AIG And Lehman Brothers’ Aftermath: Are Taxpayers Willing To Fund Private Mistakes?

By Stephan Zimmermann, on September 18th, 2008

Fact, fiction and speculation run rampant in the wake of the Lehman Brothers Chapter 11 bankruptcy filing that shook the worldwide financial community September 15. The impact ranging from Wall Street to London to Hong Kong and beyond was as devastating as the events of 9/11. The end of the continuing saga remains to be unraveled during the next coming months and years. It is bound to be a chief issue in the American presidential campaign.

Seen by many as a potential move to avert further financial panic on the world’s financial exchanges, Treasury Secretary Henry Paulsen agreed to permit the Federal Reserve to issue an $85 billion loan for roughly 80% of the U.S. insurer, American International Group (AIG).

This unexpected decision came immediately on the heels of the government’s refusal to rescue Lehman Brothers, the once venerable 158-year old brokerage firm, this week. More to the point, Paulson said in July, and reiterated as late as this week, “Moral hazard I don’t take lightly.”

“Moral hazard” generally refers to an economic term where insurance coverage against a loss might affect the risk-taking behavior of an insured.

Not Unprecedented

The AIG move is not the first time that the U.S. government has effectively rescued firms in the private sector at taxpayer expense. Recently, investment banker Bear Stearns was rescued by the government to permit its orderly acquisition by JP Morgan.

Similarly, the quasi-governmental companies of Fannie Mae and Freddie Mac were effectively “bailed out” by the federal government. It was felt that collapse of the two companies, which control nearly $5 trillion in mortgages, would be too devastating to the stock and bond markets and ultimately the U.S. and world economy.

But the practice is not new.

In December 1989, Time magazine warned “Further – and Maybe Bigger – Federal Bailouts Ahead.”

The article cautioned that speculator and entrepreneur Charles Keating’s Lincoln Savings & Loan Association’s bankruptcy could cost taxpayers $2.5 billion. It ultimately cost the American taxpayer over $3 billion.

At the time, Senator John McCain was one of the key five senators during the savings and loan scandal who shared more than a million dollars in political contributions and “favors.” The other key senators included Dennis DeConcini of Arizona, the late Alan Cranston of California, John Glenn of Ohio and Don Riegle of Michigan.

While Glenn and McCain were exonerated of wrongdoing in the Keating scandal, both were reprimanded by the Senate Ethics Committee in 1991 for exercising “poor judgment.”

DeConcini was appointed by President Bill Clinton in 1995 to the Board of Directors of the Federal Home Loan Mortgage Corporation. It is the very Freddie Mac now under government control at the taxpayers’ expense.

Key Questions

Will the bailout of AIG set a further precedent to General Motors, the subject of bankruptcy speculation for more than two years? The stock closed at $10.84 on September 16, down from $43.20 over the last 52 weeks.

Should the company be forced to seek Chapter 11 protection, a government bailout is virtually guaranteed. It has ample precedent with the Chrysler plan engineered by Lee Iacocca in 1979.

At the time, Chrysler had 360,000 workers. Lee Iacocca painted the picture of that worker base as potentially unemployed and helped convince Congress to grant him close to the billion dollars he requested. Equally as important, Iacocca, evoking patriotism, pointed to Chrysler as being the largest manufacturer of American tanks.

Ford Motor Company, although considerably more liquid than its rival, is not immune from the effects of the Lehman bankruptcy. Ford has an unfunded credit facility with Lehman Commercial Paper, Inc., of roughly $11 billion. It also enjoys relations with Lehman Brothers Bank, Inc., of $16 billion that support the retail securitization program of Ford Motor Credit Company, LLC. According to Reuters, the two subsidiaries are not included in the Lehman bankruptcy.

A careful review of each potential company large enough to warrant a federal bailout is indicated well ahead of potential bankruptcy proceeding. The state of a company’s liquidity is a good indicator of its potential solvency.

The key questions surely to be discussed and debated are what constitutes the “national interest,” how philosophical, consistent and legally transparent should the leadership of the government be and how willing are U.S. taxpayers to bear the risks of private enterprise?



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Economic Thought vs. Business Thought and the Shortcomings of Both

By Stephan Zimmermann, on September 18th, 2008

Cristian Mitreanu submits this question via email:

I would like to hear your thoughts on the subject of “economic thought vs. business thought.” Is there such thing? If yes, should this distinction be made?

He raises the question in concert with an initiative he is proposing, intended to start a discussion about the current state of business, called, “A Wake-Up Call for the Business Nation.” It ties in very nicely with the focus of economics.

What, if any, is the interrelation between economic and business thought?

In its most basic form, economics can generally be reduced to the study of choices among the uses of limited or scarce resources with unlimited demands.

On the other hand, there is a plethora of definitions for “business.” Broadly, business is generally discussed as people joining together to achieve greater productivity focused on one or more goals, either on a profit or non-profit basis from the American standpoint.

Simply doing something, such as photography or writing, that does not result in a sale is considered as a hobby by the IRS and, thus, does not constitute a “business.”

