We already knew, of course, that this “close out” at full price was partly about Goldman Sachs – and that SocGen was involved.  There was also, it turns out, some Merrill Lynch exposure (affecting Bank of America, which was in the process of buying Merrill).  Still, it’s striking that no other major banks had apparently much of this kind of insurance from AIG against their losses – Citi, Morgan Stanley, and JPMorgan, for example, are not on the list.

This information is useful because it will help the House Oversight and Government Reform Committee structure a follow up subpeona to be served on Goldman Sachs with the following purpose:

1. Did Goldman actually deliver the security that was insured?  Ordinarily when you close out a contract of this nature – particularly at par – you turn over the insured security in return for the payment.  The insurer pays in full but is left holding a security; if this recovers in price, the insurer recoups some of the loss.  But if Goldman was using AIG as reinsurance, which is what some news reports suggst, it did not have any security to turn over.  (Remember that with CDS – unlike cars – you can insure something that you don’t own).
2. If Goldman did not turn over a security, then how was it determined that the security had esssentially zero value – which was the rationale for the payment really being made at par?  Was this assessment provided by Goldman or by some independent third party?  These were highly illiquid markets, so there was generally no widely quoted price that could be used.
3. How did this valuation process differ from standard practice among market participants – when close out under such conditions is typically not at par?  If the Fed effectively allowed Goldman unilaterally to declare a security worthless and to demand payment in full, we have a major problem.
4. Secretary Geithner claimed yesterday that, if payment had not been made in full, the economic consequences would have been dramatic.  To assess this claim, we need to see the value of these claims on Goldman’s books prior to this bailout transaction.  Best practice would suggest that Goldman was not carrying this asset at face value – as it is an articulate proponent of mark-to-market and there must have been a reasonable expectation that AIG would not pay off in full.  Therefore the transaction represented a windfall gain for Goldman shareholders and insiders – rather than something that in any sense “saved the day” for the financial system.
5. As the evidence stands currently, the entire AIG transaction therefore appears to have been structured in such a way as to benefit primarily Goldman – although, for fair comparisons, we should obtain parallel details from other counterparties.  What was the entire timing and content of interactions between Goldman and the Fed on this matter?  Who exactly designed the deal and with which advisers?

The House Oversight and Government Reform Committee has done an extraordinary job peeling back several layers of a potentially rotten onion.  They need to follow the lead provided by this evidence and ask the next hard round of questions.

Some of these issues are rather technical but evidence either way will speak directly to accusations of favoritism and unreasonable government behavior.  It is time to get fully to the bottom of this matter.

By Simon Johnson

The difference between the monolines and AIG, Adams posits, was Goldman Sachs.

Apparently while all the other banks were paying monoline insurers to insure their CDOs, Goldman wasn’t, because the monolines refused to agree to collateral posting requirements (clauses saying that if the risk increased and the insurer was downgraded, it would have to give collateral to the party buying the insurance). Instead, Goldman bought its insurance in the form of credit default swaps from AIG, which was willing to agree to collateral posting requirements, as we all now know. This is one way in which Goldman was smarter than its competitors. Another way, which we also all know, is that at some point in 2007 Goldman began shorting the market for mortgage-backed securities — which would given extra incentive to make sure that they were fully insured.

Until, suddenly in September 2008, it turned out that maybe Goldman wasn’t that much smarter than everyone else, when it seemed like AIG might not be able to post the collateral it owed. And so:

“I hate to get sucked into the vampire squid line of thinking about Goldman, but the only explanation i can think of for why AIG got rescued and the monolines did not is because Goldman had significant exposure to AIG and did not have exposure to the monolines.”

There’s more.

Yves Smith points out (in an update) another possible difference between AIG and the monolines — AIG’s business in swaps allowing European banks to reduce their capital requirements, which meant that big European banks had a lot of exposure to AIG.

Another difference might be timing — AIG hit the fan at the same time as Lehman and a week after Fannie and Freddie were taken over. Another difference might be raw size: even if the monolines together were as big as AIG, that’s precisely the point — their problems could be spaced out over time, allowing the markets more time to adjust, while AIG would go bankrupt in one big lump.

By James Kwak

There are a couple of details I can’t quite reconcile (for example, the Fed balance sheet shows initial funding of $29.3 billion, but everyone says Maiden Lane III paid $29.6 billion for the CDOs), but essentially it went like this. The banks had bought CDS protection on $62.1 billion of CDOs (some of those CDOs they owned — some they did not, meaning those were “naked” CDS*). As of November, the market value of those CDOs was $29.6 billion. At that point, the banks already held $35.0 billion in cash collateral from AIG to cover the difference. (If you have a derivatives contract with someone under which your counterparty may have to pay you a huge amount of money, you generally negotiate a term under which the counterparty has to give you money as the trade moves against him, to protect you from default. In this case, a lot of the collateral came from the $85 billion credit line the Fed gave to AIG in September — otherwise AIG would have gone bankrupt because of collateral calls.)

In the transaction (I’m working off the New York Fed summary), first AIG contributed $5 billion to Maiden Lane III and the New York Fed gave it a $24.3 billion loan. Then Maiden Lane III gave all $26.8 billion to the banks in exchange for the CDOs. (The banks accepted $26.8 billion because  they already held $35.0 billion in collateral; together that makes $61.8 billion — as I said, I can’t get $300 million to reconcile.) Then Maiden Lane III gave $2.5 billion right back to AIG (this is the amount by which AIG had overcollateralized). As part of the deal, the banks agreed to tear up the original CDS on the CDOs, so AIG couldn’t lose any more on the CDS (which, remember, are separate from the CDOs).

