The Government Will Not Resolve AIG

Now that the President has signed financial reform, speculation has begun on when it will first use its biggest new tool: the non-bank resolution authority. If the ability to wind down big failing firms was available to the government back in 2008, at least a few big ones would likely have been resolved. One obvious choice would have been AIG. Today, the New York Times' Deal Professor Steven Davidoff wonders if it might now wind down AIG, since it can. This doesn't seem likely.

Before getting into how resolution would work, Davidoff notes, a systemically relevant firm can only be resolved if it's insolvent. In particular, here's what the Dodd-Frank bill says:

(iii) DETERMINATION.--On a strictly confidential basis, and without any prior public disclosure, the Court, after notice to the covered financial company and a hearing in which the covered financial company may oppose the petition, shall determine whether the determination of the Secretary that the covered financial company is in default or in danger of default and satisfies the definition of a financial company under section 201(a)(11) is arbitrary and capricious.

So in this case, AIG must be determined to be in default or in danger of default. Is it? Davidoff thinks it might be:

Recent reports by the Government Accountability Office and the Congressional Oversight Panel have stressed that it is very unclear what exactly A.I.G. is worth, and it may be the case that A.I.G.'s assets are less than what the company owes the United States government for billions of dollars in bailouts. But this is a moving figure and the stock market currently assigns A.I.G.'s equity billions of dollars in value, mitigating against these assessments.

Whether or not AIG is truly insolvent is a question that must be answered by more than just numbers. It's largely believed that the government doesn't really expect, and might not demand, it get back all of the money it used to bail out AIG. So is this debt real debt? It's hard to tell since it isn't your typical private sector-owned obligation. Because the private sector isn't on the hook for much of its debt, AIG's insolvency might not satisfy the spirit when resolution is necessary.

Davidoff also outlines three other strong arguments for why it's unlikely that the U.S. would want to resolve AIG, even if it could. They boil down to spooking the financial markets, possibly earning a worse return for taxpayers than if it was allowed to stay in business, and the political ramifications that the Obama administration will face for taking over a private firm. Taking this extreme action would be a huge deal.

For all of these reasons, it's pretty unlikely that the AIG will be wound down through the resolution authority, unless its assets experience significant further deterioration. But over the next few years, if the firm's insolvency becomes more obvious, then resolution might still be unlikely. As the firm declines in size, it becomes less systemically vital. Thus, a regular bankruptcy court may soon be able to simply wind it down the old-fashioned way. Of course, survival also remains a possibility.