The AIG Bailout and the Current Banking Mess

On Monday, Treasury Secretary Henry Paulson seemed to indicate there would be no government AIG bailout, and the markets tanked not only in the US, but around the world as investors from Taiwan to London feared that lack of an AIG bailout would trigger a broader global crisis. The camps of both John McCain and Barack Obama voiced strident opposition to any government AIG bailout on Tuesday. John McCain said on NBC's Today Show that he was opposed to an AIG bailout and "was glad that Secretary Paulson is apparently taking the same line." Joseph Biden later appeared on "Squawk Box" on MSNBC and also opposed an AIG bailout. This seemed a pretty safe tack to take after Monday's statement by Paulson that there were no talks of a government loan for an AIG bailout.

Fed Approves AIG Bailout

By mid-day on Tuesday, however, after watching markets around the world shudder in panic, rumors began to swirl that there would indeed be a government funded AIG bailout. By late Tuesday night, the rumors turned to reality with an announcement by the Fed that they would provide $85 billion in funding for an AIG bailout loan in return for 79.9% ownership of the company.

An Interview with a Former Federal Reserve Bank Economist on the AIG Bailout

With such widely divergent and shifting opinions on the AIG bailout and the current banking crisis, I thought I'd ask an expert. Timothy Yeager was an economist with the Federal Reserve Bank in St. Louis from 1998 to 2006 and is now with the University of Arkansas. He kindly consented to answer some questions about the AIG bailout and the banking crisis in general.

Was the Effective Repeal of Glass-Steagal Act Responsible?

We've all read reports of the blame for the current crisis being laid at the feet of the Gramm-Leach-Bliley Act which repealed many elements of the Glass-Steagal Act which was instituted after the Great Depression to prevent financial meltdowns.

While the Gramm-Leach-Bliley Act (GBLA) did lessen some oversight provisions, which in my opinion did contribute to the sub-prime mortgage excesses, former Federal Reserve Bank economist Yeager points out his belief that "the GBLA is a source of strength in this crisis. It reintroduced universal banking, and it is the large Financial Holding Companies that are helping to stabilize the economy. They were less-leveraged than stand-alone investment banks and able to absorb the losses better. In addition, these [Financial Holding Companies] are able to tap insured deposits and the discount window to obtain liquidity to help them through a crisis."

However, Yeager did see a need for Congress to take actions to correct some of the practices allowed under the current GBLA rules, stating that the Fed "should have the authority to prevent investment banks, GSEs and insurance companies from absorbing too much systemic risk."

Were Fannie Mae and Freddie Mac too Big and Bloated?

I then asked if did Fannie Mae and Freddie Mac's willingness to buy sub-prime mortgage debt from issuers have a role in contributing to this mess? Yeager replied that "the main problem with Fannie Mae and Freddie Mac was their lack of capital. If they held [higher] levels of capital, they would still be... able to fulfill their mission of providing liquidity for the mortgage market. Their purchase of low-quality mortgages contributed to their downfall, but that was a secondary reason.

"The primary reason for their collapse," he said, "was the low capital combined with the steep housing slowdown."

Contrary to being too big and bloated, the former Fed economist seemed to be saying that if Fannie and Freddie were bigger and had more capital, they could have weathered the storm and provided more stability to the entire banking sector and there may not have been a need for an AIG bailout.

Why an AIG Bailout but not Lehman Brothers?

Yeager suspected the AIG bailout was motivated by the Fed's fear that an AIG collapse would adversely affect several large banks which would be faced with wither raising more capital or themselves failing. The Fed likely pulled the trigger on the AIG bailout while allowing Lehman Brothers to fail, Yeager said, because of the "perception that he systemic risk was worse with AIG than with Lehman Brothers." He explained that "AIG insures billions of dollars of credit swaps, and had those defaulted, several large banks would have had major hits to their capital."

Although he agreed that bailouts can exacerbate the problem by removing accountability for excessive risk-taking, he cautioned that "the time to act and prevent excessive risk-taking is before the risks become too great." In other words, leaving them to their own fate at this point would be too great a blow to the US and indeed the global economy, so in some cases, as in the AIG bailout, the Fed may see little choice but to act to prevent collapse.

Presidential Candidates views of the AIG Bailout

I asked him about comments from both Joe Biden and John McCain that the Fed should not be party to an AIG bailout made as recently as Tuesday. Yeager dismissed these statements, saying that "the real test for the next President is whether he will hire competent people in the Treasury Department who really understand these events and can give the President good advice."

That makes it worth my mentioning that Barack Obama is being advised by Clinton-era Treasury Secretary Robert Ruben, who supported financial sector deregulation such as the Gramm-Leach-Bliley Act in the 1990s. John McCain is being advised by Phil Gramm, a chief sponsor of the Act and who according to the NY Daily News in July called the current economic condition a "mental recession" and called America a "nation of whiners," implying they were getting upset over a minor issue. In short, it seems that both parties are speaking out of turn with too little information, and hopefully their opinions and actions will be moderated by knowledgeable experts after the election and reality kicks in. Meanwhile, we should stop our whining, right Phil?

Additional Sources:
McCauliffe, Michael. "John McCain & Barack Obama both have advisers tied to Wall Street Mess." New York Daily News, September 17^th, 2008. Retrieved from nydailynews.com/money/2008/09/16/2008-09-16_john_mccain__barack_obama_both_have_advi.html on Spetember 17^th.

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