The controversy is not over paying $29.3 (or $29.6) billion for the CDOs, since that was the market price. The controversy is over whether AIG should have agreed to settle the CDS at 100 cents on the dollar (meaning that the banks get the difference between the face value of the CDOs and their current market value). Bloomberg reported a while back that prior to the government bailout, AIG had been trying to negotiate a settlement at 60-70 cents on the dollar, but that that portion of the term sheet was crossed out in the final agreement. The implication is that paying the swaps off in full was a back-door, off-the-books way of funneling cash to banks that we didn’t want to fail.

The argument for the NY Fed is that the banks had legal contracts that entitled them to the money. AIG might have been able to negotiate a haircut because it was going bankrupt and counterparties will take less money up front rather than risk getting even less in bankruptcy. However, once the government stepped in, it had no way to abrogate the contracts. The Agonist has a long post with much more detail than I have provided, arguing in conclusion that Federal Reserve Bank presidents are technocrats, and technocrats abide by the advice of their lawyers, which was almost certainly that AIG had to pay off the swaps in full. (He says the mistake was bailing out AIG in the first place back in September.)

Various people have argued, however, that the Fed could have negotiated a better deal. The Epicurean Dealmaker argues that, given the considerable powers of the Federal Reserve and the federal government in general, the banks could have been intimidated into accepting a modest haircut.

Robert Pozen, in his very worth reading book Too Big to Save?, says (p. 79) that AIGFP could have been forced into bankruptcy without putting the rest of AIG into bankruptcy; threatening to put AIGFP into bankruptcy would have provided the leverage to induce the banks to take a haircut. Lucian Bebchuk, a Harvard law professor, argued back in March that because AIG had guaranteed the obligations of AIGFP, this would constitute a default by AIG — but that wouldn’t affect AIG’s insurance subsidiaries, which could stand alone quite nicely (insurance companies get most of their money from customer premiums, not from debt).

I think that given the state of the world in November 2008, paying the banks off in full was definitely the easy choice — it’s always easier to abide by the contract and pay up, especially when you have very deep pockets. And the fact that it helped out the banks as well was probably seen as another argument for it, given the perceived need within the government to bolster the banks’ balance sheets by any means necessary.

* Apparently there is some controversy about this. In an interview, Representative Peter DeFazio said the following:

“Geithner would not answer my question when I said, ‘Were those naked credit default swaps by Goldman or were they a counter party?’ He said, ‘I will not answer that question.’”

From the New York Fed web site:

“AIGFP, the LLC and the New York Fed have entered into agreements with AIGFP’s credit derivative counterparties to terminate approximately $53.5 billion notional amount of credit derivatives and purchase the related multi-sector CDOs. Of these, CDOs with a principal amount of approximately $46.1 billion settled on November 25, 2008. Settlement on the remaining $7.4 billion is contingent upon the ability of the related counterparty to obtain the related multi-sector CDOs and thereby settle with the LLC and terminate the related credit derivative contracts with AIGFP” (emphasis added).

By James Kwak

“Far from eagerly micromanaging the companies the government owns, Mr. Obama and his economic team have often labored mightily to avoid exercising control even when government money was the only thing keeping some companies afloat.

“A few weeks ago, there were anguished grimaces inside the Treasury Department as the new chief executive of A.I.G., Robert H. Benmosche, whose roughly $9 million pay package is 22 times greater than Mr. Obama’s, ridiculed officials in Washington — his majority shareholders — as ‘crazies.’

“Causing even more unease to policymakers, Mr. Benmosche insisted that A.I.G. — one of the worst offenders in the risk-taking that sent the nation over the edge last year — would not rush to sell its businesses at fire-sale prices, despite pressure from Fed and Treasury officials, who are desperate to have the insurer repay its $180 billion government bailout.

“But in the end, according to one senior official, ‘no one called him and told him to shut up,’ and no one has pulled rank and told him to sell assets as soon as possible to repay the loans.

“A similar hands-off decision was made about the auto companies. Shortly after General Motors and Chrysler emerged from bankruptcy, some members of the administration’s auto task force argued that the group should not go out of business until it was confident that a new management team in Detroit had a handle on what needed to be done.

“But Mr. Summers strongly rejected that approach, and the Treasury secretary, Timothy F. Geithner, agreed.

“‘The argument was that if the president said he wasn’t elected to run G.M., then we couldn’t hire a new board and then try to run any aspect of it,’ one participant in the discussions said. The auto task force took off for summer vacation in July, and it never returned.”

The political argument for this position makes sense. Basically, Obama and his administration are afraid of being charged with “socialism” or “big government,” so they are doing what they can to defuse this charge. (Not that that will help given the way political rhetoric is thrown around these days.)

I’m not sure the policy argument makes as much sense. Think about GM, for example. The Treasury Department owns 60% of GM. In the private sector, if you were a private equity fund manager who owned 60% of a deeply troubled company, and you didn’t play an active role in its reconstruction, your investors would accuse you of being negligent. In a turnaround situation, the majority investor is supposed to be actively involved, especially when he’s doing it with other people’s money, since he has a fiduciary obligation to those other people. Yet the administration is going out of its way to not be involved in GM. This is from the June 1 fact sheet:

“As a common shareholder, the government will only vote on core governance issues, including the selection of a company’s board of directors and major corporate events or transactions. While protecting taxpayer resources, the government intends to be extremely disciplined as to how it intends to use even these limited rights.”

