The Feds' Bailout Black Hole

If it wasn't already obvious, this week's $30 billion check that the U.S. Treasury handed to insurer American International Group should demonstrate the folly of propping up crippled companies.

This is the fourth bailout to AIG, which already has put over $170 billion in government funds at risk, and it won't be the last. AIG lost $62 billion in the last three months of 2008.

Call it the Feds' Bailout Black Hole. Once taxpayer funds cross its event horizon, they seem to disappear forever.

It's not just AIG, of course. General Motors has received $13.4 billion from the Feds so far, and said last month that it will need another $16.6 billion.

That request will almost certainly be granted, even though GM reported last week that it lost $31 billion in 2008, or $3,700 on every vehicle sold. With sales off a stunning 53 percent from a year before, and a gale-force economic storm building, expect GM executives to show up in Washington to request a third or fourth or fifth round as well.

Let's not forget Fannie Mae and Freddie Mac, created with an explicit guarantee that zero taxpayer dollars would be used to bail them out. The law in question says: "This chapter may not be construed as obligating the federal government, either directly or indirectly, to provide any funds... or to honor, reimburse, or otherwise guarantee any obligation or liability..."

Well, we know how that turned out. After an era in which Fannie and Freddie were headed by Democratic insiders who walked away with tens of millions of dollars amidst accounting scandals, the two companies have been taken over at taxpayer expense. (Their influence, by the way, was bipartisan: Freddie wrote a $250,000 check to last year's Republican convention.)

Now we have the spectacle of the Treasury handing Fannie and Freddie a $400 billion bailout in the form of stock and debt guarantees. But Fannie is losing money quickly -- around $59 billion last year -- and it already has said it needs another $35 billion in additional aid.

The problem with dubbing a company "too big to fail" is that it becomes big to turn down when it asks for more. The usual incentives for managers to keep costs under control fade when an enterprise becomes a ward of the state. A focus on pleasing customers gives way to a focus on pleasing politicians in Washington.

Poorly-managed businesses survive at taxpayer's expense, while their better-managed rivals struggle through a shrinking economy and worry about what happens now that regulators own their competitor. A new risk-taking incentive emerges: If you're going to fail, make sure you fail so magnificently, so stupendously, that you get bailed out too.

Bankruptcy is an alternative to this bailout black hole. Contrary to popular belief, bankruptcy actually protects a company by placing creditors' claims on hold and allowing a firm to continue to operate. (Many current customers of United Airlines, Texaco, Global Crossing, and Pacific Gas and Electric might be surprised to learn those companies once filed for Chapter 11.)

A bankruptcy judge could have carved AIG up into chunks with sound components separated from unsound ones. Other companies would buy assets that had value. Shareholders would likely have emerged in better shape than they have after AIG's stock price fell from over $70 to 43 cents in a two-year period.

"Suppose AIG goes bankrupt, it is better that AIG goes bankrupt and we have a horrible two or three years than that the whole US goes bankrupt," legendary investor Jim Rogers, who co-founded the Quantum Fund with George Soros, told CNBC on Tuesday. "AIG has trillions of dollars of obligations, let them fail, let the courts sort it out and start over. Otherwise we'll never start over."

One aspect of the repeated AIG bailouts that deserves additional public scrutiny is how they enriched some of the company's counterparties at taxpayer's expense.

Those are the bailout's indirect beneficiaries, and they reportedly include Goldman Sachs, Merrill Lynch, UBS AG, and Deutsche Bank AG. They knew there were risks to dealing with AIG; the financial world would not end if AIG defaulted. (As George Mason University economics professor Tyler Cowen put it this week: "No one wants to say it, but essentially the Fed has been bailing out European banks.")

If the U.S. Congress had been asked last fall to hand over $170 billion -- enough to fund NASA for a decade -- to bail out Goldman Sachs and European banks, does anyone think this would have been approved without question? But because Congress has abdicated its constitutional responsibility, we're left with the sad spectacle of senators including Ron Wyden (D-Oregon) unsuccessfully pleading with Fed Chairman Ben Bernanke to reveal the identities of the recipients of this largesse.

There is some reason for hope. A recent CBS News/New York Times poll suggests that only 39 percent of Americans approve of bailing out banks and financial institutions, down from 46 percent in December.

Americans seem to be realizing how flimsy the justification for Wall Street bailouts was. The Federal Reserve announced the AIG bailout by saying that without it, the nation would experience "reduced household wealth and materially weaker economic performance." Yet even with the bailout, as a 42 percent decline in stocks since September shows, we've experienced precisely that.