Government bailout decisions: AIG and the auto industry

Bailouts

The issue of bailouts has incited no shortage of controversy in recent months. The first major bailout was the federal government takeover of insurance group AIG in September at a cost of $85 billion (Karnitschnig et al., 2008). The CEO was replaced and a new head brought in to rid the company of its toxic assets and turn the firm around. No sooner had Barack Obama been elected when House Speaker Nancy Pelosi was on NPR calling for a bailout of the U.S. auto industry (Langfitt, 2008). Yet, there are significant differences between these two, their role in the economy and the tactics that the government has used in the course of their respective bailouts. Public sentiment turned on AIG when the company used bailout funds to pay six and seven figure bonuses to its staff. The idea of bailing out automakers has been scorned since the beginning, and by a much larger segment of the public. This paper is going to analyze the AIG bailout and the automaker bailout in an attempt to ascertain the criteria, if any, that the government has used to make decisions with respect to the bailouts.

AIG

The insurance group AIG was taken over in an $85 billion bailout in September, at a time when financial services industry seemed on the brink of collapse. The underlying assessment is that the action was necessary, in order to bring confidence back into the financial markets (Mitchell & Smetters, 2008). AIG was, in essence, too big to fail. The government had just finished allowing Lehman Brothers to fail, rather than buying out the investment bank (Karnitschnig et al., 2008). AIG had a profitable insurance business but was subject to heavy losses from the branch of the business that sold mortgage-backed securities. The move basically bought AIG time to separate the good assets from the bad. This bailout was followed by additional financing, to the tune of $180 billion and counting.

AIG was seen as "too big to fail" in large part because its operations were intertwined with financial institutions the world over. If AIG failed, a wide range of domestic and foreign financial institutions would be put on the brink of collapse. In addition, the company's 70 million policyholders and tens of thousands of employees would also suffer, creating a chain reaction that could cripple the world economy. In some respects, the global implications of an AIG failure provided much of the impetus for the original bailout. The U.S. government may have been worried about the policyholders and other domestic players, but the mortgage-backed security market had become a source for liquidity, as foreign governments and financial institutions leaned on MBSes as a means to hold U.S. dollars.

The AIG bailout was initially subjected to strict terms. The government insisted that its funding be for an equity stake, which gave the federal government majority control of the company. Then CEO Robert Willumstad was forced to step down by Treasury Secretary Henry Paulson to be replaced by former Allstate head Edward Liddy (Karnitschnig, 2008). Yet since then, AIG has spent its money on executive bonuses, which raised the ire of taxpayers and highlighted the lack of oversight with respect to bailout spending. What were initially viewed as strict terms soon began to appear to the public as a blank check. Some claims have been made that the terms were never that strict. AIG was, for example, allowed to transfer funds to overseas banks. The American taxpayers in this scenario are essentially bankrolling the survival and profitability of foreign banks, to no particular benefit to the U.S. taxpayers. This is only partly true. The point of the AIG bailout was so that it could maintain its obligations around the world, avoiding collapse of the global financial system. While it seems somewhat unfair for that entire burden to fall to the American taxpayer, it was America's lax regulatory environment that allowed the problems at AIG to gestate in the first place. Countries whose governments favored tighter regulator regimes, such as Canada and Australia, did not need to bail out their financial institutions.

Automakers

The bailout of the automakers also began in September 2008. Congress approved a $25 billion bailout at the time but by November the automakers were lobbying for another $25 billion (Langfitt, 2008). They, too, found controversy when the CEOs of the automakers flew private jets to Washington, DC to make their plea of poverty (Ross & Rhee, 2008).

Proponents of an automaker bailout suggest that the terms of the bailout make economic sense. The $25 billion bailout -- in the form of reduced interest rates for borrowing -- is less than the cost to taxpayers if the Big Three were allowed to fail. Such a failure could cause a chain reaction throughout the automotive industry affecting everyone from suppliers to dealers to mechanics. The result could be catastrophic -- 3 million jobs and $150 billion in tax revenue lost (Krisher & Thomas, 2008). Proponents point out that if one firm collapsed, it could cause suppliers to collapse, resulting in massive plant closures affecting all automakers.

