No oversight at AIG – or just bad Oversight?

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Scott Spoerry
Senior Producer, CNN Washington

When Ben Bernanke told the Senate Budget Committee that American International Group (AIG) "exploited a huge gap in the regulatory system” and that “there was no oversight of the Financial Products division," it seemed to make sense. The Federal Reserve Chairman went on to say, "This was a hedge fund basically that was attached to a large and stable insurance company."

If nobody was keeping an eye on them, well no wonder it blew up.

But it turns out Mr. Bernanke was not quite accurate when he said “no oversight.” He made that statement on March 3rd.

Just two days later a man hardly anybody has ever heard of explained to yet another Senate committee that - hold the presses - there WAS a regulator for the Financial Products unit of AIG. (By the way, everyone just calls it FP now…that saves time and makes it sound like we know what we’re talking about).

That man was Scott Polakoff and he’s the Acting Director of the Office of Thrift Supervision (we call that OTS). OTS is the regulator for thrifts and savings banks. Polakoff has told any committee that will listen that OTS had responsibility for AIG FP. Why was OTS involved? Because among the seventy odd companies and units that make up AIG, one of them happened to be a Savings & Loan Bank.

When you think of a Savings & Loan it’s hard not to picture Jimmy Stewart facing down the evil banker Mr. Potter, but at AIG, Potter was trading derivatives at the FP unit, and FP was attached to the S&L as far as the regulator was concerned.

“We were clearly responsible as a consolidated regulator for FP,” says Polakoff, and adds, “We, in 2004, should have taken an entirely different approach than what we wound up taking regarding the credit default swaps.” By now, the term credit default swap is practically a barbershop term, but basically it’s just a sort of insurance policy on another financial product like a mortgage-backed security (often stuffed with foreclosed mortgages, as we have all learned to our sorrow).

So when Mr. Polakoff says they should have taken a different approach, what he’s really saying is that the OTS regulators weren’t sophisticated enough to realize that FP was heading for BIG trouble. And why should they have been that prepared? OTS mostly regulates S&L’s which generally take deposits and then make loans for houses and other purposes. Would you expect these civil servants to really understand the risks attached to derivatives that are designed by Math PhD’s to play the odds on pieces of paper that “derive” their value from a mortgage backed security that can’t be valued itself (except maybe by another math nerd).

It’s hard for me to blame just one regulator like OTS. One reason to give them a break? The fact that many of these derivatives trades are specifically exempted from regulation (except for “self-regulation”), which obviously makes it a lot harder to control a company that deals mostly in derivatives.

And it may surprise you to learn that there is no national regulator for insurance companies. There are FIFTY, one for every state. That means that no one was really looking at the overall AIG holding company and the seventy different insurance companies that it holds.

I won’t pretend I’m explaining every detail of what happened here. The way our regulation system is set up, almost nobody realized that greedy mortgage brokers were lying and cheating to sell mortgages to greedy investment bankers who didn’t bother to even check whether they were buying quality mortgages or just crap.

NOBODY was looking at these transactions. Then the rest of the financial world wanted to get in on this too. That included greedy derivatives traders. NOBODY was really watching them either. Finally, the whole shaky structure collapsed and here we are. And by the way I have a 401k, and I’m greedy too. I wanted it to go up and the faster the better.

The insurance regulator for New York wasn’t worried since the specific AIG companies that do insurance business in New York each had a fairly small investment in the Financial Products unit of the overall company. And in 2005 he even recommended that FP stop investing in mortgage backed securities. His 49 fellow regulators around the country? They were focused on the companies doing real insurance business in their states, and not exactly a highly organized force to fight evil.

Years ago my father handed me a book on the insurance industry and said I’d find it interesting. It was called “The Invisible Bankers” and the title was accurate beyond belief. Insurance companies have nearly as much money as the banking industry and they need to invest these assets and make money. That’s how they pay their policy holders and shareholders. They sell insurance, they make loans, they do most of the things big banks do, just without the bother of a national regulator keeping an eye on them. In fact they get to play the state regulators off against one another. It’s been a great game for a long time.

Ask Warren Buffett, a man who knows a profitable business when he sees one. He owns several insurance companies. The difference is that Buffett, as he has noted many times, has the common sense to stay away from things too complicated for him to understand. Years ago he called derivatives like credit default swaps “Financial Weapons of Mass Destruction” and he was more right than we ever have imagined.

By the way, Fed Chairman Bernanke was back on Capitol Hill again on Tuesday, backed up by Treasury Secretary Tim Geithner. And when one of the congressmen read aloud Scott Polakoff’s testimony, the revised explanation was that AIG FP was not unregulated, it was just poorly regulated.

That we already knew.