The phrase “common shareholder” is probably intended to emphasize the fact that the government is a shareholder, not the board or management, but it conveniently overlooks the fact that the government owns 60% of the common shares – which most majority owners usually use to install a majority of the board of directors.

Leaving political arguments aside, what are the possible justifications for this policy? One is that an active government presence will scare away new private investors. I think we can safely dismiss that fear in the case of GM, at least for the next year or so, since those new private investors do not exist.

Another possible justification is that government involvement will become a channel for political influence from Congress. But this was not true, for example, of the administration’s automotive task force, which operated independently of Congress.

The other possible justification is that the government is somehow incompetent in a way that a private equity investor – say, Cerberus, the previous owner of Chrysler – is not. I know there are many people who think this is the case. But first of all, even if you are the Treasury Secretary and you happen to think that the people who work for you are incompetent, there are still other solutions; for example, you could hire KKR to be the trustee for your 60% stake in GM and act on your behalf, rather than just turning your back on your multi-billion-dollar investment of taxpayer money. (I’m not recommending this, just pointing it out as an option.)

And more importantly, why is President Obama – the man who, last Wednesday night, said, “[Our predecessors] also understood that the danger of too much government is matched by the perils of too little; that without the leavening hand of wise policy, markets can crash, monopolies can stifle competition, and the vulnerable can be exploited” – subscribing to the anti-government caricature of right-wing talk radio? Does he really think that the federal government, and the dozens of talented people he hired and appointed, is too incompetent to do what any twenty-something Ivy League graduate with the connections necessary to raise a $100 million fund can do?

By James Kwak

Lewis sets out to tell the untold story of FP, based on extensive interviews with people who actually worked there. He starts by laying out the conventional wisdom about FP, which presumably he is going to debunk. The conventional wisdom, according to Lewis, is that the problem lay in credit default swaps: “The public explanation of A.I.G.’s failure focused on the credit-default swaps sold by traders at A.I.G. F.P., when A.I.G.’s problems were clearly much broader.” Indeed, Lewis implies that the government essentially framed FP: “Why were officials, both public and private, so intent on leading others to believe all the losses at A.I.G. had been caused by a few dozen traders in this fringe unit in London and Connecticut?

The problem is that, having actually paid for the magazine and read the article, it seems to me that Lewis only reinforces the case against FP and credit default swaps. He says that all of the FP people he talked to “were fairly certain that if it hadn’t been for A.I.G. F.P. the subprime-mortgage machine might never have been built, and the financial crisis might never have happened.” That sounds to me like a more damning case than I would have made.

In Lewis’s story, it was credit default swaps sold by FP that enabled banks to issue securities backed by subprime mortgages earlier this decade. He has evidence that the people at FP who were insuring these securities had no idea how much subprime debt was inside them. When Gene Park figured it out around the end of 2005, Joe Cassano actually agreed to stop insuring subprime-backed securities. Yet Lewis even holds FP responsible for what came later:

“A.I.G. F.P.’s willingness to assume the vast majority of the risk of all the subprime-mortgage bonds created in 2004 and 2005 had created a machine that depended for its fuel on subprime-mortgage loans. . . .

“The big Wall Street firms solved the problem by taking the risk themselves. . . . Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007.”

This is somewhat plausible, but it’s a funny argument. Essentially it says that: (a) FP was responsible for subprime lending because, without insurance, investment banks wouldn’t have been willing to take on the risk of the securities in the first place (and demand from investment banks is what caused frontline lenders to originate these loans); but (b) when FP stopped insuring the securities, investment banks suddenly decided they were willing to take on the risk. I say it’s plausible because it could be that FP enabled a profit machine in 2004-05 and the banks were unble to shut it down in 2006-07 without torpedoing their earnings. But if that were the case, they would all have behaved like Goldman – shorting the mortgage-backed securities markets with one hand at the same time that they originated the stuff with the other. In 2006-07, most banks simply underestimated the risk of the stuff they were holding; that is FP’s fault only if you claim that FP made banks like Bear and Lehman stupid.

So when Lewis says, “A.I.G. F.P. wasn’t an aberration; what happened at A.I.G. F.P could have happened anywhere on Wall Street . . . and did” (ellipsis in original), I’m not sure which side he is arguing. Is he saying that FP is to blame for the crash? Or is he saying that FP caused the crash, but doesn’t deserve to be singled out because it “could have happened anywhere?”

The latter argument, to me, doesn’t make sense. The problem is better illustrated when Lewis describes the rise of credit default swaps in the 1990s:

“The traits required of this corporation were that it not be a bank – and thus subject to bank regulation and the need to reserve capital against the risky assets – and that it be willing and able to bury exotic risks on its balance sheet. There was no real reason that company had to be A.I.G.; it could have been any AAA-rated entity with a huge balance sheet. Berkshire Hathaway, for instance, or General Electric. A.I.G. just got there first.”

I don’t think anyone has ever argued that for some structural reason AIG was the only company that could have created the mess it did. AIG created the mess because it made stupid business decisions that other companies did not make. Other companies made other stupid decisions, but not the one to take a huge, one-sided bet, with no reserves, on the solidity of the housing sector and the entire economy.

