Will in Insolvency

In this week’s New Yorker, Nick Paumgarten, in the Talk of the Town, kindly draws on my work  about the cultural contingency of financial reporting; he quotes me on the need to update the idea of insolvency.  Usually defined as the ability to pay debts as they come due, or assets exceeding liabilities, there has always been a strong objective thrust to the notion.  The emphasis is on measured financial activity reduced to a verifiable expression of ability. 

But as Nick notes, equally important is a debtor’s will to pay.  The differences appear in the contrast between the United States and Greece.When  Standard & Poor’s recently lowered its credit rating of the U.S. Treasury by one notch, it registered doubt not so much about the country’s ability to pay its debt, but the will of its incumbant political class to do so. In contrast, Greece’s political elite seem committed to finding ways to meet that country’s debts; alas, its resources compared to its obligations raise real doubt about their ability to do so. 

Another example of the difference between the ability and the will to pay debts arose in the September 2008 tussle over what to do about American International Group. It was then the world’s largest insurance company and shortly before the crisis  boasted a market capitalization of $180 billion. Much of its trillion-dollar balance sheet was securely housed in walled-off insurance subsidiaries. 

The roiling financial crisis infected two dozen banks with which AIG had financial contracts.  The U.S. Treasury, reeling from a series of bank failures and criticism of its responses to them, feared that those banks could disintegrate one-by-one. It had run out of good ideas to boost their solvency. 

So Henry Paulson, then Treasury Secretary, and his successor Tim Geithner, then head of the New York consortium of private banks misleadingly called the New York Fed, opted to wrest control of AIG in order to rescue those banks.  The government loaned the company $85 billion and the government siezed 80% of its equity.  The government then used that money, along with additional loans about twice that, to pay the two dozen banks off, dollar for dollar, under the financial contracts.

AIG may have been facing a liquidity squeeze while at the center of the financial crisis. But it had ample capital. And it was engaged in heavy negotiations with its counterparties about settling payments under the financial contracts–whose value was highly uncertain given the frozen capital markets.   AIG, in short, had the ability to pay its debts.

AIG’s shareholders, of course, including Hank Greenberg, who built the company from the 1960s to 2005 when he retired as CEO, objected vigorously to the Paulson-Geithner move.  Not only did AIG command ample capital internally, at its super-solvent insurance companies, many investors around the world were lining up to invest more. 

What divided the government and the shareholders was less the question of whether AIG had the ability to pay its debts, but whose will mattered.  The government’s will won out.  It was an ironic result, considering that U.S. culture is generally against governmental nationalization of private business, and that AIG had stood for the principle in fighting nationalization of its property and that of its customers around the world for decades.

You may also like...

7 Responses

  1. Ken Rhodes says:

    I am befuddled by this characterization of AIG:

    (1) “Trillion dollar balance sheet?” What does that mean? Certainly not that AIG had a trillion dollars of liquidity! How big a run on their assets could they have sustained before their liquidity sank to zero, and they couldn’t pay the next bill?

    (2) “Walled off insurance subsidiaries?” Well, if those subsidiaries were “walled off,” presumably so that when I got sick and couldn’t work, they could pay my disability insurance benefits, then wouldn’t those “walled off dollars” have been unavailable to the CDS gamblers?

    (3) “Eighty five billion?” In terms of my savings account, that sounds like a lot of money. In terms of AIG’s “trillion dollar balance sheet” it sounds like a pittance. Which was it? Did AIG need that $85 billion to meet their obligations? If so, then it wasn’t the government forcing them to take it. It was AIG, hat in hand, saying “please help us; we don’t want to have to go belly up and leave all those poor helpless creditors hanging.” Or, in reality, saying “Oops. We sure made a lot of stupid bets. You better lend us a lot of money RIGHT NOW to pay them off, or we will default and the world’s economy will go from recession to depression in less than 60 minutes.”

