmal to nonexistent risk management and repeated management failures.


Where does all that lead us?  Should a firm designated a systemically significant non-bank remain so forever?  Of course not.  How then to deal with AIG and other systemically significant non-banks, including those that de-risk?  Bloomberg View Columnist Matt Levine wrote the most concise, sensible, appropriately broad and historically-informed answer to these questions, which merits quoting in full:

“Part of the point of designating companies as ‘systemically important financial institutions,’ and imposing higher capital and regulatory requirements on them, is to make them stop being systemically important. ‘Break up the banks,’ people say, and one way to break up the banks is by making life difficult for the ones that stay un-broken-up.

“And so a SIFI designation — and also more generally its painful hangover from the financial crisis — seems to have driven American International Group Inc. to divest businesses, shrink itself and improve its capitalization. ‘This company has dramatically changed its risk profile and controls since the financial crisis,’ says its chief executive officer. That’s good! That was the point! And AIG has shrunk and transformed so much that now the U.S. Financial Stability Oversight Council is considering removing AIG’s SIFI designation.

“That’s also … sort of good? SIFI regulation is generally considered a second-best outcome: You’d prefer not to have any systemically important financial institutions whose failure could crash the economy, but if that’s not possible, you should at least keep a close eye on them. If keeping a close eye on them encourages them to stop being systemically important, you should reward them for their progress. Giving firms a realistic off-ramp from SIFI status encourages them to shrink and become less systemic. If doing that doesn’t get you out of SIFI status, then every existing SIFI will have no incentive to shrink, and every incentive to get bigger.

“On the other hand, you know, it’s AIG. It was at the center of the global financial crisis, as an under-regulated non-bank that took on massive risks whose implications were not well understood by regulators or the rest of the financial system. It would not be totally unreasonable to say that its punishment for that should be to remain a SIFI for the rest of eternity.”


He’s right.  That is the right outcome: regulate systemically significant nonbanks to protect the economy and deregulate them if, like GE, they appropriately de-risk (which will incentivize some to do so), but not AIG.  Given AIG was so egregiously reckless, required an unlimited bailout, used part of the bailout to pay bonuses to some of the very executives who were involved in the insane risks the company took and was a recidivist miscreant, it should be kept on heightened watch for a very, very long time.  Maybe not for eternity, but certainly for more than a mere nine years after AIG’s key role in blowing up the country’s financial system.

FSOC’s action will again leave AIG unsupervised as a reckless recidivist free to return to its high-risk gambling.  This is not speculation:  the Financial Times reported today that “a team of federal officials who have been stationed within [AIG] to monitor its activities will be heading for the exit” and AIG can now go back to doing whatever it wants, including making large acquisitions, which the CEO said it is going to do.  As Bloomberg News put it, “AIG Is No Longer Too Big To Fail, So Now It Wants To Get Bigger,” which the Financial Times pointed out “will be a reversal for AIG, which since the crisis has shed assets around the world … in a push to become smaller and simpler.”  That, of course, was the basis FSOC just used to justify de-designating AIG, which is immediately changing course.  The net result:  AIG will now, like before the crash, be supervised by state insurance regulators, which have no capacity to regulate a gigantic global financial company like AIG.

The message this sends to gigantic financial firms and their executives — that reckless and lawbreaking pays — will come back to haunt FSOC.  It is an historic mistake and a slap in the face to the tens of millions of Americans who suffered and continue to suffer from the devastating 2008 financial crash. 



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