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— Analysis —
Liddy's sordid chronology made it clear that no regulator had a sufficient bird's-eye view over AIG, as the London-based unit built a book of business in mortgage-based credit default swaps more than twice the size of the company's net worth. That line of business would leave the firm vulnerable to billions of dollars in collateral calls when the housing market got even the slightest bit shaky.
Sure, AIG's main regulator, the Office of Thrift Supervision, grew wary of AIG's credit-default swap exposure before the bubble burst. Yes, ratings agency Standard & Poor's saw trouble brewing, too. But neither recognized that the buildup of AIG's unhedged exposure threatened the entire company or, for that matter, the global economy. The latest fight appears to have made Washington more committed than ever to establishing a single regulator to safeguard the financial system from systemic threats such as the AIG CDS business. Previous Treasury Secretary Henry Paulson began pushing the idea in earnest a year ago, shortly after Bear Stearns Cos. failed. But that was when only one major financial firm had been bailed out. Since then, nearly all of them have benefited either directly or indirectly from bailouts of Bear, AIG, Citigroup Inc. or Merrill Lynch & Co. Initially, Paulson's idea seemed doomed for the cobwebbed bookshelf reserved for financial reform plans that go nowhere. But nothing focuses Washington more intently on a neglected task than a crisis. "We have as important a task as we've had ... since the '30s, House Financial Services Committee Chairman Barney Frank, D-Mass., told reporters after a March 17 hearing on systemic risk. Paulson proposed the Federal Reserve as grand overseer, a suggestion that was politically unpalatable. The central bank has many critics and rivals for financial regulation. But the crisis has convinced many that a systemic regulator is necessary and there are no real alternatives to the Fed. Frank's counterpart in the Senate Banking Committee, Chairman Christopher Dodd, D-Conn., has been wary of granting the Fed more power. A redoubt of House Republicans also oppose the idea, but at best they are likely to win only a clear delineation between the Fed's banking supervision duties and its conduct of monetary policy. But easy money to keep the economy chugging along and sound banking practices rarely coincide with loose money. The two chores once again came into stark relief on March 16, when the central bank announced the purchase of $300 billion in Treasury bills. In any event, the Fed is already preparing for the job. Fed Gov. Daniel Tarullo told the Senate Banking Committee last week that the central bank has taken steps to improve regulatory requirements and risk management at the institutions it regulates -- all functions that would be extended to banks and financial firms currently outside its purview. The Fed is closely monitoring liquidity risk management, capital planning and capital adequacy, firmwide risk identification, residential lending, counterparty credit and commercial real estate. "Liquidity and capital have been given special attention," he said. While the Fed's relaxed money policies have been blamed for fueling the housing boom, nobody has fretted much that looser accounting seems to be making a comeback. On March 16, the Financial Accounting Standards Board proposed to relax mark-to-market rules requiring firms to carry assets on their books at current trading value. The rules were imposed in the wake of the accounting scandals to prevent the kind of bookkeeping finagling that felled Enron Corp. But for more than a year, the financial industry has blamed the standards for forcing firms to make dramatic markdowns in mortgage portfolios. The forced write-downs, many in Congress and the financial industry say, have worsened the financial crisis by weakening lenders' balance sheets. Accountants insist the proposed alterations provide little change from today because companies already have discretion in how they value assets. But they are troubled by what they see as political pressure being applied to the FASB. "We don't believe fair-value accounting to be the cause of the economic situation we're in," Barry Melancon, president of the American Institute of Certified Public Accountants, said in a conference call with reporters. "We believe it aids transparency." In October, Financial Accounting Foundation chairman Robert Denham wrote Frank, warning lawmakers that interfering in FASB standards will undermine investor confidence. "Once Congress starts setting accounting standards through its political process, the integrity of U.S. accounting standard-setting and the credibility of U.S. financial reporting will be compromised dangerously," he wrote. Capitulating to threats from lawmakers, accounting regulators proposed to let companies exercise more judgment in determining whether a market for an asset is active and whether a transaction is "distressed." That's important, because if a market is distressed, companies do not have to use those depressed prices to value the assets on their books. As far as AIG goes, Liddy says the damage largely has been done, but he said FASB should approve its changes in time for them to be put in place for release of first-quarter numbers. "I think mark-to-market is a good concept," he told Frank's committee. "On balance, knowing what something is worth everyday is a good thing. But the requirement presumes there is a market with willing buyers and sellers. When liquidity completely dries up, there's not a willing buyer, so we have to keep marking the value of assets down to an unwilling buyer's level." Scott Polakoff, acting director of the OTS, AIG's primary regulator before it collapsed, highlighted mark-to-market's potential for overstating deterioration in asset portfolios. Despite the massive write-down of collateralized debt obligations insured by AIG credit default swaps, holders of the CDOs have suffered no actual realized losses, he said. The crisis for AIG came from the huge sums that had to be raised to meet the counterparties' collateral calls. Polakoff concedes OTS failed to recognize the liquidity risk to AIG of the highest-quality credit default swaps in its portfolio. "We focused too narrowly on the perceived creditworthiness of the underlying securities and did not sufficiently assess the susceptibility of highly illiquid, complex instruments to downgrades in the ratings of the company or the underlying securities. No one predicted, including OTS, the amount of funds that would be required to meet collateral calls and cash demands of the credit default swap transaction." S&P has received blame from some corners for precipitating AIG's downfall when it placed a negative outlook on the company in February 2008. S&P, which had been steadily downgrading the insurer since 2004, had become concerned about the way AIG was determining the fair value of CDSs. In August 2008, S&P further downgraded the company and publicly predicted that AIG's credit losses in its investment and CDS portfolios would likely be $8 billion -- and its mark-to-market losses even higher. S&P's action triggered massive collateral calls by AIG's CDS counterparties, which the company couldn't honor. On Sept. 17, the Federal Reserve Bank of New York -- led at the time by Timothy Geithner -- stepped in with an $85 billion bailout that put a majority of the company stock in the hands of U.S. taxpayers. Two infusions later, the government's commitment stands at roughly $180 billion. Polakoff says the AIG experience "makes a compelling case for a systemic risk regulator." It would be easy to assume the Fed or some other all-seeing regulator would have the foresight and wisdom to ward off future system debacles. The miscues of OTS and S&P offer cautionary lessons. Whatever their failings, both institutions became aware of AIG's overexposure to housing before the bubble burst. OTS noted weaknesses in risk management at AIG's financial products unit as early as 2005 and forced the company to begin taking corrective measures. AIG stopped issuing CDSs in 2005 and has reduced its exposure to the business from $80 billion to almost nothing. OTS' actions occurred too late to prevent disaster. Would a systemic regulator be more prescient? S&P saw problems a year earlier, in 2004, but the fact that none of the obligations insured by AIG swaps have suffered a loss suggests that the ratings agency's downgrades exaggerated the risk and perhaps unnecessarily triggered the company's liquidity crisis. The Fed may become the assigned guardian of our financial system. But the miscues of OTS and S&P show that a problem must be spotted early and the right corrective action taken. Unless the Fed gets both right, a future central banker is likely to land before an angry Congress when the next crisis hits. |
The blowup over bonuses paid to the traders in American International Group Inc.'s discredited financial products arm required company chairman 
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