Just as the Great Financial Crisis has begun to fade a bit from consciousness, one of its main perpetrators returns to remind us all why we can’t let our guard down vis-à-vis Big Finance.

Hank Greenberg, the former CEO of AIG, has filed suit to force the government to repay stockholders who he claims were short-changed when the government bailed out AIG to save the financial system. He claims this despite the facts that his stock would have been worth nothing had the government let the company fail, and the board of directors approved the bailout.

This is incredible, and yet it should almost be expected, since the one unlimited resource on Wall Street is gall. But, perversely, this is a great reminder of why the financial sector can’t be trusted to police itself and must be regulated stringently to avoid another crisis.

AIG Had Us Staring Into the Abyss

Just to review, AIG was the linchpin that would have sunk the financial system and the economy without the government coming in and bailing them out after the failure of Lehman Brothers. This was so because AIG had issued a gigantic amount of Credit Default Swaps, which are essentially unreserved-for insurance, on a massive share of the “innovative,” garbage-like, mortgage-debt securities that were ready to go bad at the popping of the real estate bubble — Collateralized Debt Obligations, CDO Squared, and the like.

All of the big Wall Street firms had bought this insurance from AIG that allowed them to make believe their balance sheets weren’t built on quicksand. The failure of Lehman Brothers meant big insurance payouts were due to the holders of the CDS, and AIG had nowhere near the resources to pay them off, because they had no reserves against the insurance.

So if the government hadn’t stepped in, not only AIG but the whole financial system would have fallen like a house of cards, and the economy with it. So the government had no choice but to bail them out as the lesser of two evils. The alternative would have been human suffering on the scale of the 1930’s.

“Idealism is fine, but as it approaches reality, the costs become prohibitive.”
— William F. Buckley, Jr.

Heads I Win, Tails You Lose

This is a helpful reminder of the fact that Wall Street is not capitalist. In capitalism, you risk your own money for the chance at gain if you succeed or the certainty of loss if you fail.

Wall Street operates in a corporate-socialist milieu that has as its guiding principle, heads I win and tails you lose. In other words, the profits from their reckless gambling in the good times goes into their pockets, but when the excrement hits the fan and everything falls apart the government and the taxpayer have to step in to save the system.

This asymmetry of risk and reward is called moral hazard. If someone pays no price for recklessness, they will become more reckless. But Big Finance plays this risky game with the lives and livelihoods of each and every citizen. This is why free-market, laissez-faire economics doesn’t work with the financial system.

This is one area where I think most national Republican politicians are dead wrong in pushing back against regulating Wall Street. Strict regulation is needed. But they need to regulate the Hell out of the Big Banks, not the community banks that are getting put out of business by the compliance costs of Dodd-Frank when they had nothing to do with causing the crisis in the first place.

Moral Hazard, Incorporated

In finance, it is said that the guy with the lowest standards sets the market. That is why Big Finance can’t be left to regulate itself. Either that, or the bill for the next crisis may dwarf the government’s ability to pay, and then we will all be sunk.

“Instruct regulators to look for the newest fad in the [banking] industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid.”
— William Seidman, “Full Faith and Credit”, 1993