After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

A year ago last week, the United States government saved Bear Stearns from bankruptcy, enticing JPMorgan Chase to buy the insolvent company with government guarantees. Fed and Treasury officials—and almost everyone else—argued that the step was necessary to prevent a systemic financial meltdown. We got our systemic financial meltdown anyway. And smashing our core free-market principles to save failing financial firms got us something worse still: a poisonous mob mentality seeping into the American spirit. AIG, the immediate catalyst for the mob, isn’t even a company now. It’s a three-letter shorthand for everything that’s gone wrong in an arduous year of random bailout after random bailout.

Let’s review. First, the government saved Bear Stearns because it thought that if the firm’s creditors and trading partners lost even $1, panicked investors would flee the rest of the financial system. But those panicked investors were starting to figure out that the financial system was rotten to the core. They fled anyway.

Six months later, the government let Lehman Brothers fail, resulting in yet more panic and confusion—but not because Lehman’s investors had thought that losses were inconceivable. No, the heightened panic erupted partly because many remaining investors had assumed, over the previous six months, that since the government had saved Bear, it would save Lehman. They weren’t shocked that an uninsured investment in a private company could lose value; they were shocked at the government’s capriciousness and at their own (unconscious) dependence on the government’s actions.

Then, just hours after letting Lehman fail, the government decided that it couldn’t let AIG, the now-infamous insurance company that had made half a trillion dollars’ worth of bad bets on mortgages alone, suffer the same fate. And so it swooped in with the first of three bailouts, totaling $173 billion. In its rescues, the government has made sure that AIG’s lenders as well as its trading partners would not lose anything on their holdings with the company. AIG’s trading partners, remember, are those supposedly sophisticated global financial institutions whose managers took it on faith that the insurer could make good on nearly every mortgage in the country should those mortgages lose value. Not once did these global banks wonder how a single company could take on so much exposure to one market.

The government seems never to have considered the prospect of allowing AIG to go through the normal bankruptcy process. True, an AIG bankruptcy would have been a breathtaking event. It could have caused cascading losses for Europe’s banks, necessitating more government bailouts there, and a (bigger) international crisis; it could have caused insurance policyholders to cancel their contracts around the world, straining reserve funds for failed insurance companies; and it could have caused fright in Asia, where AIG insurance has always been a trusted product. Further, in a bankruptcy, AIG’s short-term lenders could have seized their collateral from the firm and sold it instantaneously, further depressing stock and bond markets. So, yes, there’s no question that an AIG bankruptcy would have been terrible—even cataclysmic.

But it’s reasonable to ask: could it have been worse than what we have now? Consider that in a bankruptcy and orderly liquidation of the firm—even one financed by the government, if no customary private bankruptcy financing were available—an impartial judge and an impartial administrator would have taken on all of the tasks that the government and AIG itself have handled so erratically for the past six months. The administrator and the court would have decided which employees from AIG’s exploded “financial products unit,” which created the mortgage derivatives, should be encouraged to stick around to help the company’s new administrators figure out what was going on. With the court’s permission, the administrator would have determined how much to pay such employees. The administrator would have hired outsiders to muddle through AIG’s mess, just as outsiders eventually muddled through Enron’s mess eight years ago. And an impartial, methodological accounting of AIG’s assets and liabilities would have determined how much AIG had left to pay all of those European and American banks that had bet so recklessly that a company like AIG could never fail.

Above all, this impartial accounting of AIG’s assets and liabilities would have defused the bonus controversy that has now exploded into visceral public anger. By determining how much, if anything, AIG could give the employees due those big bonuses—which are part of employee contracts signed early last year—a bankruptcy would have avoided the disturbing question that so many mainstream politicians have raised in the past week: can government bailout money force a company to break a private contract? It’s a truly worrying prospect in an economy built on private contracts. Bankruptcy enables a consistent treatment of the sanctity of contracts, even in an environment of anger. It allows the administrators of failed companies to oversee the renegotiation of such contracts according to the resources available to pay out on them and the competing goals of various creditors, including employees.

Finally, in a bankruptcy, the government’s goal for AIG would have been obvious: to wind down a failed company, getting the firm’s good assets—the insurance business—into more competent hands as soon as possible, even at a fire-sale price. It’s also quite likely that a global advertising effort to assure ordinary insurance customers that such policies were safe, backed up by government money for this purpose if necessary, would have worked in stemming panic among policyholders. Franklin Roosevelt’s decisive actions to protect bank deposits in the 1930s renewed public confidence in banks within days.

In place of a wrenching but consistent and well-tested process of winding down a failed company, what have we chosen? A world of investors who can never be sure, in the future, that if they put their money into a company that fails, they can depend on a reliable process to recoup some of their funds. Instead, they may find themselves at the mercy of a government veering from whim to whim as it reads the mood of a volatile public.

Even worse, we’ve got a broader public that suspects that its government will not commit to any core principles of fairness. Because the public has utterly lost faith that the government will allow failed executives to take financial losses or failed companies to die, the public is trying, bluntly, to do this job itself—and it’s an ugly, dangerous, and scary spectacle. AIG has now taken its logo off one of its Manhattan buildings, and it is instructing its workers not to put their personal safety at risk by leaving the building wearing anything with the corporate insignia. AIG executives are paying private security guards to stand outside their mansions and protect them from angry trespassers. Worst of all, we’ve got a Congress happy to stir up the mob to deflect its own responsibility for the debacle, as well as a president transparently unsure about what to do: he’s smart enough to realize that an angry mob can quickly turn on its hero.

It’s true that an AIG bankruptcy would have been extraordinarily destabilizing; it’s also true that not all cataclysms are created equal. The current outbreak of mass anger and resentment stands as a good example. In saving the remnants of failed companies from free-market failures, Washington may be sacrificing the public’s confidence that the government can ensure that free markets are reasonably fair and impartial. One year into an era of exhausting and arbitrary bailouts, it’s not clear that our policy of destroying the system in order to save it is going to work.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.