AIG

I received a question from a friend about AIG, but not about the on-going bonus scandal.

Are we giving all of this money (or a huge chunk) to AIG as a result of the CDS (credit derivative swap) positions they had vis-a-vis Lehman? Would we have been better off bailing out Lehman?

How about this for a hedge of an answer: Mostly No and Maybe Yes.

To get a sense what happened that brought down the financial system in mid-Sept, read this first.

Lehman's failure didn't affect just Lehman's counterparties. Lehman's failure caused everyone to worry about all their counterparties. That is, Lehman's failure made everyone worry about the failure of everyone, and this made it impossible for AIG to get out of all their CDS positions, not just their Lehman positions.

It's possible that things would have been better had Paulson simply bailed out Lehman, although we'd still be facing the problem of lots of bad assets on bank balance sheets. Suppose Paulson had bailed out Lehman. Morgan Stanley would have been next, and then others. At some point, political patience would have run out and they'd have let someone fail. And that would have brought AIG down.

I think Paulson didn't expect the bank-run type of phenomenon (described in the nyt article) that was kicked off by the Lehman failure. I think he did expect Lehman's failure to cause AIG to have to write off a lot of losses due to its Lehman CDS's. But he figured AIG would be able to get access to enough liquidity to cover those losses, and that's where he was wrong.

And what about the bonus scandal?

The depth of the public outcry has me concerned about bad regulations being written regarding managerial labor markets. Getting managerial incentives right is both hard and important. And frankly, quizzing the man on the street about how to do it is probably not too productive, but that seems to be roughly what Congress has in mind.

While it's clear that too much risk was taken on Wall Street over the past decade or so (with disastrous consequences), it's also clear that encouraging the right amount of risk taking is really important. Innovation is the goose that laid the golden egg for the US economy, and we don't want to stifle innovation (which, by nature, is risky) in a misguided attempt to punish Wall Street. We want entrepreneurs with good ideas to get funded, and the financial system plays a key role in this process. A populist backlash would, I think, not be a good thing for standards of living in our country.