Fifty Chimpanzees or One Toothless Gorilla

AIG has several incredibly warm and cuddly commercials. One features a hysterically laughing baby (one has to ask the question this past week--is that baby still laughing?). The message--policyholders, you are safe, secure and happy being AIG customers. But after last week's takeover, are AIG insurance policyholders safe? With a sigh of relief, the answer is yes.

In the flurry of words on the Sunday talk shows it has been suggested again that the current crisis on Wall Street shows that insurance should be regulated by the feds and not the states. A commenter on my previous blog posed the question: do you want fifty chimps or one gorilla?

We all have a stake in how AIG treats its policyholders, and a stake in how the whole industry works too. Without the atmosphere of trust and good faith that surrounds insurance, no one could get a loan to buy cars or homes. Imagine where the economy would be without credit and the insurance industry.

AIG's financial meltdown this past week was not the result of failed insurance regulation. (Go ahead. Read that one more time, real slow.) AIG has about seventy insurance company subsidiaries. Each and every one is under the jurisdiction of a state insurance regulator. Not a single AIG insurance subsidiary is insolvent. Not a single one, or all of them together, is the cause of AIG's difficulty. The fault for AIG's woes lies in two federal laws that hurled us headlong into financial services deregulation. As a result of this deregulation, AIG's non-insurance parent company is not held to the same investment, accounting and capital adequacy standards as its state-regulated insurance subsidiaries.

According to the first one, the 1999 Gramm Leach Bliley Act, state insurance regulatory authority is limited to actual insurance entities and transactions with those entities. Senator Phil Gramm (the guy who thinks we are a nation of whiners and having a "mental recession") led the Senate Banking Committee that sponsored the act that bears his name. He later joined UBS Warburg, the investment banking arm of a large Swiss bank as a lobbyist. The second piece of deregulation legislation Phil Gramm deserves to be known for is the Commodity Futures Modernization Act of 2000. The act specifically banned regulation of something called "credit default swaps." And it is precisely the creation and trading of these unregulated CDS's that led to AIG's downfall.

In a nutshell, here is how a CDS works. Imagine lending money to your brother-in-law whose creditworthiness is only so-so. You would be reassured to find someone who would guarantee repayment of the loan -- even if you had to pay a premium for the guarantee. This arrangement is a "credit default swap." Now, further imagine that your brother-in-law defaults, and the guarantor of the loan doesn't have the capacity to pay off either. In the unregulated world of credit swaps no one has really paid attention (and the hands of state insurance regulators were tied) to whether the sellers of were capable of meeting their obligations. As a result of a wave of bad home mortgage loans threatens to capsize our whole financial industry, including a number of "unsinkable" giants like AIG.

As AIG was floundering last week, insurance regulators were concerned that the company might raid the funds of its insurance subsidiaries. The regulators were fully prepared to seize the subsidiaries in order to protect policyholders - literally, to throw out management and change the locks. Fortunately for AIG, it didn't come to that.

In the aftermath of the AIG and other bailouts, people are asking what permanent reforms are needed. So what about the suggestion that federal regulation of insurance is needed because having the fifty states regulate insurance is too disjointed? I would strongly disagree. State regulators can be faulted for many things (including being ardent and mistaken supporters of Gramm Leach Bliley) but they did the job they are supposed to do by protecting AIG policyholders. However, I would suggest at least two reforms. First, we should re-create the Depression-era wall of separation between insurance and banking that was torn down by the Gramm Leach Bliley Act. (Some provisions of GLBA are arguably beneficial, so I don't suggest a total repeal.)

Second, credit swaps and other exotic financial securities need oversight. Insurance regulators faced a similar challenge in the 1990's when insurers were investing heavily in junk bonds. At the request of insurance regulators, state legislators in many states acted to limit exposure to these risky investments. Congress needs to similarly rein in the use of risky credit default swaps.