Thursday, January 10, 2013

AIG, Financial Contagion and Transparency

As the public furor over the AIG shareholders suing about the terms of the US government's bailout subsides, it is important to remember that the bailout would have been unnecessary if there was transparency in the financial system.

The driver behind bailing out AIG and paying off 100% of the value of its derivative positions was the fear of financial contagion.  Under financial contagion, the collapse of one firm triggers a domino effect that causes other firms and the financial system to collapse.

Regular readers know that under the FDR Framework, the government is responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manners so the market participants can independently assess this information and make a fully informed investment decision.

To provide an incentive for market participants to use this information, under the FDR Framework, market participants are made responsible for all gains and losses on their investments by the principle of caveat emptor (buyer beware).

Market participants know that they will not be bailed out of losing investments and as a result, they limit their investments to what they can afford to lose given the risk of the investments.  This effectively ends financial contagion.

How does this apply to AIG?

If market participants had information on the size of AIG's derivative portfolio, they would have ceased doing additional business with AIG far sooner because they would have known that there was a high risk that AIG could not perform if there were problems with sub-prime mortgage-backed securities.

Bottom line:  if there had been transparency, Wall Street would not have needed to be bailed out because the losses that Wall Street firms would have suffered from AIG's failure would have been within their capacity to absorb.

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