Why Bail Out AIG’s Creditors?

Simon and I wrote on op-ed in the New York Times today, trying to debunk the idea that, as we put it, “A.I.G.’s traders are the people that we must depend on to save the United States economy.” The AIG bonus fiasco, as I’ve written earlier, has been particularly useful in raising the political cost of the administration’s current bailout strategy. But, as I said then, “$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.” And as far as the cost to the taxpayer is concerned, the big bill is for bailing out AIG’s creditors. In his op-ed in the Wall Street Journal today, Lucian Bebchuk wants to know why.

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

48 thoughts on “Why Bail Out AIG’s Creditors?

  1. I think you folks are missing the point here.

    Over the last few decades, those with financial and legal expertise were allowed to rewrite the bankruptcy laws relating to derivatives. The result is that derivative counterparties are senior to other creditors. To be more accurate (i) derivative counterparties have the right (but not I believe the obligation) to terminate contracts upon bankruptcy and (ii) those counterparties who hold collateral have the right to foreclose on it — the value of the contract (if terminated) gets frozen at the date of bankruptcy and counterparties become unsecured creditors for any non-collateralized value.

    (i) means that the financial institution will be stripped of its hedges — probably selectively in a manner that minimizes their value — and this will devastate the value of the assets on the balance sheet. (ii) means that the bankrupt financial institution can not get any collateral back, even if the value of the contract moves in a favorable direction, but also that the financial institution doesn’t need to post any more collateral.

    A few additional notes: Even FDIC resolution cannot stop this process. This process can be triggered by many things less than bankruptcy such as: government ownership of 80% of a company, receivership, conservatorship, possibly the breach of other contracts.

    In short, we now have a bankruptcy system where the assets of a bankrupt LFCI belong to other LFCIs and bond-holders have claim only to Lehman-like remains. It is this realization that has devastated the bond and commercial paper markets. I suspect they will not recover (absent an implicit ongoing government guarantee) until the super senior status of over the counter derivative counterparties is revoked.

    In short, you need to explain why you think there will be more than say 10% of the value of the assets left on the balance sheet to distribute in a prepack bankruptcy if such a bankruptcy is allowed to happen.

  2. AIG is the lynchpin of this whole mess. No wonder the banks don’t want to unload so-called toxic assets. If you had a reasonable expectation of getting paid out at par on this stuff (the Feds keep on paying!) because its insured by AIG, WOULD YOU SELL??? HELL NO!

    The sooner we haircut anybody with a CDS issued by AIG, the quicker we’ll be on our way out of this mess.

  3. Something that I’ve been pondering for a bit now with AIG and its CDSes, is that for those who purchased a CDS on a bond they didn’t hold their risk of failure as a result of non-payment on a CDS seems to be pretty small.

    That is to say, their only stake in the game are the fees they paid to AIG for issuing the CDS. Why not refund the fees plus interest and be done with that group of creditors?

    I suppose a CDS owner might have used that as collateral for other loans that may get called if the underlying CDS isn’t honored by AIG and thus create the feared chaos.

    Though, certainly by now, at six months in, we should have some idea as to what these downstream obligations are, and as you suggest, bailout those on a more selective basis.

  4. I’m actually curious about AIG’s foreign creditors and counterparties (as well as the debt-holders of other American financial institutions that are allegedly TBTF).

    You have been promoting the kind of re-organization that would have some of the creditors and counterparties of “private” US financial institutions lose (some of) their capital.
    I’m wondering what would be the geo-political implications if such a move: will it start a war with China? Would it send the entire eurozone spiraling down? A revolution in Saudi-Arabia?

    We heard the Chinese finance minister saying something like “we expect the Americans to make sure our investments retain their value”, suggesting that someone else should take the fall for the risk inherent in their investments…

  5. How can the USG own 80% of the company and NOT run it? I’d rather let a judge decide which creditors to reimburse than Tim Geitner. Just watch–when he is forced to resign from the government, he’ll land on Wall Street making big bucks, enough to hire an expert to do his taxes.

  6. How can the government pour new equity into AIG and insist that AIG not honor employment contracts with its employees? That is theft. Tens of billions to foreign banks and Goldman Sachs for collateral payments and a small fraction of that in deferred compensation. Bailout AIG and AIG meets its contractual obligations. That’s what bailout means.

