AIG Bonuses

With the handing out of $165 million worth of bonuses to AIG executives, some are upset. In large part the reaction to this is on pure emotion and the remedy disregards respect for due process. The anger directed at Edward Liddy, the CEO of AIG, is downright absurd. He joined AIG after the disaster in the credit default market, taking a salary of $1 and compensation in equity. If there's no value left in the company, Liddy will not profit.

Only a part of AIG was part of the mess that resulted in a government bailout. AIG lost huge sums of money on credit default swaps that they wrote. Many of AIG's business units are profitable, and there is no reason why the executives that lead those businesses shouldn't receive bonuses. Since AIG is planning to sell some of its business units, it would be very unwise to push their leaders out and sell a business that is in shambles. Such a policy punishes those that had nothing to do with AIG's failures. If we still believe AIG is an investment for the government, this policy destroys the value of the investment.

The bonuses as a percentage of the bailout money received are a very small part of the total. The bonuses in question are $165 million compared to the bailout of at least $90 billion, perhaps more by now. The federal government is running a deficit of $1.7 trillion. Even if the bonuses are completely undeserved, this is no reason to invalidate contracts and throw out the rule of law.

The bill passed by the House to tax the AIG bonuses at 90% is a clear violation of the spirit of the Constitution. I am not a Constitutional scholar by any means, but this is a clear example of a bill of attainder. The text of the bill does not explicitly single out AIG or this group of executives, but the intent is clear from the words that Congressmen use.

"Our message is clear: If you won't give the bonuses back, we will tax them back," Rep. Steve Israel, D-N.Y., said at a Wednesday press conference to announce the legislation.

Taxing these bonuses at 90% reduces us to mob rule.(Should we not consider this confiscation just because they get to keep 10%). The intent of this bill is to:

1. Punish by taxing at a 90% rate
   
2. Single out a specific group of individuals
3. Impair private contract

My guess is that many of the same people that oppose Guantanamo Bay are in favor of this bill of attainder. Where is the ACLU on this one?

The Bailout

The bailout measure failed the House 228-205 and the Fed has continued to provide short-term loans to banks. Most people don't understand what is meant by a bailout and what exactly is being bailed.


The Numbers - Hank Paulson, Secretary of the Treasury, is asking for $700 billion. It would start with $250 billion with the rest subject to Congressional veto. $700 billion is about 5% of the gross domestic product.

What would they spend the money on - Mortgage-backed securities and Collateralized Debt Obligations

• Mortgage Backed Securities - Cash flows paid out of principal and interest from mortgages. The buyers of these securities need to look at interest rate risk, prepayment risk, and default risk. They also need to look at the value of the underlying collateral in the event of a default in order to value these securities.
• Collateralized Debt Obligations - A special purpose entity created to buy fixed income assets(other structured securities, mortgages, bonds, loans). They are sliced up and sold to investors in tranches. The senior tranche receives payments first, followed by mezzanine, subordinate, and equity tranches. So, if the underlying asset does not pay off, investors in the equity tranche lose first.
  

Why? - Bank balance sheets are filled with mortgage backed securities and CDOs that there is not much of a market for right now. The credit markets have tightened and banks are not willing to lend money.

What does it all mean? - Estimates of the actual cost of a bailout have varied. The securities that the government buys are probably worth more than zero. Some even say that the Treasury will make a profit on this deal like in the Mexican bailout. Some have asked where the government will get the money for this scheme. It will get money from where it always does: taxing, borrowing, or printing. At least right now, it is in a good position to borrow with treasury bond rates at very low levels. The Treasury can borrow at these low rates and buy these more illiquid securities, behaving like a very large hedge fund. Albeit, a hedge fund with other motives than return on investment.


If you have any questions about this situation or if you think I should cover more in this entry, post a comment or send me an email.