The AIG Bonus Brouhaha

Robert Murphy
Saturday, March 28, 2009

I have been resisting the growing tendency to label our current woes as the Great Depression II. The conventional statistics of our economy today are nowhere near the misery of the 1930s. However, the proposed 90% tax on certain executive bonuses has convinced me that we are in for a decade of stagnation.

To recap: Back in September 2008, the giant insurer AIG was on the brink of bankruptcy when the Federal Reserve rushed in with an $85 billion rescue package. (There have been subsequent bailouts, bringing the total infusion thus far to $170 billion.) At that point the government seized AIG, and among other things it replaced its CEO with Edward Liddy, the very person Congress was recently interrogating about the bonus payments.

The reason AIG was in such dire straits had nothing to do with its conventional insurance business, which remained strong. Instead, it was AIG’s Financial Products division that brought the corporation to its knees. This group had dabbled in complex assets tied to subprime mortgages, and been left holding the bag when borrowers began defaulting at much higher rates than expected.

Beyond directly holding some of these “toxic” assets, AIG was also crippled by its massive issuance of credit default swaps. These are insurance policies that guarantee the buyer a certain monetary payoff if “credit events” occur. For example, a hedge fund might hold $1 million in bonds issued by GM. To protect itself from a GM default on its bond payments, the hedge fund can buy a credit default swap from a company like AIG.

As the housing and financial markets deteriorated last summer, the companies who had bought credit default swaps from AIG became nervous. They worried that AIG would suffer so many claims that it couldn’t satisfy them all. So AIG’s counterparties insisted that AIG post collateral to back up their contractual obligations. It was these “margin calls” that finally killed the company.

Fast forward to the present. The scandal is that AIG paid $165 million in executive bonuses, with large sums going to some of the very people who worked in the Financial Products division that caused all the trouble. That is certainly a bit odd, especially considering that that money effectively came out of taxpayers’ pockets.

The public was right to be outraged. But the real problem was the bailout in the first place. No matter what AIG does, it will now be with taxpayer money. Obviously, even a company that the government seizes is still going to pay its employees, pay its heating and electric bills, and buy raw materials. If citizens don’t object when their government starts nationalizing companies like they do in South America, then the citizens shouldn’t be shocked when their tax dollars get spent by the government’s handpicked CEO.

By all accounts, these bonus payments were contractual obligations before AIG’s seizure. Now if the government had simply stayed out of it, and let AIG go into bankruptcy, then the standard and time-tested proceedings would have decided whether to prune back these payments. After all, when a company goes bankrupt, it means that it does not have enough assets to pay off all of its creditors. So some people have to take a hit. And perhaps a bankruptcy court would have decided that Financial Products executives should take the hit before those who had bought credit default swaps.

But the government didn’t let AIG go into bankruptcy, since the giant insurer was allegedly “too big to fail.” If a private buyer had come in and rescued AIG with an $85 billion loan, that buyer would have certainly insisted on all sorts of immediate cost-cutting reforms. Yet the federal government obviously wasn’t too concerned about its new toy.

Even though it is indeed outrageous for AIG executives to pocket those millions, it’s an even worse outcome if the government taxes it back from them. This would be an ominous precedent, where the IRS basically mugs an unpopular group just because it can.

Many financial institutions lost their heads during the housing boom. On a free market, they would have been ruined by their recklessness. Yet now these firms are kept alive, or rather, they are kept undead, as zombies. For now these giant companies all take their marching orders from DC politicians, about the only group I trust less than AIG executives.