The Moral Hazard of AIG

“I’d give it an F – no, make that a D.” So said veteran insurance boss Bill Berkley of the W.R. Berkley Corporation on May 26th, when asked to grade the US government’s involvement with AIG during the past couple of years – when it first let AIG reach the brink of failure, then rescued it (pumping tens of billions of dollars into the coffers of Goldman Sachs and other troubled banks as it did so) through what in any other country would be called nationalisation but in America had to be disguised as something called “conservatorship”.

Among other failings, according to Mr Berkley, the government “was obsessed with process over outcomes” and, as a result, failed to get to grip with the fundamental problems (though he reckons it did a better job sorting out the disastrous financial products unit than it did running some other parts of the business). In particular, it messed up a previously terrific life insurance business, and has seen its best employees leaving in droves, not least to Mr Berkley’s firm. “These employees didn’t want to leave, they loved AIG,” Mr Berkley explained, “But in they end they were demoralised.”

On the face of it, this disaster – along with the unresolved messes now in public hands that are Citigroup, Fannie Mae and Freddie Mac – provides yet more proof of why nationalisation is a bad idea. So should we be relieved that the US government did not take our advice in The Road From Ruin to nationalise more financial institutions in the aftermath of the market meltdown of late 2008? Let’s be clear. We are not in favour of nationalisation per se. However, we do think that a “Scandinavian style nationalisation” of financial institutions could have avoided many of the subsequent problems that have afflicted Wall Street and the economy.

In the early 1990s, Sweden, Norway and Finland nationalised troubled banks during a financial crisis – but this was always going to be a temporary arrangement, as bad assets were removed into government hands to clean up their balance sheets, so the restored banks could swiftly be returned to the private sector. This worked a treat, allowing bad debt to be restructured and confidence to return to the financial system quickly and more cost-effectively than has been the case in America – which is a case study not in the dangers of a surgical nationalisation but of an unthinking nationalisation as an act of desperation by a Treasury Secretary, Hank Paulson, who refused on ideological grounds to think about how nationalisation would work until it was too late and he had no choice but to nationalise in whatever way he could.

Not only has the US government failed as an owner of AIG, it has also created a new form of “moral hazard”, at least according to Mr Berkley. (Although his firm sometimes competes with AIG, Mr Berkley has a reputation as a straight shooter in the manner of Warren Buffett, but without the Sage of Omaha’s tendency to play to the gallery and occasionally talk up his own book.) He says that, since it has been in public ownership, AIG has been one of the most aggressive pricers of property and casualty insurance, and that the prices it has been selling at are “clearly uneconomic”. In other words, AIG is likely to make significant losses on these insurance sales. (Arguably, this subsidised insurance is a part of the government’s economic stimulus programme – though this is not an argument we’ve heard anyone in the government make.)

Mr Berkley says that there is no way that Hank Greenberg, the legendary long-time boss of AIG until he was forced out a few years ago, would ever have engaged in such uneconomic pricing. And is the reason why people are willing to buy insurance at a price that is clearly going to cause AIG to make losses because the market believes that the government will bail out AIG again if it has to? That’s what everyone believes, says Mr Berkley – who, if he is right, should have gone with his original instinct, and given the government an F.

Anyway, now that its new financial regulations seem about to be adopted by Congress, maybe Team Obama should turn their attention to sorting out as fast as possible the messes that are AIG, Citigroup, Fannie Mae and Freddie Mac?

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