Concerning AIG

Story Highlights:

• The US government announced the rescue of AIG Wednesday morning.
• Recent policy inconsistency makes it difficult for investors to gauge risk, and government intervention may only be prolonging the pain.
• But we can surmise systemic risk was genuine and AIG's failure might have depressed markets further.
• It's reassuring the government is willing to take extreme measures if necessary, and the overall cost of the deal may yet be relatively modest.

____________________________________________________________________

Topping several days of financial drama, investors were greeted Wednesday morning with the announced government rescue of insurance giant American International Group (AIG). After Standard and Poor's and Moody's downgraded AIG's credit rating Monday night, it urgently needed to find $14.5 billion in collateral. Any possibility for a capital infusion fell through yesterday, and this morning the Fed announced an $85 billion bridge loan in exchange for equity warrants equivalent to an almost 80% stake in the company.

There are positives and negatives associated with the deal.

Often in this space we've noted what we believe to be generally appropriate and measured "help" from the government throughout this year's financial turmoil. And that sentiment remains largely unchanged. But government intervention has a way of eventually yielding negative unintended consequences—and we could be seeing some now.

It's perilous enough the government has assumed the role of judge, jury, and executioner—deciding which companies survive and which do not. This is known as "moral hazard" in economist-speak. A seldom mentioned feature of moral hazard is policy inconsistency. By aiding Bear Stearns, Fannie Mae, Freddie Mac, and AIG yet leaving Lehman to declare bankruptcy, the Fed and Treasury have perhaps created more confusion than calm—particularly in the short term. Such inconsistency makes it more difficult for investors to gauge risk, elevating volatility and perhaps even scaring away private investors who would otherwise fill the void.

Whereas previous private sector intervention was limited to a Fed-backed purchase of Bear Stearns by JP Morgan (Fannie and Freddie were already quasi-government institutions); the AIG deal gives the government direct control, essentially nationalizing (at least in the near term) a private institution. What happened to the defiant, free market flag waving Hank Paulson of just two days ago?

Such inconsistency is concerning, and illustrates the ills of government intervention. Historically the US government has mostly left business decisions to the private sector, and we're generally perfectly happy with it. Let's be very clear: That the government says a bailout was "inevitable" doesn't necessarily make it so. Maybe we'd be worse off without an AIG bailout, maybe not. By preventing natural market forces from running their course, the government may only be prolonging the pain. There's no way to know.

But that's a contention to be debated for posterity only. The deal is done, and it's not without some merit. To begin with, only those closest to the matter are likely to fully understand the ramifications of an AIG failure. It's impossible to say whether a government rescue was the right decision, but it's reasonable to surmise systemic risk was genuine—AIG is bigger and more interconnected than Lehman.

And though the market hasn't reacted well to the news so far, it might have fallen much further given an AIG failure. It is somewhat reassuring that the government is willing to take extreme action to defend against perceived systemic risks.

The feds have taken on both assets and liabilities at AIG. Which means the entity is likely to be run in whatever way the feds believe is in the best interests of the broader economy, not the shareholders. It's impossible to say how they'll balance in the end (the deal could net positive or negative in terms of government finances), but the overall cost may still turn out relatively modest. Forgive us if we grow a tad concerned when one of the largest financial institutions is claimed for the "greater good" rather than the investing public.

The recent developments in financial markets have been dramatic and material. And as yet, the knock-on effects are impossible to fully predict. Stay vigilant—we should all know more as events unfold over the coming days, weeks, and months. Concerning AIG, it looks as if the insurance giant will live to see another day—if only under a nationalized banner.