Volcker Blames State Regulators for AIG's Fall -- and He's Got a Point

(MoneyWatch)  There's more than enough blame to go around as pundits determine just who caused the collapse of the world's once largest insurer, American International Group. Everyone from Treasury Secretary Tim Geithner, who once headed the New York Fed; to the past and present cast of characters at Goldman Sachs, which led AIG down the garden path; to Joe Cassano, who ran the AIG Financial Products unit that bought the toxic mortgage-backed securities, has been vilified.

The latest salvo is from Paul Volcker, former Federal Reserve chairman and author of a plan to split up the financial system to limit the power of the nation's largest investment banks.

According to the Wall Street Journal, Volcker addressed a group assembled at insurer AXA Equitable, saying that "ineffective state regulation was part of the problem that brought American International Group near bankruptcy." Those are fighting words to state regulators and the National Association of Insurance Commissioners (NAIC), who take no responsibility for AIG's untimely near-demise.

But the real target of those remarks -- and the one with the most to lose -- is Eric Dinallo, who, as New York State's insurance superintendent, had oversight of New York-based AIG in 2008.

Not surprisingly, Dinallo, who's running for New York Attorney General, took up the challenge and answered Volcker, repeating what NAIC had already said: AIG's insurance companies were closely-watched. The source of the problem was the London-based AIGFP unit under Cassano, which insured literally trillions of dollars of toxic mortgage-backed securities.

And AIGFP was regulated by the federal Office of Thrift Supervision. The OTS has gone through several management changes since the crisis and is due to be overhaued when the feds figure out how to regulate the financial markets.

But Volcker has a point in that insurance is a state-run system. The former Fed chief, and arguably Wall Street's wisest man, says insurance regulators need to stop being so provincial, and look not only at the local companies in their states but also at insurers' national holding companies. In AIG's case, its holding company failed to keep enough reserves to meet collateral calls when AIGFP started to unravel.