Mercatus Scholar Hester Peirce's Study: "Securities Lending and the Untold Story in the Collapse of AIG" (with Lofchie Comment)

Mercatus Scholar and former Congressional and SEC staff attorney Hester Peirce posted a working paper titled "Securities Lending and the Untold Story in the Collapse of AIG," in which she argues that the reasons for AIG's collapse were more complicated than conventional accounts suggest (particularly those used to justify the regulatory responses embodied in Dodd-Frank).

Ms. Peirce argues, among other things, that the cause of AIG's downfall was related less to derivatives and more to its securities lending business, particularly to its reinvestment of the cash collateral that it received from securities lending. In short, AIG's practice appears to have been to borrow money short-term by lending securities for which it received cash collateral, and to reinvest that money in risky and often long-term assets. While such a strategy can be highly profitable when times are good (the investment is risky, but performing assets pay a far higher return than AIG was required to pay on the cash it borrowed), it is disastrously bad, both from a profitability and a liquidity standpoint, when the reinvested assets start to tank.

Lofchie Comment: One focus of Ms. Peirce's argument is that, following AIG's collapse, regulators mistakenly focused on derivatives as the villain rather than AIG's other cash management practices. Today, regulators seem to be focusing on securities lending transactions, often by imposing punitive capital transactions. Arguably, once again, regulators are focusing on the wrong risk. Securities lending generally has been quite safe, which was the case even with regard to AIG. The dangerous activity is the reinvestment of the cash collateral, and that should be regulated like any other investment activity. Borrowing money short (by "lending" securities) and investing that money long is a dangerous play.

Click here to view the working paper titled "Securities Lending and the Untold Story in the Collapse of AIG," by Hester Peirce.