From a small northwestern observatory…

I was trying to explain to a lawyer why AIG was “too big to fail”.

While I let that sink in, I’ll tell you a little story. Back when I was an academic, every summer our Finance department would have a little private, in-house, self-edification symposium we jokingly called “Finance Camp”. Usually running 4 to 6 weeks, it would consist mainly of a weekly, afternoon session of 1 – 2 hours, in which each of us would take turns making a presentation on some aspect of that summer’s theme. One summer it was bond portfolio duration. Etc. You get the picture?

Anyway, one summer, we decided that the theme would be “bankruptcy”. While planning for the sessions, we realized that the Law School also taught “bankruptcy”, so we should invite the 3 or 4 law professors who taught that subject. We planned for a big “round robin” intro meeting, followed by alternating weeks of presentations from finance and law. Good idea, right?

Sigh… as it happened, not only were we talking about two different SUBJECTS, we were frankly talking about two different LANGUAGES. Case in point — from a finance perspective, if bankruptcy is properly priced ex ante, then the event of bankruptcy is irrelevant. From a legal perspective, the very concept of such irrelevance is inconceivable.

So, back to AIG. Everyone, I guess, seems to bemoan the fact that we have (or had) companies in America that were “too big to fail”. Because what they do is so clouded in mystery, it’s hard for the person on the street to grasp how badly the economic machinery would suffer if AIG failed. Imagine, instead, if Boeing and Airbus were one company, and they suddently went out of business, taking with them all the expertise not only to build new planes but also all the expertise to repair, maintain, and service all the existing airplanes. In short, air-transport in the world would grind to a halt by 8am t. Yeah… THAT big.

So, why are Boeing and Airbus so big? After all, these companies are fairly new to the game — Boeing didn’t even get into commercial aviation until the jetliner days, and Airbus is a fairly recent amalgamation. What ever happened to venerable names, like Douglas, de Havilland, and Lockheed?

In short, they were victims of efficiency. Monopoly theory suggests that as firms become more-and-more efficient, the “also-rans” drop out. One big mistake and a firm ceases to exist. Think about automobiles — the U.S. alone used to have dozens of auto manufacturers. Today, we’re down to three domestic producers (not counting off-shore headquartered labels which are actually made here). Indeed, world-wide, the number of profitable auto makers may be just a hand-full after this recession is over.

It might surprise the lay person to read that financial services is actually a fairly low-profit business, compared to making automobiles or airplanes. Car makers can easily knock a few thousand dollars off the list price and still make money. Boeing is currently making millions of dollars in concessions on airplanes. On the other hand, margins on financial instruments are extraordinarly thin. If so, then how are the AIGs and Merrill Lynchs of the world able to pay seven- and eight-figure salaries? Simple — a one percent margin on a billion dollars worth of business is still $10 million.

In a world like that, where financial houses constantly trade with other financial houses, we end up with razor-thin margins, which leads inexorably to monopolies. Add to it the fact that these financial houses are massively intertwined, and we end up with houses of cards that could completely collapse if a major, key-stone player falls down.

How do we fix it? The first question is should we fix it? Is the cost of having to pick up all of Humpty-Dumpty’s pieces every few years greater than the cost of inefficiency? Of course, this question probably doesn’t matter, since the regulators in the U.S. and most everywhere else seem inexorably headed toward new rules which will add significant inefficiency to the process. Is that a bad thing? Probably not — it would be nice to go back to the day when there were 10,000 mortgage lenders in the U.S. rather than just a hand full, when there were dozens of major stock brokerage firms rather than just a few, and when AIG didn’t completely own the insurance business (and a few other businesses that may surprise you, like airplane leasing). The price of this — and let’s call it an insurance premium — will be significant inefficiencies in the financial marketplace.