AIG's Demise Speaks to Mark-to-Market's Importance
Blaming mark-to-market accounting for the banking sector’s woes is like blaming a polar bear stranded on an ice floe for global warming. The stranded bear points to the problem; though he didn’t cause it.
The AIG debacle demonstrates the risk of ignoring market values. Congress is balking at being asked to approve yet another heap of money for AIG. There’s a growing sense that if we knew in September how big the hole in this bucket was, we might not have started filling it. But we did know in September.
Or at least somebody knew. And the way they knew was by marking-to-market the assets AIG Financial Products had insured. AIG is now turning into a scandal of the highest order. Consider the fact pattern: the Treasury Secretary convinces Congress to spend $150 billion to bail out one of the largest trading partners of his former firm. If something similar happened in a third world plutocracy, we’d shrug.
As details emerge, we now know a bit more about what happened. We know AIG Financial Products sold insurance protection to banks and brokers on over $440 billion of mortgage CDOs and other fixed income assets. We know the protection did not require AIG to collateralize its trades unless they were downgraded. And we know that the Fed’s first $85 billion loan facility was necessary to prevent the AIG FP default that an unmet margin call would have triggered.
What Congress did not know in September was that the collateral calls were based on marking-to-market the assets guaranteed by AIG FP. Those who claim these assets are impossible to value are either ignorant or deceptive. At least 20 firms would soon be calling AIG for margin based on the market value of these toxic assets and AIG’s impending downgrade. AIG was not disputing the valuation. It simply did not have the cash.
AIG’s collateral arrangement probably did not require it to post the full mark-to-market loss upon a downgrade below AA. More likely AIG would have to post some fraction of the mark-to-market loss. It would need to post more as its ratings continued to fall or the insured assets continued to weaken.
Suppose the $440 billion of assets AIG FP protected were worth 50% in September. AIG would have had an expected loss of $220 billion. But since it was still single-A, it might have only had to post some fraction of that number, perhaps 25%. That would have meant a $55 billion margin call. AIG’s initial $85 billion loan facility would have been viewed as a down-payment on a much bigger bill that would shortly come due.
Would politicians in Washington have allowed the initial funding if they knew it was only a fraction of the expected loss? I use “expected loss” and “mark-to-market” somewhat interchangeably. Many commentators have objected to this, claiming that in a distressed or illiquid market such as we now face, mark-to-market over-estimates the expected loss. Some optimistically argue that we just need to give AIG enough money to wait out the storm, and when prices recover, the taxpayer will be paid back.
Waiting out the storm is unlikely to work here. Nearly all of the CDOs of the type AIG insured have built-in Events of Default (EOD). EODs are triggered by ratings downgrades in the CDO’s underlying asset pool. If an EOD is triggered, the structure of the deal requires that the assets be unwound, i.e. sold into the market. In such cases, waiting for the market to recover is not an option. The assets get sold, and depending on the proceeds, the classes of the CDO are paid off sequentially.
It is entirely possible that there are not enough proceeds to pay off the senior-most class, the class AIG insured. The required payment from AIG to the owner of the asset would need to be made immediately, with no hope of recovery. We ain't kidding when we say toxic.
Knowing the mark-to-market in September would have given policymakers a good grasp of the magnitude of AIG’s troubles. Had Congress known the size of the expected losses, and the composition of the counterparties that were being bailed out, they might have refused to begin pumping money into a hopeless situation. They might have made the more sensible decision to abandon AIG to its own folly, and let AIG FP’s counterparties lick their own wounds.
If any taxpayer money needed to be spent, it would have been better spent making sure that the insurance subsidiaries of AIG were unaffected by the travails of the holding company. Astonishingly, the initial reaction by regulators was the reverse. Back in September, Eric Dinallo, the New York State Superintendent of Insurance and the man charged with protecting policyholders of AIG’s insurance subsidiaries, actually proposed sending $20 billion of capital FROM the relatively healthy insurance companies TO the sickly holding company.
It is unquestionable that some reasonably good valuations of the assets AIG FP had insured have been known all along. These valuations were, after all, the basis for the collateral calls. Now as values continue to fall, and AIG continues to weaken, we are being asked to cough up more money. AIG and its counterparties know the extent of the expected losses. One would hope Treasury Secretary Geithner and Fed Chairman Bernanke also know. Congress has not yet been given the full picture.
Congress is finally pressing for details on which firms AIG posted taxpayers’ money to. This is a good start. A fuller questioning would ask the following: Back in September, when the first funds were called for, what was the total mark-to-market loss on all of AIG FP’s exposures? The answer to this question is certainly knowable, and Congress has a right to demand it. If the expected losses were greater than September’s margin call, why was the scope of the problem not fully revealed?