March 17, 2009

Bonus Coverage

Um, someone explain to me why everyone is so outraged over bonuses being paid to AIG executives? It's not like this was some kind of a secret that this is how they were going to be paid, and that they would be paid handsomely to boot. This has been a standard practice in the insurance industry for a long time, both for salespeople as well as those in other segments of the industry -- in particular, in asset management, and in this day and age of blurry lines between industries, that subspecialty of the insurance industry that sells things like annuities, money markets, stocks, bonds, and a whole host of other things you used to have to hire a stockbroker for.

After all, asset management is where the money is. In between collecting the premiums, paying its people, and paying out claims, the insurance company is sitting on top of a lot of money. It doesn't put that money in a passbook savings account -- it uses it, out on the market. It buys stocks, bonds, and commodities futures. A big insurance company has the same kind of market clout on Wall Street as a small mutual fund, and behaves in a fashion similar to a mutual fund.

You might say that this segment of an insurance company's operation seems to have little to nothing to do with the business of insurance, and you'd be right. But the people who buy and sell stuff on the market generate much more revenue for the insurance company than the salespeople do -- and their compensation packages reflect this. No one so much as squeaked about this back when profits were fat and the solution to high premiums was to buy stock in the company.

AIG got into financial trouble not by selling personal lines like auto, life, and homeowners' policies. Those sorts of policies were and continue to be perfectly ordinary and predictable sorts of things as part of their regular operations. Any insurance company can predict with an astonishingly high degree of accuracy how many of its insured policyholders are going to die over the course of any given twelve-month period, and therefore how much money it will have to pay out in life insurance benefits. (This is in the aggregate, of course; if you ask about an individual policyholder, they won't even try to make a prediction.) So in terms of personal lines, underwriting, and claims, the various AIG companies (there are over 200 corporations operating under the AIG umbrella) are perfectly healthy.

The issue is that the managed assets are also the working capital of the company, from which claims and operations are paid out while they are being managed. Normally, this is simply a requirement that a certain portion of the insurer's assets remain liquid, or at least readily-liquidatable, for use in keeping the doors open, and being able to pay out claims. But when the market takes a sudden dive, well, things start to look pretty grim pretty fast as the working capital gets reduced to a fraction of its former value. And it's those same asset managers, the ones who allegedly mismanaged AIG's assets and resulted in the entire corporate structure becoming endangered, who are getting these bonuses.

Here's a few things for Chuck Grassley to consider, then, before he encourages these people to step out of skyscraper windows if they take their bonuses. These people had contracts. So we're looking at $165 million in bonuses being paid to people who entered into contracts back when they could have been working for hedge funds and in the boom-boom years, earned ten to twenty times as much as they agreed to take from AIG -- in exchange for the security of certainty of payment. AIG has to follow through on those promises.

Now, perhaps the contracts were not well-considered, given that they were "retention" contracts for people who still leave the company at what a snapshot picture suggests is something like 11% a year, and they seem to be largely fungible. But regardless, they were promised this money and if they don't get it, they'll sue and win. So it's better to pay them and be done with it.

Reason enough to pay the bonuses, although perhaps there may be good reasons to change the way they are compensated in the future. And this is not Chris Dodd's fault. Or Tim Geithner's. It's how things were done and we have to deal with cleaning that mess up. That's not to say that the government shouldn't demand management shake-ups. The outrage is not that AIG is honoring its contracts, or even that legislators or Treasury Department officials didn't try harder to get those contracts re-written, or that any particular legislator or regulator made any particular proposal.

And we're talking about less than .1% of the total AIG bailout here. AIG did manage to make over $750 million in business activities like luxurious conventions and sales incentives go away. But the government, first at President Bush's urging and then again at President Obama's urging, has now sunk over $180 billion into AIG to keep it afloat -- thereby acquiring an 80% ownership stake in the umbrella organization. And people are choosing to get pissed off over $165 million?

The issue should be that the government doesn't know dick about running an insurance company and has now taken an 80% interest in the world's largest insurer. So, not knowing dick about running this company, they kept on board all of the same yahoos who got the company in trouble in the first place. Doing so suggests that these people weren't really at fault for the company's distress.

If that is the case, paying them bonuses ought to be non-controversial. This would be credible and reasonable if we want to say that the collapse of the financial markets last year was something unpredictable, something that the best and brightest could not have seen coming, then we have no reason to think these people are incompetent and undeserving of executive-level compensation. Pay them, let them get the company back up on its feet enough to pay the government back itsmoney (with a reasonable rate of return for its use).

But if we're going to say that the management and/or asset managers of AIG did make significant mistakes and bear some measure of blame for failing to prevent the collapse fo the market as a whole and AIG as a market participant in particular, fine. Maybe they should have seen it coming. Then pay off their contracts and get them out the door. If they did do something wrong, then they can be relied upon to repeat whatever mistakes they made again, especially given that now they've learned that the government will bail them out if they do screw up.

The outrage is that this isn't happening. An 80% interest is a controlling one under any set of laws anywhere. The government has bought so much AIG stock that it can, almost at will, convene stockholder meetings and fire the board of directors of AIG en masse and replace them with hand-picked pros from Dover. It ought not to be too hard to get new people in who can buy and sell stocks, structure annuities, and predict with reasonable accuracy how much money pork bellies are going to sell for in September, if the incumbent set of managers are incapable of that.

The fact of the matter is, the government doesn't know dick about running an insurance company, which is why I objected to the form of the AIG bailout in the first place. No one saw the crash coming, with only a few exceptions, and we've no reason to think that AIG's management team are any more incompetent than any reasonable replacement slate of executives.

Now, the President, the Secretary of the Treasury, and Senator Dodd do look unseemly rushing to point fingers of blame at AIG for distributing bonuses because back when the bailout was structured, they didn't do or say a thing about them -- so it sure looks like their outrage today is a response to political pressure rather than something they actually care about. But while I certainly take note of their hypocrisy on this issue, it's really kind of beside the point.

The point is the government is now doing something it should never have started doing in the first place, and no one should be surprised that it's doing it badly.

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