Tuesday, May 5, 2009

The REAL Reason AIG Had To Be Rescued

The mere mention of insurance giant AIG can start a highly polarized and emotional debate in a roomful of near-comatose Quakers with one side shouting AIG must be allowed to fail and the other screaming AIG must be rescued and neither side knowing “why” for certain. To get a handle on the AIG issue one needs to understand the Federal Regulations that were put in place in the 1930s regarding the Banking, Brokerage and Insurance industries- - -regulations that arose as a result of the “Great Depression”.

Prior to 1933 it might have been difficult to tell a commercial bank from a brokerage house because their business activities were often similar. But the Glass-Steagall Act of 1933 changed all that and unambiguously defined what activities could be engaged in by banks and which ones could be pursued by brokerage firms. Glass-Steagall had the clear intent of separating the two businesses thereby limiting the risk to any given sector of the financial services industry and the nation’s system of payments, loans and settlements as well as the consumers’ ability to invest in “Corporate America”. The Act also made it clear that to mix the two activities was a violation of federal “Anti-Trust” laws.

Glass-Steagall gave rise to a host of federal administrative rules and regulations that still pertain to banks and brokerage houses today. It created a layer of federal regulation to which banks and brokerage houses had to adhere in addition to the regulations that might be imposed on them by the individual states in which they did business. Significantly and specifically missing from this attempt to federally regulate financial services was the insurance industry. In 1945 a similar attempt to rein in insurance industry was made via the McCarran-Ferguson Act but a last minute heavily debated political compromise which stated, “. . . federal anti-trust laws will not apply to the ‘business of insurance’ as long as the state regulates in that area. . .” effectively emasculated McCarran-Ferguson by prohibiting any federal layer of regulation from being imposed on the industry and making the regulation of the insurance industry a state-by-state issue.

Over the past 60 years or so various attempts to make insurance companies subject to federal anti-trust and other regulations have been defeated by a well financed and immensely effective lobbying effort orchestrated by the insurance industry and their buddies- - the trial lawyers. As a result here’s where we stand today. If your bank fails you can expect the Federal Deposit Insurance Company (FDIC) to protect you in amounts up to $250,000. If your stock broker defrauds you (we’re not talking about regular market risk investment losses here) the Securities Investor Protection Corporation (SIPC) is there to protect you in amounts up to $500,000. But if your insurance company fails or defrauds you, your only recourse is to file a complaint with your State Insurance Commissioner’s Office. Oh, and did I mention that in almost all of the 50 states the Insurance Commissioner’s Office is headed up by a former insurance agent, lobbyist or similar industry veteran. (Talk about the fox guarding the hen house!)

So, AIG was not under any real federal scrutiny thus any meaningful regulation or watch dog efforts were, by law, up to the Insurance Commisioner and/or the Attorney General of the State of New York. But the New York Insurance Commissioner’s Office was ill-equipped to deal with AIG’s fast and loose securities dealings- -especially their huge dealings in mortgage backed securities and their derivatives. Interestingly enough former NY Governor, the now disgraced Eliot Spitzer, when he was the NY Attorney General, made a run at reining in AIG but was politically steam rollered by the vast resources of the insurance lobby. There are even some who believe Spitzer’s recent downfall was a successful act of vengance perpetrated by a cabal of industry lobbyists. I doubt it, but stranger things have happened.

Now to be fair AIG didn’t invent the mortgage backed security or any of its derivatives (the credit for that generally goes to Lehman Bros.) but AIG sure raised the purchase, sale and accounting for them to a new level which probably might have been OK had the housing bubble not burst taking sub-prime mortgages along with it. However, if the insurance industry had been subject to federal regulations similar to those limiting the activities of banks and brokerage firms the chances are that AIG would never have been allowed to engage in the selling of those securities in the first place. OK, you say. So what? They took the risk and it flopped so why shouldn’t AIG be allowed to fail just like Lehman Bros. was allowed to fail? The answer is something called “re-insurance”.

In Florida, where I live, insurance companies writing business in this state are required to purchase a certain amount of “re-insurance” to further secure their risks beyond just their immediate cash reserves. So, Allstate, State Farm, Gieco, Progressive and the rest must back up their liabilty to the automobile policy holders in this state by purchasing “insurance” of their own to back their promise to pay me if I have an accident. This is known as “re-insurance”. This regulation requiring “re-insurance” also applies to homeowner’s policies and other forms of insurance as well. Virtually all 50 states have “re-insurance” requirements. And just who is, by far, the single biggest provider of re-insurance to all these companies- -in fact the biggest single provider of re-insurance in the world? Yep, you guessed it- - -our friends at AIG.

If AIG were allowed to fail the domino effect would be catastrophic. It would simply mean that Allstate and most, if not all of the others, would have no re-insurance and would therefore be out of compliance with state regulations in every state. Again- - OK and so what? Why shouldn’t each state suspend that particular regulation and allow State Farm (and all the others) to operate without re-insurance? Well, that would be OK if they all had sufficient cash and other reserves to handle the next big hurricaine in Texas or spate of tornados in Kansas but they don’t. That leaves only one other option- -let each individual state provide its own re-insurance fund. An OK idea except that it shifts the payment burden away from the insurance companies themselves and onto the backs of the taxpayers instead. And Heaven knows we already have a heavier tax burden than we deserve. Just imagine what the cost of picking up re-insurance premiums nation-wide would add to the tab.

You’ve probably wondered when this “essay” would turn political- - -well here it is. In bailing out AIG and making noises about finally putting the insurance industry under some umbrella of federal regulation it would appear the Obama Administration got it right. In my opinion, they did. But not without charges of “nationalizing businesses” and turning the US into a “European model of socialism”. Charges they continually defend without explaining the “why” of it all. Treasury Secretary Geithner has been hammered about this issue in press conference after press conference and all he offers are vague answers. Even BHO was asked about it in his nationally televised news conference and made some vague reference to wanting to make sure he had “all the facts”.

Yet, in less time than it took you to read this post, Secretary Geithner (or BHO himself for that matter) could have made this exact same explanation to the American public and would have silenced the critics quickly. But the fact that the Administration has not done so makes me ask myself - -and you- -three questions:

1. Is the Obama Administration just another bunch of biased, bumbling beaureaucrats who accidentally stumbled on the right solution? Or. .
2. Are they so arrogant they actually think the public doesn’t need an explanation and should just follow their decisions blindly? Or. .
3. Now that AIG has been rescued will the momentum to finally bring the insurance industrty under federal regulation be buried in an avalanche of industry contributions to campaign coffers of local, state and national politicians everywhere?

Use the “Comments” link below to let me know what you think.


How T got her groove back said...

Hal... very interesting. I'm going with choice #2. This administration doesn't care what really concerns intelligent, political, Americans and we don't deserve an explanation. The other 1/2 of the country are BHO zombies ~ "Whatever you say Barry is good enough for me!"
When BHO says things like, "I'll have to check the facts on that and get back to you." (which he never does) makes me wonder if HE even knows what's going on. I have to believe he is more than a mere puppet!

Anonymous said...

Interesting explaination, Hal. I still wonder about the massive run on money markets that took place in Sept.(?) that brought down the house of cards. Some say it was Soros who caused it...as he almost brought Britain down singlehandedly. Nonetheless, I agree that reason #2 is most likely. After all, we're all such dunderheads that we don't even have the good sense to live among the elite in NY, DC, LA, or SF. Bet you thought I'd say Chicago, but, no. I've lived in Chicago and there is nothing elitist about it.

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