Ultimately, I think Lewis is actually too harsh on FP. They made bad decisions, they essentially blew up all of AIG, and they required an enormous taxpayer-funded bailout to limit the collateral damage. But holding them responsible for the bad decisions at all the Wall Street investment banks seems a bit much.

By James Kwak

Have we completely lost of sense of what is and is not a conflict of interest?  Have we really built a system in which greed fully overshadows responsibility?  Is it not time for a complete rethink of what constitutes acceptable executive behavior?

One of our country’s leading corporate attorneys made a telling point to me on Wednesday night, “the only way to control executive behavior is to criminalize it,” i.e., civil penalties do not change behavior – the prospect of jail time has to be on the table.  His broader point was that antitrust action can make a difference in today’s world, but only if this includes potential criminal charges.

The same NYT article reports the following official statement from AIG.

“A.I.G. is a large institution that engages in standard commercial activity with companies all over the world,” Ms. Pretto said. “These activities are handled in the normal, day-to-day course of business and rarely, if ever, rise to the level of the C.E.O.”

I have three specific comments on this.

1) Do not insult our intelligence.  Either Mr Liddy is running the company or he is not.  Of couse a CEO doesn’t handle every detail, but he/she sets the tone, the compensation, and – have we forgotten? – is responsible for what happens.

2) According to the NYT report, Mr Liddy has an apparent conflict of interest.  Please answer these questions as simply and directly as possible, because otherwise they will be repeated indefinitely.  When did Mr Liddy disclose this and to whom at the Federal Reserve Bank of New York (or to which other responsible government officials)?  What did Hank Paulson, then Secretary of the Treasury and former CEO of Goldman Sachs, know and when did he know it?

3) If the Obama Administration thinks this is a storm in a tea cup, think again (I’m sure Valerie Jarrett gets this, but someone please check).  Straws may or may not break camel’s backs, but simple symbolic issues – that millions of people can understand and relate to – can bring major political damage in the midst of a broader, more complex economic fiasco.

Let me be very clear on my position vis-a-vis AIG-Goldman and the broader Washington-Wall Street Corridor.  I’m not saying that anyone has broken any laws, but rather that laws need to be changed.  I’m not even saying that there have been transgressions against the prevailing code of ethics for executives and politicians – although surely we agree that this code needs to be dragged, kicking and screaming, into the 21st century. 

I’m just saying that we have a problem – ultimately, with the belief system that underpins how big finance behaves – and we need to fix it.

Last week went something like this:

1. We learned about the $165 million in retention bonuses at AIG Financial Products.
2. A lot of people, up to and including President Obama, got mad.
3. Various commentators, including Ian Bremmer (on Planet Money, around the 14-minute mark) and Joe Nocera, said, in Nocera’s words, “Can we all just calm down a little?”

Their argument is basically that $165 million is small change, the government should be working on bigger issues, and the demonization of AIG is making it harder to solve the real problems.

Andrzej Kuhl, a former colleague of mine, put it well in an email to me after reading our New York Times op-ed:

I feel that the timing of the piece is harmful and its final conclusion is too limited.

Don’t take me wrong, I am a strong believer in compensation plans being tied to performance.  And not just a short term – one year – window, but a performance measured over a multi-year period.  Ideally, compensation enhancements should have multiple parts, ranging from evaluation of the performance of an individual, to that of a larger unit within which the individual performs.  I also believe that all individuals are replaceable and should be moved aside if their performance has been sub-par (and bringing a company to the brink of bankruptcy is definitely below par).

Having said that, I strongly believe that the current brouhaha over bonuses at AIG, and other TARP recipients, has reached the level of a national hysteria.  What should be an effort for some lower level functionaries, has been occupying front pages of newspapers, tying up valuable time of top government officials (including the president), as well as encouraging members of the congress to pontificate in circus-like hearings and propose retroactive tax legislation of dubious legality.  In effect, our leaders are following, or being forced to follow, the angry crowds.  But history also teaches us that such crowd-pleasing games, just like feeding a few Christians to lions, only obscure current problems and defer their resolution.

Ironically, those same historical facts described in your article could have been used to present a much broader set of recommendations.  Rather than adding fuel to the fire (focusing on the lack of justification for retention bonuses), you could have called for a radical restructuring of the financial services industry and its compensation practices.

After all, even if we claw back the $165M (or even the $218M reported by Reuters today), the economy will still be in shambles and the mind set among the leaders of financial services establishments will not be much changed.  On the other hand, if we can muster as much bi-partisanship into congressional work on budget, economy rescue plans, financial services regulations, etc. as we witnessed on the “bonus tax” proposal, we could be a step closer to the real solution.

I think there are two separate issues. On the first issue, I agree completely with Andrzej, and in large part with Bremmer and Nocera. I began my first post on this topic with these words: “$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another.” I agree that the bonuses have an insignificant direct economic impact. I also agree that the furor that erupted over the bonuses has made it harder to solve our big problems. Not only have the president, his economic team, and Congress been distracted by Bonusgate, but the public backlash will make it much harder for the administration to get money from Congress when they do need it – not only as the economy deteriorates, but even when it comes time for things like health care and education.

At the same time, let’s not forget that Bonusgate has also had some positive effects. First, though small in itself, it strikingly illustrates a broader issue of tolerating business at usual in a failing financial sector. Scond, it has finally made the administration realize that there is a political cost to repeated generous bailouts of the financial sector.

