The government's AIG dilemma

Sorry for being way behind on the big news of the day. Stuff's been happening here in the Time & Life Building.

Anyway, the government has decided to renegotiate and ease the terms of its deal with AIG. Reports the WSJ:

Under the terms ironed out late Sunday, the government would give AIG more money, including $40 billion from the U.S. Treasury's $700 billion Troubled Asset Relief Program. It would also receive less interest than on the bulk of the original loan, while freeing AIG from exposure to some of the risky financial instruments that nearly caused it to file for bankruptcy protection.

The original AIG loan was arranged in a couple of days as markets shuddered after Lehman Brothers' bankruptcy. Its terms were meant to be pretty draconian, incentivizing the company to break up and sell off its parts to quickly repay the loan. Funny thing, though: In the middle of a financial crisis people don't want to pay top dollar for financial companies, even pretty good ones like AIG's insurance subsidiaries. Plus, it turns out it wasn't just AIG's derivatives-trading arm, AIG Financial Products, doing dumb stuff. The WSJ reports that AIG's securities-lending business took the collateral put up by short sellers that borrowed securities from it, and put it into mortgage securities that now it can't sell. Smart!

The government's dilemma is that the people at AIG responsible for this mess really do deserve to be tarred and feathered, or maybe drawn and quartered. There's ample reason to be punitive. But once they made the decision that AIG was too systematically important to fail--and I'm not saying that was the wrong decision--the Fed and Treasury needed to structure their bailout in a way that allowed AIG to survive, at least until the financial situation improved dramatically. They didn't do that the first time around, which is why they had to restructure the deal on Sunday.

One other thing: There remains a widespread misperception (a misperception I used to share), that the U.S. government has no oversight responsibility over AIG, because insurance companies are regulated by the states. AIG's main insurance subsidiaries are in fact regulated by New York State Insurance Commissioner Eric Dinallo. But the regulator responsible for monitoring the parent company's overall safety and soundness was and is ... the federal Office of Thrift Supervision.

The OTS, a branch of the Treasury Department, regulates all federally chartered and most state-chartered savings institutions and their holding companies. AIG has a subsidiary called AIG Federal Savings Bank, so OTS regulates AIG. OTS examiners regularly reviewed the accounts of AIG Financial Products. So AIG was subject to closer federal scrutiny than Bear Stearns or Lehman Brothers. Not very effective federal scrutiny, mind you. But the feds had a hand in the company's fate even before they stepped in to save it.