SIGTARP: AIG still a risky mess

July 25, 2012, 8:01 AM UTC

Correction and Update, 7/25 9:20 AM

FORTUNE — AIG (AIG) could be a drag on taxpayers for years to come, even after the bailout of the insurance giant is long done. That’s the conclusion of this month’s quarterly report from the government office that is tasked with overseeing the $700 billion TARP bailout fund.

Most commentators, including me, have focused on whether the government made money or not on its bailout of the failing insurance giant. This quarter’s SIGTARP report takes a stab at that. Overall, the government is still out $30 billion from the AIG bailout, according to the SIGTARP report. In compensation, the Treasury holds just over a billion shares of the insurance giant. That stock is worth roughly $33 billion. So on paper we’re ahead $3 billion. But that’s on paper. If the government were ever to dump its AIG stake today, which is equal to 61% of the company, the stock would surely plummet, pushing the investment well into the red.

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But the SIGTARP report smartly takes the next step. The report points out that even if the bailout turns out to be profitable, trying to regulate AIG to make sure the firm doesn’t blow up again won’t be easy or cheap. This was, of course, a cost that always existed, but was just ignored. AIG was supposed to be regulated by the now defunct Office of Thrift Supervision, but clearly never really was. Even though the OTS has been gone for a while now, and AIG has amazingly not been assigned a new regulator, according to SIGTARP. That may work in the wake of the financial crisis, when all eyes are on risk, and the government still owns a controlling stake in the company. But AIG will eventually need to be put under government watch, and all the costs that entails.

It is assumed that the Federal Reserve will take over regulation of the insurance giant. But the question is whether there’s a better answer. The government, despite the fact that it had to pledge over $150 billion to save the company, has done very little to change the insurer since the financial crisis. AIG has lowered its holdings of risky derivatives contracts. But it’s still the same sprawling conglomerate of insurance companies taking all types of hard to quantify risks around the globe as it was when it had to be bailed out nearly four years ago. It even has the same auditor it did back then.

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Treasury officials argue that the government is doing better on its AIG investment than the SIGTARP report lets on. It’s part of a long running dispute between Treasury officials and TARP’s inspector general as to what should be counted as bailout profits. Treasury officials say the Federal Reserve has made an additional $13 billion on fees and interest from the AIG bailout that is omitted by the SIGTARP. “AIG has taken significant action since the crisis – working with Treasury and the Federal Reserve – to restructure, reduce risk, and streamline its operations to focus on its core insurance business,” says Treasury spokesperson Matt Anderson.

What’s more, you could argue the problem of complexity is the same problem the government has with JPMorgan Chase (JPM) or Citigroup (C) or any of the too-big-to-fail banks. But at least with the banks, you have a group of companies that are relatively similar. Industry wide stress can give you some kind of confidence as to whether any one bank is not adequately prepared for the risks it is taking, plus there is some regulatory economies of scale. But stress tests are unlikely to work on AIG, because there is essentially nothing to compare it to.

The SIGTARP doesn’t say it expressly, but I think the report makes a strong case for why AIG should be broken up. There was a similarly strong case to be made for Citigroup, when the government still owed that bank, but Treasury never wanted to go down that route. Given the fact that Citi has continued to languish there is some evidence that the bank, or its successors would have been better off. But since taxpayers no longer own Citi, breaking up that bank is now off the table.

An AIG break-up, on the other hand, would still be doable. And since Uncle Sam is unlikely to be able to exit our AIG investment anytime soon, there is plenty of time to consider it. We probably should.

Correction and Update: I wrote that AIG had been regulated by the OCC, and that that agency had been dissolved. That’s not correct. The OCC still exists. I meant to write the OTS, which is gone. Also I added a response from the Treasury Department.