The second issue is more complex. Bremmer and Nocera basically say, “calm down.” (Andrzej says something more subtle, which I will get to in a bit.) In Bremmer’s words, “if you are a subsistence worker, outrage is a luxury you cannot afford.” I’m not sure what this is supposed to mean. Outrage is an emotion, not a rational choice. Blaming outrage is like blaming greed: it’s an unavoidable part of the human condition. The question is whether we can do anything about it.

Bremmer, Nocera, and (to some extent) Andrzej blame our political leaders in Washington for indulging in populist bonus outrage instead of acting like responsible adults. But this raises an interesting question about the relationship between economic policy and democratic politics. I’m no expert on democracy, but I can make a couple of basic observations. We live under a democratic system. We want our elected officials to be sensitive to the concerns of their constituents. We don’t necessarily want them to do everything that a majority of people want – they are supposed, to some extent, to resist popular pressures and instead do what is in the public interest – but at the same time we get very upset when they seem to ignore popular opinion, or seem out of touch with popular opinion. When that happens, an administration can lose popular legitimacy, and without popular legitimacy, it will find it very difficult to get Congress to cooperate.

This is the risk the Obama administration now faces, as eloquently described by Frank Rich. Even if the administration officials believe that Bonusgate is a distracting sideshow – as they probably do – they cannot simply ignore, or belittle, the concerns of Main Street; if they do that, they lose whatever ability they have to solve our “real problems.” I think that the last administration was at fault for not dealing with the bonus issue back in September, and the new administration is at fault for not dealing it when it learned about it. But that’s water under the bridge, and Washington has to meet the public partway. And I think that is what Obama was trying to do.

This is not a country where technocrat-economists can design perfect policy solutions and implement them without regard for public opinion, nor would we want it to be. As I said in a recent post, I have made the mistake of thinking that an ideal solution could be imposed without taking proper consideration of the political difficulties involved. In the country we have, the ability of the government to implement the “right” policy solutions depends instead on its popular legitimacy, which means at a minimum feeling the public’s pain.

Now, Andrzej raised a slightly different issue: whether I (and, by extension, the many commentators who piled onto this issue) am at fault for helping to stoke bonus outrage. President Obama has to be sensitive to popular opinion; I don’t. In my case, Simon and I wrote an article trying to debunk one of the arguments for the AIG bonuses. We wrote it first because we believed what it said, and second because we thought its relevance went beyond AIG, since it dealt with the broader question of whether failed institutions can hold up reform by insisting that only they can fix the problems they created. So the question is whether we should have published it or not. (I agree with Andrzej that a better outcome of Bonusgate would be a systemic fix for flawed incentives in the financial industry. But publishing the article you most want to write, for reasons I won’t get into here, usually isn’t an option, unless you have your own column.)

Perhaps from a narrow utilitarian perspective one could argue that the article did more harm than good, because it contributed to the outrage that is making it harder for the administration to get real work done. From a broader perspective, however, one could argue that the value of the free exchange of ideas outweighs the short-term costs generated by the article. Of course, there is no way of quantifying and weighing these costs and benefits. And in any case they are probably relatively small either way; I don’t want to make the mistake of exaggerating my own importance.

In summary, I agree that Bonusgate has had some negative consequences (along with its positive ones), but I’m still comfortable with my small contribution to it. If we were much, much bigger, then perhaps I would pay closer attention to the potential consequences of what I write. But for now I’m willing to write pretty much anything I believe to be true.

Now, the government has not explicitly guaranteed AIG’s liabilities. But the main reason for bailing out AIG in the first place was the fear that an uncontrolled failure would have ripple effects that would take down many other financial institutions who were dependent in some way on AIG; most commonly, they had bought insurance, in the form of credit default swaps, from AIG and were counting on being paid. And a major usage of bailout money has been to make whole AIG’s counterparties holding those credit default swaps, primarily investment banks trading on their own account or on behalf of their hedge fund customers.

I still think it was a mistake to let Lehman fail, because of the sudden panic it created. But we are in a very different situation today. Many people now believe that the government may decide to let bank creditors lose some of their money. As Bebchuk says, instead of continually giving AIG taxpayer money that is effectively used to bail out other banks (many of which are in Europe, allowing European governments to free ride on the U.S.), the government could let AIG fail and bail out those other banks directly, thereby at least getting increased ownership stakes in return. Bebchuck also explains that AIG’s insurance subsidiaries would not become insolvent if the AIG holding company went bankrupt, because they have their own reserves. (Insurance operations are regulated on a state-by-state basis, and state regulators establish reserve requirements for insurers.)  Furthermore, he argues, failure is not an all-or-nothing proposition:

For example, the government could place AIG in Chapter 11, but commit to provide supplemental coverage that would make up any difference between the value that creditors would get from AIG’S reorganization and, say, an 80% recovery. Such an approach could allow setting different haircuts for different classes of creditors.

I think that the government could let AIG fail, if – and this is a big if – it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors (not to mention employees – bankruptcy would settle this whole question of whether the bonus contracts are legally binding once and for all).

There was clearly no time to do this between September 15 and September 16. But the government by now has had six months to study the books of AIG and its major domestic counterparties. People are no longer willing to take it on faith that the future of the free world depends on an implicit blanket guarantee for AIG. At least we want to see some evidence.

Update: Matthew Yglesias puts it very well.

I, for one, don’t think that “saving” the too-big-to-fail financial institutions is or was among the legitimate purposes of our financial policy. The idea is—or at least ought to be—that we’re trying to prevent them from failing in a way that causes everyone else’s business to go under.