    It would have been better to bailout AIG’s counter-parties directly when and if it became clear that this was in the interest of the American people. Paulson/Bernanke/Geithner bailed out AIG under Bush. Obama supported it then and has continued this disastrous policy. The scandal is not the $160M in bonuses it is the $170B thrown down a rathole.

  7. I have a very important question to ask:

    Why does James Kwak’s byline not mention anything about founding Guidewire Software as if being a Yale law student was more reputable?!

  8. The following is penny wise, pound foolish.

    “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.” – Kwak

    Seriously do we really think the government and AIG can under take the assessment effort without anyone leaking. When the leak happens, do we really think the market will discriminate between the strong banks from the weak? I expect if we stir this thing up again, LIBOR, TED spread, and etc. will be on the news regularly again. On a side note, aren’t we already pot commited as they say in poker anyway?

    Let’s focus on tackling the global financial crisis. The saving from optimizing the handling of AIG pales in comparison to the cost of the distraction this effort will create and the additional prolong suffering the world will have enduring.

  9. I think Anonymous, above, is missing the point. The point is: what is the evidence that forcing losses on creditors will cause a world financial catastrophe?





  12. You mention about the insurance companies not being at risk due to their reserves.

    Here is an FYI … from the article wherein AIG was allowed to tap the reserves of its subsidiary insurance companies to the tune of $20 Billion dollars on September 15th.

    The talks between A.I.G. and its regulators led to the announcement at midday by Gov. David A. Paterson of New York that the state would allow A.I.G. to borrow $20 billion from its own subsidiaries, to help bolster its capital in the face of potentially disastrous credit downgrades.

    Mr. Paterson said he had authorized the state insurance superintendent, Eric R. Dinallo, to include the $20 billion asset transfer in the broader plan being worked out at the New York Fed.

    Normally state insurance regulations would prevent a holding company like A.I.G. from pulling assets out of its subsidiaries, which are insurance companies that need sufficient liquid resources to pay their claims.

  13. For anonymous at the start. You should read up on the FDIC Act and the order of precedence of claims. The government gets first crack at all money owed to it, then the depositors and then after that are the senior creditors and derivatives. Any and all assets pledged as collateral are frozen and subject to the prioritization above. Finally, the FDIC Act provides for the ability to not honor any obligation that would be contrary to public policy. That vague statement provides a great deal of latitude.

    No matter, there is absolutely no situation where any creditor of any kind will come before the depositors when disposing of an insolvent financial institution.

    We would never survive the run on the banks that would ensue instantly upon the first occurrence of that happening.

  14. “..aren’t we already pot commit(t)ed…”?

    I think I speak for many taxpayers when I say: F*** the pot. Let AIG tank.

  15. Would you feel this way if it increase the likelihood that more businesses will fail and more jobs (including yours) will be lost as a consequence?

    I share your emotional feeling toward AIG. However, I can’t agree with risk making a terrible situation much worse for a lot more people.

    Let’s put out the fire first.

  16. We are in a really difficult situation…most of us have been “bred” to believe that US monitary policy can “save the world”. Unfortunately, that is a dangerous falacy, and on top of that, by the fact that “we the people” have been hell bent on not giving up that falacy (delusion) we have allowed really what may prove to be OUTRIGHT crimes against our country by the self-dealing that may have taken place all in the name of “SAVING THE WORLD” !

    It takes alot to wake up the collective conscious of a nation–while a crime on the order of several trillion dollars may have been committed against our country by the looting of US coffers (all in the name of “saving the world”) , it may be that the stolen money was most essential at this time in our history because for a generation, capital market cycles have brought us to a point where ALL CAPITAL MARKETS are correcting to a ‘real level”. And if this correction takes place (which i believe it will happen regardless of anyone who thinks that the our country’s monitary policy or anything eles can prevent) the DOW will have to be between 2000-3000 in order to be at a “right” place.

    Nothing can prevent this from happening, but not having several trillion dollars of US goodwill going to bulk up the chances of certain banks staying alive (self-dealing and a crime against our country), since as we probably already know, many banks were dead or on the way to the grave since the fall of 2007!

    All i am trying to say here is that if there is any way that all of the rest of the scams and subterfuge attempts (public/private partnerships, backstopping banks without taking them into recievership, and every penny that went to AIG without it being in receivership) can come to a hault, and our legeslature goes after the black hole promoters (everything in parentheses), it will go a long way to shore up any bit of good will that is left in the US DOLLAR and any little hope that all of us can keep in our hearts!!!

