The Real Questions About AIG

By Derek Stimel, Ph.D., Assistant Professor of Economics at Menlo College

$165 million in bonuses paid by AIG. $93 billion (a number more than 500 times larger than the bonuses) paid by AIG to Goldman Sachs, Merrill Lynch, and various European banks among others. These numbers and the total $173 billion in government bailout paid to AIG raise many questions. However, they don't seem to be the questions anyone is clearly discussing. Here we not only ask the questions, we try to provide some informal answers.

Why did AIG pay these bonuses and make these payments to other bailed out institutions and foreign banks? Simply put, AIG used a substantial amount of the bailout money to pay its liabilities: to pay people it owes. This improves AIG's balance sheet. Frankly, it is the same advice even an incompetent financial advisor would give to an individual. Imagine you had $10,000 in credit card debt and suddenly the government gave you a check for $5,000. Wouldn't you use at least some of that money to pay part of your credit card liability? That's what AIG did. Now, you can certainly say the bonuses are more like you take part of your government check to “treat yourself”, but we'll get back to that in a minute.

What did the now outraged President Obama, Federal Reserve Chairman Ben Bernanke, Treasury Secretary Tim Geithner, numerous Senators and Congressmen, expect AIG to do with the bailout money? Did they think AIG would use the money to re-invest in the business model that has brought them the point of bankruptcy? Did they think they would hire more workers to sell insurance? If so, that's rather naive. If not, their outrage seems rather disingenuous. Imagine that the restaurant around the corner is failing and in danger of going out of business. Would you walk in to the empty restaurant, hand the owner a check for $100,000 then sit back and complain that the owner didn't expand the menu or hire more wait staff? In markets, there's supply AND demand. Where is the demand for AIG? Really, what did the government expect AIG to do?

Still, isn't it reprehensible for AIG to pay bonuses to people who helped bring the company to the point of bankruptcy? Probably. The main criticism of bailouts has always been the problem of moral hazard. Oversimplifying, but moral hazard is the idea that rewarding bad behavior encourages more bad behavior. Even more insidious, if the people behaving badly anticipate the bailout, they might behave even worse ahead of time. The question, though, is it acceptable to be aware of moral hazard, give the bailout anyway, and then become outraged when moral hazard develops?

As distasteful as the bailout is, Chairman Bernanke defended the bailout on 60 minutes based on the mantra “too big to fail”. This is what technical people refer to as “systemic risk”. The idea is that if AIG fails, it will cause other entities to fail (those that were expecting payments from AIG for example). That cascades through the economy causing multiple bankruptcies. Even worse, people and businesses not even connected to AIG might panic and the negative impact could be even larger from all the chaos. The analogy Chairman Bernanke used is that if your neighbor's house is on fire because he dropped his cigarette, you help put it out, and then you worry about punishing your neighbor afterward. The point he made is that bankruptcies need to happen in an orderly fashion, to prevent panic. We already have a law for that; it's called Chapter 7 of the United States Bankruptcy Code. Continuing Chairman Bernanke's analogy, we, the taxpayer, have come out of our house to fight the neighbor's fire, but rather than grab the hose, we are tossing our flat screen television, clothes, and wallet on to it. Still if AIG failed, where would we get our insurance? It's not like their failure would create opportunities for new companies, or for other solvent companies to expand. Oh wait, it would. It's called creative destruction.