  2. Interested Observer says:

    The last statement in Ken’s comment is a specious assumption that has been repeated often and never backed by credible evidence. Would we have gone from recession to depression? The answer is far from clear. Other banks may have failed, but surely those banks had assets to cover their deposits (at the very least). And, AIG’s real estate holdings alone could have covered its obligations. Had our elected officials refused to bail out the banks, perhaps we would be in a far superior position – where Wall Street is no longer the primary export of this country and the superior means of generating income. How is what Wall Street is doing any different than gambling? Making a bet with odds that they believe to be calculated. The same way that one plays poker or blackjack. Put the fear of God these bankers so that they only may bets they can afford to lose (ie, no leverage whatsoever). Have a Federal Bank that loans directly to individuals and small businesses – cut out the middle man who takes federal money for free (ie. close to 0%), and then uses it to gamble the house away. One day, I hope, we will live in an environment with sensible regulation, free of public debt from private endeavors.

  3. Lawrence Cunningham says:

    Ken,

    To ease your befuddlement:

    1. By trillion dollar balance sheet, I simply mean that AIG’s December 31, 2007 financial statements listed total assets of $1,060,505,000,000 and total liabilities of $964,604,000,000 for book value of its equity of about $96 billion. It had plenty of capital to cover its debts as they came due.

    2. AIG’s insurance subsidiaries around the world were heavily regulated, including by capital rules that essentially guarantee solvency. AIG’s insurance operations were so well-capitalized that the New York State Superintendent of Insurance, Eric Dinallo , had authorized the release of $20 billion to the corporate parent. There was plenty more such capital available.

    3. AIG sought a bridge loan from the Fed and would have been happy for the Fed to guarantee its financial contracts. But it did not beg for a deal, which it was indeed forced to accept, in which it sold 80% of itself for a loan without anyone even consulting shareholders or conducting a valuation. AIG only approved the deal after Paulson fired its CEO, Bob Willumstad, and replaced him with an old friend, Ed Liddy, whom he’d put on the Goldman Sachs board.

    4. Notably, Willumstad had only been in office for three months, and was trying to straighten out the financial products business, which his predecessor, Martin Sullivan, had allowed to escalate out of control. AIG, which is neither a bank nor a Wall Street player, was used to bail out those swashbuckling firms, which Paulson once ran and to which Geithner was beholden.

  4. Brett Bellmore says:

    “When Standard & Poor’s recently lowered its credit rating of the U.S. Treasury by one notch, it registered doubt not so much about the country’s ability to pay its debt, but the will of its incumbant political class to do so.”

    Given that they only downgraded long term debt, I suspect it might be more accurate to say that they registered doubt concerning the present and near term will of the incumbent political class to do what is needed to preserve the country’s ability to pay. The destruction of which will render a future political class’s will rather irrelevant.

  5. Ken Rhodes says:

    ” By trillion dollar balance sheet, I simply mean that AIG’s December 31, 2007 financial statements listed total assets of $1,060,505,000,000 and total liabilities of $964,604,000,000 for book value of its equity of about $96 billion.”

    Well, look at those numbers.

    On average, AIG’s assets were 90% mortgaged. So to come up with $50 billion, would they presumably have had to sell off $500 billion in assets? Liquidity???

    The question I asked at the end of my number (1) remains unanswered: How big a run on their assets could they have sustained before their liquidity sank to zero, and they couldn’t pay the next bill?

    In re: Interested Observer’s comments–I agree. I have advocated that position for the past two years on this forum. Banking used to be a boring, but sensible and effective, part of our economy. Then we repealed Glass-Steagall and every banker became a no-limit poker player with a huge line of credit at the casino’s cash window.

  6. Roger Pryor says:

    Yes, Ken, it was a liquidity problem, not a capital solvency problem AIG faced, and the decision to nationalize it was a remedy for a capital solvency problem, not a liquidity problem.

  7. Ken Rhodes says:

    Roger, your characterization is correct, I believe, but I think the decision to nationalize was not an economic response at all, but rather a political necessity. The only way to prop up the row of dominoes threatened by AIG was a massive injection of cash, because of the liquidity problem, and the only way that could be accomplished was with the political expedient that both political parties (and the public) could accept.