Why I am Angry at AIG

Yes, I usually write about international politics, but with the AIG bonus scandal dominating the headlines, I can't help but sound off. Congress hauled AIG chairman Edward Liddy in for a ritual flaying, though they were probably barking up the wrong tree. He was the poor soul hired to fix the mess at AIG and is working for a dollar a year. Nevertheless, public outrage was boiling over, and Congress had to vent. And vent it did:

"There's a tidal wave of rage throughout America," announced Gary Ackerman (D-N.Y.). Judy Biggert (R-Ill.) called it a "travesty," Carolyn Maloney (D-N.Y.) found AIG "morally reprehensible," Shelley Moore Capito (R-W.Va.) perceived "an insult," and Paul Hodes (D-N.H.) contributed the words "ridiculous" and "unconscionable."

And it got worse from there. Stephen Lynch (D-Mass.) charged AIG officials with "malfeasance," "violation of fiduciary duty," "arrogance" and "probably illegal" behavior.

"Do you have anything to say for yourself?" Lynch asked.

"I take offense, sir, at the use of --"

The congressman cut him off. "Well," Lynch said, "offense was intended, so you take it rightfully."(from Thursday's Washington Post)

Fallout from the bonus scandal has revolved around who knew what and when about the paying out of these bonuses. Congress is heading towards taxing the bonuses at something like 90 percent, spooking much of the financial sector in the process. But nobody is talking about the real scandal, the creation of the huge bubble in the financial sector by letting loose risky financial instruments in the market - completely unregulated. This is what led to the downfall of AIG in the first place. And now Congress claims innocence and outrage! But there are Congressional fingerprints all over this crisis.

The origins of the crisis can be found in the deregulation movement of the last 30 years. In particular, the Greenspan era was a time of pressing for deregulation of financial markets. After financial interests spent at least $5 billion lobbying Congress, a number of bills were passed overturning past regulations and prohibiting regulations on securities and derivatives. The fact that Congress felt the need to exempt these instruments from existing gambling and "bucket shop" laws suggests that there was an understanding that these financial instruments, which in fact resemble bets and led to the 1907 panic and stock market crash because of widespread speculation, are risky and illegal.

At the heart of the matter are mortgage securities and credit default swaps, a form of derivative (a financial instrument whose value is based on something else. It's basically a side bet) in which one "bets" on the success or failure of an enterprise, and pays out if it fails. (For great discussion of credit default swaps, see this article, and this two part series.) It acts as a form of insurance, but it isn't called insurance, or it would have to be regulated. Insurance providers are required to set aside a certain amount of money to cover potential losses, but in the case of swaps, there is no such requirement. As a result, when the market for mortgage securities began to perform poorly as the housing market fell, the credit default swaps backing these securities had to pay out. But the investment houses selling the swaps didn't have the money to pay off the obligations. They couldn't cover their "bets." AIG, Bear Stearns, Lehman Brothers, J.P. Morgan all fell victim to this problem.

Complicating matters is the fact that credit default swaps are not tracked - no one knows how large the market is, who owns them, what they cover, or if the money exists to pay them off. This uncertainty is part of the problem contributing to the banking crisis and putting a price on "toxic assets." Without transparency, people and institutions are reluctant to make transactions when there is a possibility that the "bets" won't be covered. As long as everyone paid their obligations, the system worked. Now no one wants to do business with one another for fear that the money to pay obligations won't be there later. Banks won't lend to one another, or to us, the average person. The bubble has contracted, but no one knows exactly how far.

So I don't share Congressional outrage - I am outraged at them for letting this happen to us. To me. And for hypocritically venting public rage on an issue so trivial as $218 million in bonuses, when the economy has lost billions of dollars and governments are spending hundreds of billions of dollars to jump-start our economy. And for diverting our attention from the real issue, fixing our economic and financial system so that our economy can grow again, safely.