Of Bailouts and Boldholders

So where is all that AIG bailout money going?  AIG itself is already bust, so the money we're pouring into it is entirely going to rpotect AIG's so-called counterparties. Josh Marshall yesterday laid out why the government feels it needs to do this:

If you've got a big insolvent bank and you need to make up a big hole on the balance sheet you've got, broadly speaking, four groups of people you can get the money from, or put a different way, who can take the hit: shareholders, depositors, bondholders and taxpayers.

Now, for most of these banks the stock price has essentially fallen to zero. So they're pretty much already wiped out. Not much to be accomplished there, although those folks want to hold on to their equity in the hopes that they may recover on the upside. Then you have the depositors. But in FDIC insured accounts, they've got a federal guarantee up to $250,000. And presumably those with really big sums on deposit have been proactive enough to spread their money around several institutions. So not much luck there either.

Which leaves you with bondholders (the companies creditors rather owners) and taxpayers. Now, on the one hand, this sounds like a no-brainer. If you lend money to a company that goes bankrupt, that's tough luck. Maybe you recover a percentage on the dollar of what you were owed. But too bad. Why taxpayers should cover those loses is really hard to answer. But let's try it. 

The counter-argument is that if bondholders, especially the most 'senior creditors', take a big hit it, will create a big shock to the financial system worldwide, making bond-investing money extremely risk-averse for a long time and making the credit markets seize up again on far worse a scale than happened last fall in the wake of the Lehman bankruptcy.

A second issue is that a lot of these bondholders are other financial institutions, so you create a cascade of failure.

"A cascade of failure" certainly sounds ominous, like something the government should do its best to prevent. But it begs the question of which institutions, exactly, is it that are going to suffer from that cascade of failure? My friend AB lays out one obvious set of beneficiaries:

I am almost certain that many of the counterparties to AIG's credit default swaps, and thus the ultimate recipients of bailout expenditures, are hedge funds. There is no way to be sure because the information is confidential to AIG and the government has not forced public disclosure of those parties. Why am I so sure? Because 1) AIG was only one of a handful of entities that sold this type of protection and 2) the vast majority of protection buyers did not actually hold the underlying debt, but were instead making "naked" short trades betting that the paper would default, in other words, exactly the kind of trades hedge funds would make.

If this is true, then bailout money is not being spent to shore up core capital ratios of our most important lending institutions, but instead is going to benefit hedge fund managers and their investors. Hedge fund losses, even up to the point of liquidation, do not threaten the overall economy. When Amaranth lost 9 billion within a matter of weeks a few years ago, the government did not step up. There was no systemic risk then when a few very wealth investors lost their shirts. Why should there be now? And, needless to say, counterparty risk -- the risk that a counterparty like AIG will not honor its contracts -- is a well-established business risk, one that investors pay their money managers to avoid. When the managers do not properly avoid the risk, the resulting losses are just like any other losses that a hedge fund may experience. Besides, the entire legal basis for the light regulation hedge funds is that their investors are savvy and wealthy, a group seemingly in little need of tax-payer-funded largesse.

In sum, taxpayer dollars are going, in large measure, to protect the profits (or at any rate staunch the losses) of hedge funds--organizations run for the wealthy by the superwealthy. The urge to go grab a pitchfork when you realize this becomes almost unbearable. It's hard to escape the conclusion that it turns out that the old socialists were right when they claimed that the main point of the state is to protect the property interests of the bourgeoisie.

Let me accept, however, that as of now there is not yet enough popular outrage to spark the wholesale dispossession of these insipid denizens of Richistan. After all, Obama's already being called a socialist as it is -- imagine the reaction if he actually did take a socialistic approach to this crisis. 

I have, however, a concrete proposal -- why not pass a law mandating that any counterparty to any institution that is receiving a bailout, if it wishes to collect on its contract, must publicly disclose its contractual obligations? Such a law would have two obvious benefits. 

At a policy level, it would rapidly help to shine light on who holds the liabilities for the losses in the system right now. Given that a huge amount of the financial markets jitteriness has to do with the unknown nature of all the untransparent transactions that Wall Street has done over the last decade, this would immediately help to end the uncertainty which may not be the cause of the crisis, but iscertainly an exacerbating force.

At a political level, moreover, this law would be enormously beneficial, since it would mean that the real beneficiaries of the bailout monies would become much clearer. This would force naked political reckoning -- which of course, is precisely why such a law is unlikely ever to pass. Once it became clear who was getting the bailout money, populist outrage would likely get even worse, probably mandating the passage of laws putting politically unpopular counterparties at the back of the queue. Of course, this is exactly why I like the idea.