  17. Bart, good question that many people wonder about.

    the reason is that the government does not own a controlling interest in the voting stock of AIG. Therefore, it can’t directly run AIG.

  18. Whether or not this solution would work, I appreciate the excellent information that I’ve not seen before.

  19. I suspect my initial comment came across as more critical than I meant it to be. I am very much in support of your goals — I’m just not sure that it is possible to achieve them without some revision to current bankruptcy laws.

    Allowing AIG (and its ilk) to fail under the current bankruptcy regime might actually benefit the very creditors you think need a haircut.

  20. I completely agree with the thought stream of letting AIG go to bankruptcy court and have a judge determine in what order and how much creditors of AIG should get paid. However, I can not shake my microeconomics view of this whole financial mess. As AIG failed and banks started failing and the whole credit mess crumbled upon itself, wouldn’t prices and markets correct themselves at the bottom end?

    I guess what I am thinking is that it seems that too many people at the leadership level are worried about protecting the housing market and keeping credit flowing and not concerning themselves with the interest of the people. If these financial institutions were allowed to fail, and as people could no longer get credit and became unemployed and people became less able to buy products, wouldn’t the price of everything from electronics to food drop. Wouldn’t that lead to more capital being freed up by the people who are still employed leading to an increase in demand? An old southern coworker of mine once told me, “Never try to remove a rattle snake from your house by grabbing him by the tail. He will just reach back around and bite you.”

    It is amazing to me how many people are outraged by AIG’s payout of these “retentions” and not even blinking at the fact that Wal-mart pays its CEO’s million in compensation while paying their cashiers so poorly that many have to rely on government programs to get healthcare. This is all done while our trade deficits are expanding at an alarming rate.

  21. I wish I could have hope like you for an investigation that leads to prosecution, but after the last 8 years of war profiteering and looting of the treasury (not to mention other countries treasury by the previous administration via Halliburton KBand R and Big Oil and our young men and women in the armed forces), or the outright murderous policies and criminalities (lying about intelligence, torturing, outing CIA agents, firing US attorneys for political reasons, killing hundreds of thousands of innocent civilians and countless other easily provable crimes) I don’t see any kind of justice being meted out over bankers who got a little crazy with the math. If it hasn’t happened by now. .if enough people weren’t shocked and outraged enough to storm DC for those crimes–EIGHT STEADY YEARS OF THEM — then how can I expect this to be any different?

    Oh, because it has hit our personal bank accounts. . . Well, that changes everything. .

    How pathetic have we become? How can we ever redeem ourselves?

  22. TO: Dwight from Cleveland

    Take a look at this article: http://www.twincities.com/allheadlines/ci_11722986

    To recap for you, the CEO of US Bankcorp admitted to a crowd something that he was sworn to secrecy about when given the TARP 1 money. Basically, all of the press and hype you heard about Fed/Treas “needing” to “INFUSE” the TARP money to the banks to keep money flowing for lending was just a front to a SHOCKING AND SINISTER REALITY that the TARP was a front for passing money to the elite top “toobigtofail” to”savetheworld” banks when really, when several would have already failed if it hadn’t been for the bizarre “letting lehman fail b—sh–” and subsequent money train that flowed from the treasury in the front door of AIG and out the back to these entities, their affiliates and their subsidiaries. No articles have yet wrapped their articulations around the idea that this crime is even bigger than we see today when you include all the affiliates and subsidiaries on the list of parties given money by AIG.

    It is not about the bonuses, the BONUSES just jarred the public by looking at the “bonus tip of the iceberg” scheme that was accomplished by “letting” lehman fail and “giving” AIG money instead of taking them into receivership…..

    I wonder when the justice department will officially work on calling in the guilty parties?

  23. PS the USBancorp CEO admits in the article that the money was for acquiring smaller firms but he was instructed by the party passing out the money (guess who) that he should tell the public that the money was for lending…I wonder why this didn’t get press? I answer my own question by knowing that it is because this scandal is too big for the psyche of our country to fathom. As i said earlier, we were all so bred to believe that our US monitary policy could “save the world” that we cant fathom that instead of saving the world, this policy was used for what alledgedly may be self dealing. The public/private partnership looks like another chapter in this scandal!