The automakers' bailout has nonetheless been subject to intense public scrutiny. Opponents point to the failure of the Big Three to develop products that appeal to today's consumers. Foreign automakers like Honda and Toyota do not need bailouts, they argue, because they make better, more appealing cars and manage their money better. Since the initial controversy, Ford has backed away from requesting bailout funds. The government, however, has duplicated its involvement in Chrysler, forcing out CEO Rick Wagoner and giving the firm funding to buy time to make arrangements with Fiat for its survival.

Similarities

The rationale for each bailout is similar. Both the Big Three automakers and AIG were deemed too big to fail. The spinoff effect for the automakers and AIG both would be disastrous for the economy. The automaker spinoff effect could collapse a major industry; the AIG effect could collapse the world's financial system. The government, in both instances, is essentially acting as a rational actor. Despite the costs and the optics of these bailouts, they ultimately are the best financial transaction for the government.

Both bailouts are also subject to similar criticisms. Opponents point out that AIG was about to fail because of the bad debts they had amassed in backing their MBS securities. This poor decision making precipitated the need for a bailout, rather than financial misfortune. Similarly the automakers had made a string of poor strategic choices. They were in their present market position simply because they had been bested by superior competitors. Likewise, executives at both companies had been accused of arrogance and failing to understand that their circumstances were a consequence of their poor decision making.

Conclusion

The bailouts of the U.S. auto industry and insurer AIG shared more similarities than differences. The U.S. government acted as a rational actor, initiating bailouts that it views as less expensive than the alternative. The conditions attached to each bailout seem similar as well. In both cases, CEOs were fired, but operations were allowed to continue as normal. Even the private jet controversy did not result in a significant change to operations at the Big Three.

The major difference between the government's bailout treatment of the two appears to be with respect to ownership and control. Without any official ownership say, the federal government has been forced to find alternative approaches to compel the automakers. By contrast, AIG is subject to full control. In some ways, the AIG bailout is viewed more favorably -- bonuses not withstanding -- in part because of the ownership stake. With a substantial, profitable business the taxpayers may yet break even on AIG. With the automakers, taxpayer ire is higher because there is little chance that this will happen. The government has less control over the automakers, and as a result there is less likelihood that the industry will reform itself sufficiently. Even if it did, the taxpayers would not see any benefit since they have no stake.

In light of this, the government treatment of the auto industry compared to financial institutions seems reasonable. Both have received bailouts, in proportion to the amount of damage that would be wrought on the U.S. economy if they failed. The lack of ownership stake in automakers makes for more public application of leverage than with AIG, were the 80% ownership stake allows the government to work its machinations behind closed doors. If anything, government bailout of the auto industry seems generous, given that they have little in the way of viable businesses. That bailout seems more like a proxy for the bailout of the auto suppliers industry that would otherwise be required, if the Big Three failed. In essence, the government is less inclined to bailout the automakers but does so to help the support industries. Were it not for that consideration, the bailout might not happen at all, which accounts for the differences that do exist in these similar bailout situations.

Works Cited:

Langfitt, Frank. (2008). Automakers Lobby Pelosi for Bailout Cash. NPR. Retrieved April 30, 2009 from http://www.npr.org/templates/story/story.php?storyId=96713932

Karnitschnig, Matthew; Solomon, Deborah; Pleven, Liam & Hilsenrath, Jon E. (2008). U.S. To take over AIG in $85 Billion Bailout. Wall Street Journal. Retrieved April 30, 2009 from http://online.wsj.com/article/SB122156561931242905.html

Mitchell, Olivia & Smetters, Kent. (2008). AIG Rescued: Was an $85 Billion Loan the Right Answer? Knowledge @ Wharton. Retrieved April 30, 2009 from http://knowledge.wharton.upenn.edu/article.cfm?articleid=2051#

No author. (2009). Why bail out AIG? St. Petersburg Times. Retrieved April 30, 2009 from http://www.tampabay.com/opinion/editorials/article980880.ece

Ross, Brian & Rhee, Joseph. (2008). Big Three CEOs Flew Private Jets to Plead for Public Funds. ABC News. Retrieved April 30, 2009 from http://abcnews.go.com/Blotter/WallStreet/story?id=6285739&page=1

Krisher, Tom & Thomas, Ken. (2008). Advocates: Automaker bailout essential. Associated Press. Retrieved April 30, 2009 from http://www.azcentral.com/business/articles/2008/11/12/20081112biz-automakers1113-ON.html