Eric Dinallo: What I Learned at the AIG Meltdown
February 3, 2010 by Eric Dinallo
By ERIC DINALLO
The bailout of American International Group (AIG) in September 2008 continues to be a matter of public controversy. It is essential that we learn accurate lessons from the crisis and not force the facts to fit preconceived notions.
Some have suggested that Treasury Secretary Timothy Geithner’s congressional testimony last week conflicts with mine from last year, in which I said that AIG’s crisis did not come from its insurance companies. An accurate understanding will dispel that suggestion.
There are four key points to bear in mind:
One, the insurance policyholders at AIG were protected by reserves that each of the insurance companies are required to hold by state regulation.
Two, the unregulated use of credit default swaps and other high-risk instruments by AIG Financial Products, a federally regulated noninsurance unit with wildly insufficient reserves, caused AIG to stumble and threatened the financial system.
Three, in September 2008 the Federal Reserve acted to protect the financial system from what it believed to be an imminent risk of catastrophic damage from AIG Financial Products.
Four, in November 2008, when the Fed restructured its AIG financing, including the termination of tens of billions of credit default swaps and the widely criticized purchase (at par) of the underlying securities, the Fed had over $70 billion already at risk with AIG and was appropriately considering the value and operations of AIG’s insurance companies.
Mr. Geithner, in his testimony, was clear on what many of us saw as we handled the crisis: “By September 2008, for the first time in 80 years, the United States risked a complete collapse of our financial system.” Lehman Brothers had been allowed to go bankrupt and the result was devastating. If AIG’s holding company was allowed to go bankrupt, the damage to the whole financial system could have been unimaginable.
My job at the time, as New York Insurance Superintendent, was to protect policyholders of AIG’s New York insurance companies. I represented state regulators at meetings with Fed and Treasury officials that led to the federal rescue of AIG. Everything may not have been handled perfectly, but we believed then that we were staring into the abyss.
My role was to make it clear that whatever happened with the AIG parent company, policyholders and the funds set aside to pay their claims, would be protected. In my congressional testimony, I said that AIG’s insurance companies had adequate reserves to protect policyholders. Mr. Geithner does not contradict that. What he does say is that a bankruptcy of the parent company would have caused problems for the insurance companies, policyholders, and the insurance market as a whole.
I agree. If AIG had gone bankrupt, state regulators would have seized the individual insurance companies. The reserves of those insurance companies would have been set aside to pay policyholders and thereby protected from AIG’s creditors. However, as Mr. Geithner correctly points out, AIG’s insurance companies were intertwined with each other and the parent company. Policyholders would have been paid, but only after a potentially protracted delay. It would have taken time to allocate the companies’s assets.
So it’s true that AIG’s insurance policyholders would have been protected and an AIG bankruptcy would have been bad for those same policyholders and the insurance industry. This remained true in November 2008 when the Fed and Treasury expanded the bailout and purchased at par AIG’s credit default swaps.
Mr. Geithner has not suggested that state insurance regulation caused AIG to fail or that the insurance companies themselves caused the crisis. Indeed, on March 3, 2009, this newspaper, questioning the motivation of the federal government’s actions, stated “State laws segregate the assets needed to protect policyholders within the highly regulated subsidiaries at AIG, and if they were to fail, state guarantee funds exist to ensure claims are paid. Have Fed and Treasury staff . . . studied state . . . insurance regulatory schemes and deemed them inadequate?”
Mr. Geithner correctly noted in his testimony that AIG’s parent company, which had selected the federal Office of Thrift Supervision (OTS) as its primary regulator, was “largely unregulated” and that both AIG’s parent company and AIG Financial Products were not regulated by states. Under federal law AIG was allowed to select its own regulator for the parent company and its noninsurance operations. In 2009, an OTS official told Congress that OTS was responsible for regulating AIG Financial Products and had failed to do that job properly.
Mr. Geithner does note that insurance regulators were not aware of the risks being taken by AIG Financial Products, a unit that we were not regulating. As Federal Reserve Chairman Ben Bernanke has stated, the unit was an undercapitalized “hedge fund basically that was attached to a large and stable insurance company.”
The essential lesson of AIG, and of the broader crisis, is the need to reform financial regulation. And that reform should learn from state insurance regulation. One major cause of the subprime disaster was that those who originated mortgages and derivatives could sell them and not worry about their risk or capitalization.
By contrast, insurers are required to keep enough reserves to meet their promises. If that principle applied to all financial services, a replay of the crisis of 2008 would be much less likely.
Financial institutions should be required to hold adequate reserves so they can deliver on their guarantees. Congress erred in 2000 when it deregulated credit default swaps and other derivatives and permitted the evasion of basic capital requirements. Oh, and financial institutions should not be allowed to select their own regulator.
Mr. Dinallo, a former superintendent of insurance for New York State, is a professor at New York University’s Stern School of Business and a candidate for New York State attorney general.