(Yglesias also has just given me a massive insecurity complex, since he’s written nine posts so far today. I also liked this one.)

Update 2: I wish I had read James Hamilton earlier. Here’s the bottom line:

I accept the argument that a complete failure of AIG would have unacceptable consequences. The relevant question then is, what combination of parties is going to absorb the loss?

The concern I wish to raise is that any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Societe Generale, and Calyon, to pick a few names at random, as major contributors to this particular collateral-damage-minimization relief fund. But if they are to contribute, the plan must be something other than doling out another $100 billion every few months to try to keep the operation going a little longer, but instead requires seizing this bull by the horns. Split AIG into a core business we want to protect– with enough equity to be a viable operation, and a hefty fraction of the existing management team fired– and a derivatives business that’s going to be systematically liquidated in large part by abrogation of outstanding contracts.

By James Kwak

The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.

• The bonus contracts – which have still not been released to the public – reflect the instinct of Wall Street to favor its employees over any other stakeholders. In the companies I worked at, it was common practice that all bonus plans were contingent on overall company performance: if the company had no money, you didn’t get any, either. Even our commission plans for sales people included the caveat that the plan could be changed by the CEO at any time for any reason. The fact that AIG did not similarly protect itself shows the Wall Street habit of putting itself first, or a failure to recognize the possibility of a bad year, or, most likely, both.
• The failure of the Treasury Department and the Federal Reserve to review and renegotiate the bonus plans as a condition of federal assistance last fall – despite the fact that the plans had been public knowledge since May – reflects the rushed, ad hoc nature of the deals that were struck. Or it reflects the understanding in Washington that the ways of Wall Street had to be respected. Or, again, both. And the failure to even say anything about the bonus plans since the initial bailout – even just to get ahead of the obvious public relations fiasco – reflects an overall strategy that amounts to hoping that problems will go away.
• The seeming inability of the government to do anything but throw up its hands reflects the failed strategy of the bailouts so far: provide as much cash as needed, but do everything you can to minimize the impact on the companies being bailed out. The fact that this is happening at AIG – the one the government has owned 80% of since September – shows that any “nationalization” so far has been a red herring. In a bankruptcy, or a government conservatorship, employees and other creditors would not have a legal right to all of their money. In the current situation, by contrast, AIG management can choose whom it wants to make whole, which is what makes self-dealing and other sweetheart deals possible. In this context, $165 million in employee bonuses pales against tens of billions of dollars of collateral provided to counterparties – beginning with Goldman Sachs. Yes, this was to cover open trading positions. But if AIG had gone bankrupt or had been taken over, it’s not clear that Goldman would have been first in line.
• The testaments to “the best and the brightest” – here, referring to the people of AIG Financial Products – reflect, I don’t know, either absolute, brazen obscenity, or a world-historical example of making the mistake of believing your own hype. The fact that people on Wall Street believe that they are the best among us is bad enough. The fact that people in Washington are willing to accept it is worse.

However, this scandal may yet serve a purpose. One characteristic of both administrations’ responses to the crisis has been to devise subsidies for the financial sector that are too complicated for even conscientious readers to make out, such as the asset guarantees for Citigroup and Bank of America, or the preferred-to-common conversion for Citigroup. Employee bonuses, by contrast, are strikingly easy to understand.

The key issues throughout this crisis have been political as much as economic. In this case, the Obama administration has been taking a difficult political position – propping up financial institutions in their current form and insisting everything will be OK – when it would have been easier to play the populist card. This was by no means an inescapable choice; according to news reports in February, David Axelrod and Rahm Emmanuel were in favor of being tougher on the banks. Perhaps the AIG bonus scandal will force the administration’s hand toward the decisive action that we need.

In fall 1997, a key issue for Indonesia’s IMF program was whether the government could close the banking operations belonging to one of President Suharto’s sons.  There was an epic and fascinating struggle and, in the end, the government did not have sufficient political will or power.  The subsequent loss of US support, and further currency and economic collapse is (messy and painful for many) history.

It is striking that Ben Bernanke now asks whether the United States today has sufficient political will.

How did we get to the point where the U.S., with a strong balance sheet relative to the size of problem banks, is regarded – by the markets and more broadly – as less likely to resolve the problems in its financial system than say the British (with big banks relative to a weak fiscal position) or the Germans (who talk all the time about how they are not going to bail anyone out)?

You can point the finger at Congress.  The parliamentary system in Britain and Germany means that the government can implement and innovate a bailout policy without worrying about being able to legislate enough financial support.  The Obama Administration has much to worry about in this regard.

The problem surely goes deeper – at least back to the bailouts of the fall.  Poor communication, particularly by Hank Paulson, undermined popular and congressional support.  And the lack of a consistent strategy exacerbated initially negative perceptions.

But the underlying issues are deeper still and laid bare by this week’s latest round with AIG.  We have moved far beyond financial policy and into the kind of scandal that really gets taxpayers’ backs up.  The greed of bankers slaps you in the face while the hubris of their leadership remains unchecked. 

There is no sense of responsibility, no feeling of shame, no acknowledgment of any kind of mistake: read Lloyd Blankfein’s FT article again – or print it out and tape it to your wall.  Because we now know, from the newly disclosed AIG counterparties list, that the wealth of Goldman Sachs insiders remains high solely because we saved their sorry bank, their failed risk management strategy, and their pretence of wisdom with our cash in mid-September.

