Monday Morning Quarterback vs. AIG

Tue, 24 Mar 2009 08:05:00 -0400

Photo by victoriabernal

Setting the Conditions For Failure

First, a flashback. Prior to last September, AIG was in the very profitable business of selling insurance to banks and other entities. These policies were a bet against the chance that the mortgages the banks were holding (or securities comprised of them) became insolvent. In that heyday AIG was raking in dough (in the form of premiums) and brought on a bunch of fancy-pants executives, who would not work for AIG without the promise of big salaries and big bonuses. AIG signed contracts with these executives committing millions of dollars as an incentive for the executive joining the company. "If person X works at AIG during the previous year, he/she will receive $Z million as a bonus for that year."

We'll put that aside for now. Concerning the topic of insurance, AIG was an enabler. When a banker looked at a securitized collection of mortgages, he/she thought "Wow, these could be profitable but they're quite risky. How could I take advantage of this profit opportunity without all that risk?" Enter AIG: the insurance they sold was cheap enough that the banker's risk was greatly reduced at the small cost of an insurance premium. In the banker's mind, AIG is a huge multinational corporation, so the odds that:

1. The mortgages go bad, and

2. AIG can't provide coverage in the case of failure

...are theoretically very low. Unfortunately AIG was making the same assumption about mortgages and was taking a huge risk of its own, rather than building up capital in safe investments. It bet all those premiums, along with its wedding ring, chopper, and yacht that the dealer would bust.
Experiencing Failure

When the dealer showed 21, the banker, sitting at the same table, reluctantly gave up his chips and turned to AIG, expecting most of those chips to come back. Alas, AIG was penniless. Thus, last September it was suddenly realized that AIG owed gobs of money because tons of mortgages were going sour. Why did these bankers expect money from AIG? That's easy: they had a contract. The contract stated, very roughly, "Banker X will give $Y as a premium. If the attached mortgage goes insolvent, AIG will give $Z to Banker X."
Overreaction and the Sanctity of Contracts

Fast forward to March 2009. AIG has received $170 billion from taxpayers because it owes at least that much, mostly to banks. Unfortuately for US taxpayers, the contracts it has with those banks are just as legally binding as the contracts it signed with its executives concerning their bonuses. As the government shoveled into the company, AIG simply funneled it to its debtors. It gave billions[1] to Deutsche Bank, Merrill Lynch, Bank of America, etc. etc. It then gave $165 million in bonuses to those executives who were owed money. Cue mass hysteria among the public, and even outrage from President Obama. There's some merit for the anger: how can a company that the US Government rescued from certain death turn around and dole out a chunk of it to people who were probably already richer than most Americans?

After much gnashing of teeth and wringing of hands, the US House decided that the best way to solve this "problem" was a 90% tax on bonuses for those earning over $250,000. This is incredibly dangerous. Much like the recent insanity surrounding the Terri Schiavo case, Congress decided to put the important issues on hold in order to intervene in a very specific situation, one that is arguably not theirs to solve.

What is at stake here is the sanctity of contracts. Strictly speaking there are no contracts being violated in this case, but this is essentially the same thing. The US House can't break the bonus contracts, so they decided to steal the money back instead. The message this sends to all of corporate America is: commitments mean nothing. The House's actions are simply like those of a child, pitching a tantrum on the floor because they weren't doing anything about bonuses back when the contracts were signed. AIG's name has been destroyed as a result.

Fortunately, my frustration is waning as Obama and the US Senate seem to have little interest in this silly bonus tax, and several of the bonus recipients have returned at least $50 million total. Slowly the focus is shifting back where it belongs: the birthplace of executive compensation. If these bonuses defied logic (and it seems like they did), then why were they set up in the first place? We're already the current mess, but we can prevent future problems by encouraging companies to keep their bonus policies sane.