AIG Debacle Shows Gov't, Risk Management Do Matter

In “Alice In Wonderland,” Alice fell down a rabbit hole, thus beginning a bizarre, surreal journey. Now we all know how Alice felt, after a week that began with the death of Lehman Brothers, quickly moved on to the nationalization of American International Group, and ended with the initiation of a hastily drawn, massive federal bailout plan before Congress, with warnings that inaction could mean a global economic meltdown.

As insurance journalists, our focus is on the AIG component. How did the biggest impact player in the industry end up on the edge of a cliff this week? Maurice “Hank” Greenberg–the company's legendary builder, who got booted out as chief executive over an accounting scandal in 2005–had it right, blaming it on a breakdown in risk management.

An insurance organization, he professed, is naturally risk averse, and if he had been there, he would have made sure this didn't happen. AIG, he acknowledged, had a small amount of subprime investments on its books while he was there, but he would have seen the danger and never let this happen.

It will be left to historians, or some Congressional committee, to sort this all out and point fingers. But there can be no argument over his main observation–that the simple concept of risk management broke down at AIG, along with just about everywhere else in this shaky financial services industry. And now we're all paying for it.

AIG is not the only culprit here. Guaranty insurers failed to see the danger. The bankers couldn't recognize it, or didn't want to. And investment experts–individual, institutional or corporate–also didn't catch on in their desperation for a higher return. There were a precious few sirens of warning out there, but no one heeded them.

Who will be next to take a fall? No one knows. But the government has decided it is time to go from casting a lifeline to each new drowning victim of mortgage-backed securities and instead send out a flotilla of lifeboats to pick up the castaways before they capsize all the seaworthy vessels, and drag down those with their heads still above water, drowning us all in another Great Depression.

A few of those on the right decry Washington's intervention in the markets as anathema to the conservative credo of smaller government being better government. They fear the creation of a new bureaucracy and Washington's intrusion into the free market system. Regulators should remain at arm's length, or disappear altogether, many still believe.

It is obvious most investors are a little dubious about that hands-off philosophy, as expressed by the soaring Dow Jones Industrial Average on Friday, Sept. 19, when the government announced it was putting together a program to buy up bad securities and bolster money market accounts–as well as the deep dip the stock market took the following Monday, when the plan wasn't yet finalized.

Everyone is asking, what went wrong? How could this have happened? Mr. Greenberg had it right–not just for AIG, but about the whole financial mess we are suffering through. It was a failure of basic risk management.

The concept of securitization of mortgages had one fatal flaw–the homeowner paying it back. If the people making these loans had properly exercised risk management, they would have set up models that projected interest increases and decrease-in-valuation scenarios to estimate the potential for defaults.

With such information, the risk involved with these securities–backed as they were with subprime mortgages granted to people with a poor credit history–would have been clearly projected to investors. Obviously, that didn't happen, and the people buying up and guaranteeing these securities didn't bother to make sure risk management practices were being followed.

Going forward, it's clear that only strong regulators can make sure proper risk management practices are in place. This underscores the major fault of the conservative philosophy that has infected government for decades now–the notion that government doesn't matter, and that it should just get out of the way and let the market police itself…that the only worthwhile government is small government…and that to make government small, it must be starved by lowering taxes.

In fact, the conservative mantra has produced nothing but contempt for government and incompetence within it. Look no further than how the feds mishandled Hurricane Katrina as the primary example.

I do not advocate a return to rampant liberal excesses of wasteful spending that turned into social handouts and burdensome regulation that tended to stifle growth and innovation (though some argue that any government regulation is too much).

The argument over expanding or contracting government needs to cease. The argument must be over how we make government more efficient and effective.

Insurance is a central player in this debate. Does the industry need 50 regulators–or more, if you count Washington, D.C., Puerto Rico and other non-states? If so, do we need 50 different sets of regulations? Would the federal government do any better a job? Or would centralization increase the risk of a national meltdown for consumers?

Whatever the outcome of the debate over modernization of financial services oversight, some facts are now clear.

o Government matters.

o Regulation makes a difference.

o Risk management is critical.

These are all key points we should agree on, given the circumstances of this month's stomach-churning roller coaster ride.

There will be a lot of finger-pointing over the next few months while Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke try to keep our economic ship afloat, as none of us wants to see 1929 all over again.

My father grew up during the Depression (not the first in U.S. or world history, by the way), and he left me with some powerful impressions of what it meant to struggle in a world falling apart. His father made enough money to open a restaurant shortly before the fall began. Men came in hungry and couldn't pay. He didn't have the heart to turn them away and lost the business to IOUs. He and his family struggled and made it through, but were scarred in some way.

I think of photographs and newsreel footage of those forlorn-looking people on soup kitchen lines and men on street corners selling apples during the 1930s. I don't want to see those desperate times come back to haunt us in a new century, when we thought all of that was behind us.

Seeing AIG nationalized with an $85 billion federal bailout loan made me feel like Alice looking down that rabbit hole of economic despair. The question is, how do we all keep from falling–or, worse, being dragged in?