Clear the breakfast plates; let's tackle the matter of systemic risk. Currently, the nation is outraged over American International Group Inc. (NYSE:AIG), not only for the bonuses but also for pass-through bailout funds to counterparties. That's today's news. But tomorrow's news is always: How do we fix the system so this doesn't happen again? One popular solution in the fix-it mode is to create a single systemic regulator, a body (probably the Federal Reserve) whose job it is to insure market stability.
Given everything we know about AIG, the notion of an effective systemic regulator has an absurd quality. Take just the bonuses, which are a sideshow, but one that provides salient lessons. In the Financial Times Thursday, John Gapper discussed the fact that traders at AIG Financial Products seem to have gained a major-league trader's option against, well, everyone else. That is, as Gapper writes, an employee "has an incentive to take big risks to make money. If his trading strategy works he gets a bonus but it if it fails, the bank (and ultimately the taxpayer) pays." Gapper argues that derivatives traders at AIGFP have a "trader's option squared." They had the right to not only bet the company on credit-default swaps, but to argue that they are irreplaceable, since only they understood what they had done. (If this is true, by the way, how do we know what they're doing now? Maybe they're further embedding their option by making the situation worse. Just wondering.)
Indeed, AIG CEO Edward Liddy made this gun-to-the-head argument to Treasury Secretary Tim Geithner in his letter about the bonuses, and to Congress Wednesday. This also may explain why bonus negotiations appeared to have been so skewed toward the traders; Talking Points Memo, which smells fraud in the case, is doing some good reporting on the nitty-gritty of that issue. But step back a bit and ponder this scene. Dollar-a-year Liddy is arguing that only these traders can resolve the Gordian knot of these CDS trades. Don't pay them, and the whole shebang blows up. And, he added to Congress, if AIG blows up, it will bring the rest of the financial system down with it. That argument, by the way, was parried by an S&P analyst before Congress, who argued that AIG was not a systemic risk at all and that CDS contagion might not be so dangerous.
Great. That clarifies the situation entirely.
The larger point here is that we don't seem to know -- either about the nature of the CDS book or about the systemic effect of an AIG failure or bankruptcy. The fact is, if we truly understood the situation, then the trader's option would be moot. But we clearly do not. AIGFP continues to be characterized as a black box ruled by the traders. This raises three possibilities. First, we (including Treasury) are being fooled by the lethality of AIGFP and, by extension, AIG. Who wants to test it? Second, the CDS book is so complex that no one can untangle it. Third, traders at AIGFP possess an insight, born of creating the book in the first place, that makes them irreplaceable. Only in the third case does paying the bonuses makes sense. But even that comes with a caveat: If these guys can figure it out, why hasn't the government over the past six months of ownership camped out in London and modeled the damn book and gained a greater sense of certainty about its dynamics? Why over this length of time do the traders remain irreplaceable?
This is not to underestimate the complexities of this problem, and it's not to suggest that staff-less Geithner and the new administration has had enough time to work through the CDS book (although the Fed is running for systemic regulator and has been around throughout). But, over the long term, it should provide skepticism when architects of regulatory reform -- Hank Paulson Wednesday, but he's hardly alone -- toss out the notion that we can easily determine systemic risks and that, with a few tools and a steady inflow of data, can build rational maps of the markets. We're faced here with a problem that's not dissimilar to the complexities faced by drug developers. If we understand a biological system comprehensively -- as a rational model -- we can easily develop effective therapeutics. But ask the folks at Merck & Co. (NYSE:MRK) or Pfizer Inc. (NYSE:PFE) how easy comprehensive modeling is. In finance, maybe we could start with a nice contained problem, like that CDS book at AIG. The bracing reality in both cases is that we're not as smart as we sometimes think. - Robert Teitelman
See Gapper's column from The Financial Times
Robert Teitelman is the editor in chief of The Deal.
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