Dr. Peter Drucker suggests that a business has as its “purpose to create a customer (so that) any business enterprise has two – and only two – basic functions: marketing and innovation.”

Less academic but well-known and regrettably too often misquoted is President Calvin Coolidge’s comment that “the business of America is business.” What the president actually said in 1925 is, “After all, the chief business of the American people is business. …Of course, the accumulation of wealth cannot be justified as the chief end of existence.”

Just as western economics still largely acts on the assumption of the concept of Homo economicus, so does business seem defined and propelled around the economic principle of “maximization.” In most western – and, increasingly, Asian – businesses, that translates to maximization of profits, whether denominated in dollars, yen, rupees, rial, renminbi, or countless others.

“Business” may be thus be considered as carrying out some of the major functions of economics. However, the shortcomings of one translate to the shortcomings of the other.

Is religion or the pure pursuit of science, for example, part of economics? Certainly, since both need to make decisions regarding the use of scarce resources.

Of course, both have been turned into “businesses.” Witness the growth of the Catholic Church and its fueling of empire-building and wealth control over the centuries, or the churches in the United States that can command billions of dollars on television advertising or political campaigns.

Too often, science has been turned from a mere exploration of mankind’s cerebral potential to a dollars-and-cents business. Witness international drug companies, to mention but one example.

The financial fallout from the Wall Street panic of September 15 will, no doubt, have massive worldwide repercussions far from the financial sector. Blame is already cast by politicians and pundits alike.

Unfortunately, few seem to address that the basic fault lies not within specific individuals or institutions or political parties.

The basic fault lies in the fact that neither the teaching of economics nor of business places much emphasis on the nature of man. It focuses entirely too much on the generation and maximizing of profits and how to achieve them rather than on the human application of the benefits or disadvantages that can be achieved through business.

Both the private or governmental sector need to address those very basic questions that are currently largely ignored in favor of ultimate “maximization.”

What do we really need and how do we best achieve and distribute a “satisfycing” amount of the essentials that all human beings require?

The time is ripe for a new theory that effectively integrates natural and human values with mankind’s behavior without the myopic pursuit and maximization of profit.

Stephan is a former department chair for economics and taught at various colleges and universities at both graduate and undergraduate levels. If you would like Stephan to answer your economics-related questions, read his post “Got an Economics Question?” and submit your questions in the comments area there.



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Subprime Crisis Leading to Increased Lawsuits, Studies Show

By G.L.C., on September 18th, 2008

The present financial crisis has resulted in an increase in the number of lawsuits filed in the country. The mortgage meltdown is forcing financial institutions to leave the negotiating table and turn to the courts to resolve subprime-related disputes with their partners. In the past, large financial institutions often shied away from suing each other, preferring to work out problems quietly because they did not want to jeopardize future business relationships. Now, if the cases filed in the courts are any indication, then these companies are dropping their reluctance to sue each other.

HSH Nordbank AG is suing UBS AG in a New York state court over losses HSH sustained on a $500 million portfolio of collateralized debt obligations linked to the U.S. mortgage market. M&T Bank Corp sued Deutsche Bank AG and others in June to recover more than $82 million it said it lost by investing in collateralized debt that had been billed as nearly risk free. Another lawsuit involved Barclays PLC and the now defunct Bear Stearns over the high-profile collapse of two mortgage-linked hedge funds.

The severity of the subprime losses means that more such corporate disputes are likely to land in court. The stakes involved are so high, and many experts are not surprised about the increase in the number of lawsuits.

The increase in litigation is not restricted to litigation between financial institutions. A study by Navigant Consulting found that the volume of private lawsuits in the U.S. stemming from the current financial crisis has already surpassed levels seen in the aftermath of the savings and loan debacle two decades ago when 559 lawsuits were filed over six years. From January 2007 to the end of June of this year, 607 civil cases were filed in federal courts. These cases related to the meltdown in the subprime mortgage market. More than half of the lawsuits were filed in the first six months of this year.

As the present crisis gets more serious, the litigation will also increase. The result of the study is scary – it shows only the lawsuits filed in federal courts and doesn’t reflect the number of lawsuit filed in the states.

As the present crisis deepens, we are likely to see an increasing number of bank failures resulting in another wave of lawsuits. Eleven banks have already been seized by regulators.

A study by Stanford Law School and Cornerstone Research found the number of class action lawsuits filed against Wall Street firms surged in the last year, fueled by the meltdown in the subprime mortgage market. There was a 43% jump in the number of securities fraud class action lawsuits last year. Forty-seven Wall Street firms sued in 2007, more than four times the number sued in 2006. New York City’s retirement and pension funds for city workers filed lawsuits against mortgage lender Countrywide Financial Corp., claiming the lender misrepresented the risk of its mortgage-backed securities.

An increase in volatility in the market, like the one that is now taking place as a result of the subprime mortgage problems, is directly correlated to an increase in the number of lawsuits filed. If economic conditions were to decline in the future, then a strong resurgence of lawsuits would likely follow.



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