This resentment against bankers pervades Congress, and even the Administration begins to get the message – being called “asinine” yesterday by Richard Kovacevich, the Chairman of Wells Fargo, may have helped underline to Treasury how deeply the bankers appreciate the help they have received.  There can be no resolution and no moving on until there has been a proper congressional investigation, with full subpoena powers, into exactly what did and did not happen around AIG.  This will take months and may well slow down the economy (Jamie Dimon’s clever point: if you vilify us, you will lose), but it is now inescapable.  And, if channeled productively, this kind of hearing may lead to a better regulatory system (and smaller big banks) than the current anemic proposals on the table - as last weekend indicated, the G20 process is currently worse than useless on this issue.

Ben Bernanke knows all this, at the same time as he sees our economy worsening and global storm clouds still gathering.  So where will he take us, starting with the Federal Open Market Committee meeting this week?  The British experiment with quantitative easing is pushing down the yield on long government debt.  It’s risky - inflation, once started, is not so easy to control.  And it may not work so well in the US (where the dollar tends to appreciate as the world becomes more scary) as in the UK (where they can successfully push for depreciation, particularly vis-a-vis the hidebound eurozone). 

Inflation breaks the political and social logjam around banking.  With some luck, it helps growth – at least in the short-term.  And of course the surviving bankers win big.

[Scott] Polakoff [acting director of the Office of Thrift Supervision] acknowledged that his agency technically was charged with overseeing AIG and its troublesome Financial Products unit. AIG bought a savings and loan in 1999, and subsequently was able to select the OTS its primary regulator. But that left the small agency with the enormous job of overseeing a sprawling company that operated in 130 countries.

Is there another side to this story or is it really as simple as that?

Update: ProPublica had a good story on this back in November. Here’s one short excerpt:

Examiners mostly concurred with the company’s repeated assurances that any risk in the swaps portfolio was manageable. They went along in part because of AIG’s huge capital base . . . and because securities underlying the swaps had top credit ratings.

I have to admit I don’t fully understand the ongoing AIG bailout saga, so I thought I would do a little research to try to figure out what is going on. I thought I would just look up all the term sheets, but I found it’s harder to get that kind of information from the Federal Reserve web site than from the Treasury web site. For example, the original September 16 press release doesn’t say what the terms of the 79.9% equity interest are, and I still haven’t been able to figure that out. If you know the details, let me know and I’ll update this post. In any case, I think this is the best single-page overview you’ll find on the web.

September 16: The Federal Reserve gave AIG an $85 billion line of credit for 2 years at a very high interest rate – 3-month LIBOR (an interbank lending rate, which is generally pretty low) plus 8.5 percentage points on the full amount (whether or not it was drawn down). In exchange, the government (not sure which entity) got warrants on 79.9% of AIG stock – I don’t know what the price was, or if they were ever exercised.

October 8: By early October, AIG had already drawn down over $60 billion of its credit line. The Federal Reserve authorized the New York Fed to “borrow” up to $37.8 billion in illiquid securities from AIG and give it “cash collateral” (I think that means “cash”) in return. The problem was that AIG had lent some securities (call them A) to counterparties in exchange for cash or other collateral (call that B), and had then used B to buy some other securities (C) that had lost value. So when the counterparty wanted to return A and get B back, AIG couldn’t give them B back, because the money was tied up in C. So the New York Fed agreed to take C and give AIG cash so AIG could close out its trade – meaning the Fed effectively got stuck with the risk.

November 10: This time the Fed and Treasury got together.

• Treasury invested $40 billion of TARP money in AIG for preferred stock paying a 10% dividend. Treasury also got warrants with an exercise price of $2.50 on 2% of AIG’s outstanding common stock (although I don’t know how this relates to the original warrants on 79.9% of the common stock.)
• Some of that $40 billion was used to pay back the line of credit, which was reduced from $85 billion to $60 billion. The interest rate was reduced from LIBOR + 8.5 percentage points to LIBOR + 3 percentage points (a huge reduction), and the term was extended from 2 years to 5 years.
• The New York Fed created a new entity called AIG RMBS LLC with $1 billion from AIG and a $19.8 billion loan from the Fed. That $20.8 billion was used to buy residential mortgage-backed securities from AIG. Those securities had a face value of $40 billion but a “fair value” of $20.8 billion, or 52 cents on the dollar. (I wonder what those RMBS were on the books at prior to the sale.) The purpose here was simply to relieve AIG of some toxic assets and minimize its losses on them. Interest on those securities and proceeds from sale will pay back the loan to the Fed, meaning that AIG will take the first $1 billion in losses and the Fed anything else. The $20.8 billion paid to AIG (to buy the securities) was paid back to the New York Fed to retire the lending/borrowing facility created on October 8.
• The New York Fed created another entity called AIG CDO LLC with $5 billion from AIG and a loan of up to $30 billion from the Fed. The purpose of this entity was to buy CDOs from third parties who had purchased “insurance” (credit default swaps) from AIG. Since AIG’s biggest exposure was the possibility of having to pay out on this insurance, the idea was to buy up the assets (CDOs, in this case) that had been insured and require the third party to close the CDS contract. (Imagine AIG had underpriced insurance for houses on the Gulf Coast, and the government was buying the houses in order to cancel the insurance contracts.) According to the Fed web site, it looks like this entity has spent $20.1 billion to buy up CDOs with an aggregate face value of $53.5 billion – 38 cents on the dollar – but I’m not certain I’m reading that correctly. If those CDOs lose value, AIG bears the first $5 billion in losses, and the Fed bears the rest.

So as of November AIG had a $40 billion preferred stock injection and a $60 billion credit line. AIG had also put $6 billion into two new entities which could borrow up to $50 billion from the Fed and use the total funds to buy toxic assets: some from AIG (and I have no idea if we overpaid for those or not) and some from third parties.

March 2 (updated 3/2 7:30 am): The announcements are out.

• The $40 billion in preferred shares that Treasury got in November are being exchanged for $40 billion in preferred shares that are on better terms for AIG. There’s no way to get around this point. It’s the Series D to Series E conversion on the term sheet. The new preferred shares pay a “non-cumulative” dividend, which means they basically pay no dividend. More specifically, they only pay a dividend if AIG decides to pay the dividend. And they are non-cumulative, meaning that if AIG skips a dividend payment, they never have to pay it. (With a cumulative dividend, if you skip one payment, it gets added onto the next one.) The only condition is that if AIG skips the dividend for eight quarters in a row, Treasury can appoint some members of the board of directors.
• In addition, Treasury is providing up to $30 billion more in cash in exchange for more preferred shares on yet different terms. That’s the Series F on the term sheet. I don’t see anything about dividends, so this is basically an interest-free five-year loan.
• The terms on the credit line will be improved by reducing the floor on the interest rate (previously 6.5%). In addition, the credit line will be reduced by up to $34.5 billion, according to the two following provisions.
• Two life insurance subsidiaries will be put into separate trusts. After AIG and the New York Fed agree on the valuations of those subsidiaries, the Fed will buy up to $26 billion in preferred stock in these trusts. That money will be used to pay down the credit line.
• AIG will create new entities that own the rights to the cash flows from certain blocks of life insurance policies. The New York Fed will loan these entities $8.5 billion, which AIG will turn around and use to pay down the credit line. The $8.5 billion will be paid back (or not) by the new entities from the life insurance cash flows. (In other words, AIG is securitizing the life insurance policies and the Fed is buying the securities for $8.5 billion.)
• AIG is issuing convertible preferred stock equivalent to a 77.9% ownership share to Treasury. This looks like Treasury is exercising the rights it got under the original loan agreement. The terms of the convertible preferred stock were not released as far as I can tell, but we can probably assume there are no dividends.

In summary: AIG gets better terms on the first $40 billion in preferred stock; AIG gets $30 billion more in cash in exchange for new preferred stock on even better terms; and the credit line gets reduced by giving Treasury some assets (that AIG was presumably unable to sell on the open market). The overall effect is to reduce AIG’s debt burden and shift more risk to the taxpayer. Whether the taxpayer got a good price for taking on that risk is far too complicated for anyone to figure out from just reading a term sheet, since it depends on the nature of the assets.

I know that AIG is different in many respects from the banks that everyone is worried about. In particular, AIG was a net seller of CDS protection, while most banks are (should have been?) net buyers of protection. But one thing still scares me. When the weekend of September 13-14 began, AIG said it needed $40 billion. After digging through the books, Goldman and JPMorgan put the price tag at $75 billion, and declined to put together a consortium to lend the money. The Fed lent $85 billion, thinking that would be enough. Almost six months later, we still don’t know the extent of the damage.

Update: I rewrote the March 2 section.

Update 2: Does anyone else find it strange that, less than one week after announcing that future capital will be given to banks in the form of convertible preferred shares with a 10% dividend, Treasury has already issued preferred stock on three different sets of terms (one to Citigroup and two to AIG), none of which are consistent with last week’s announcement? Also, with the AIG Series E and F, we have reached a new high (or low) of generosity, with a noncumulative dividend in one case and no dividend in the other. Of course, this is a company we already “own” – we control most of the equity, and we have implicitly guaranteed the debt – so maybe none of these terms really matter.

Until now.

Today’s government re-re-bailout of AIG (WSJ article; Yves Smith commentary) can be hard to follow, but one provision is the creation of a new entity with $5 billion from AIG and $30 billion from the government to buy collateralized debt obligations (CDOs). The goal is to buy CDOs that AIG insured (using credit default swaps), because if those CDOs are held by an entity that is friendly to AIG, that entity will no longer demand collateral from AIG. The theory is that in the long run these CDOs will not default and that the new entity will make money on the deal.

The rub is that this entity is planning to pay 50 cents on the dollar for these CDOs. This has two problems. First, 50 cents is almost certainly more than these CDOs are worth on their own (hence the title of this post). If they were really worth 50 cents on the dollar, AIG wouldn’t be having the problems it is having posting collateral; like the original TARP plan, this is an unfounded bet that the market is mispricing these assets. Second, and more bafflingly, the CDS contract is presumably separate from the ownership of the CDO; that is, buying the CDO from the counterparty doesn’t eliminate AIG’s obligation to pay if the CDO defaults, and hence doesn’t serve its stated purpose. If, on the contrary, the CDS contract is contingent on the counterparty holding the CDO, then the CDO is worth a lot more than 50 cents to the counterparty, because it is insured for 100 cents by AIG – and we all know the government isn’t going to let AIG default on those swaps. And no sane counterparty would sell for 50 cents.

Supposedly Treasury had enough time to think about how AIG should be bailed out and this is a better bailout than the original. If it is, I must be missing something.