  24. Beyond the relationships damaged by such a massive failure, what are the legal implications of bankruptcies crossing different jurisdictions? Do creditors of solvent subsidiaries have precedence over creditors of insolvent foreign holding companies?

    Doesn’t such a massive internation bankruptcy beg for individual national stakeholders to alter local laws and or nationalize subsidiary AIG units if the local political leadership feels the U.S. courts are haircutting the wrong creditors?

    What precendents do we have for such a mess?

  25. I really like the main article — certainly not the circumstance that prompted it. I listened to all of the AIG testamony to the House Finance Committee. I really feel sorry for him, although I don’t believe that his only reward for trying to do the impossible is only one dollar. Get real. Going the blog logic, he’s probably been given some amazing promises by some of the “counterparties” to see that the government funds the winddown.

    All of that aside, the Fed and Treasury should have staff actually in AIG monitoring every bit of the daily operations of the FP section, and should definitely demand a list of all counterparties who are “indirect” recipients of the bailout proceeds. As I believe, if we follow the money, we will know much better the “conspiritors” in maintaining the oligarchy’s present grip. I hope that Bernanke and Geithner are not involved in the back end at all, but we’ll never know without looking, and circumstances will remain suspicious until we know for sure.

    If we think that the paltry (less than 1/10 of 1%) are upsetting, just imagine the repercussions of complicity in a broader fraudulent conspiricy (by the way, it could be effectively perpetrated by Bernanke’s and Geithner’s staff members without either’s involvement or knowledge).

    I have really wondered all along that we could let all of the weak instituitons fail and do our best to pick up the pieces. The actual price could easily be less.

  26. I can understand why the US tax payer may be pissed off that Deutsche Bank and many other foreign entities were the biggest beneficiaries of the AIG bailout.

    But the idea that the US tax payers can select to bail out only the domestic counterparties of LCFIs, or bail them in a way that lets domestic counterparties get lot less of a haircut without inviting foreign retaliation is unrealistic.

    If foreigners get too riled they will retaliate by nationalizing US assets in their jurisdictions. If this gets out of hand the effect this would have on the global economy would likely be similar to the effect of 1930’s vintage protectionism.

  27. alittlehopeinmyheart,

    The link didn’t lead to the story, but rather a blank comment page. I get the basic idea by your description though. It does seem that many in leadership, even when their intentions are good, still suffer from a belief that their in a postion that is “holier then thou”. Nobody seems to be asking the tough question, let alone answering them with reality based relational answers.

    Listening to the Republican representatives argue with the Democratic representatives about how to “bail out” our sinking economy is like listening to the captain and the first mate of the Titanic argue weather they should use smaller buckets allowing more and faster trips or bigger buckets holding more water.

  28. A.I.G. – The RipOff of American Taxpayers Continues, while the Mainstream Media Barks Up the Wrong Tree

    US taxpayers should not be held liable for AIG’s debts – especially its debts to those who purchased credit default swaps from AIG.

    Instead of simply paying off the CDS holders, why doesn’t the US government offer to purchase their stock instead?

    Why hasn’t the mainstream media examined alternatives such as the purchase of counterparty stock.

    Why does the mainstream media simply assume that the ONLY way to prevent a financial Armageddon is to pay off the credit default swap holders (such as Goldman Sachs) as if the US taxpayers owed the money to Goldman.

    And why hasnt’ the mainstream media been asking questions about Hank Paulson’s decision to bailout AIG by paying off his old company. It seems like this is a clear example of self dealing.

    But instead, what we hear from the mainstream media is a lot of hysteria about AIG’s bonuses. Isn’t it obvious that the bonus issue is a red herring?

    The mainstream media has not closely examined the claim that US taxpayers had to “pay off” those who had purchased credit default swaps from AIG (i.e. AIG’s counterparties).

    First, the US taxpayers were (and are) under no legal obligation to “pay off” the counterparties. It would have been (and would still be) perfectly legal for the US to let AIG go bankrupt.

    The mainstream media argued that IF the government let AIG go bankrupt, it would have led to some serious consequence.

    However, the mainstream media (and apparently the Treasury) did not consider alternative ways to “pay off” those who purchased CDS from AIG.

    The assumption was that US taxpayers had to step in and simply cover AIG’s debts.

    But there were many alternatives. For example, the government could (and still can) tell the counterparties to jump in the lake (i.e. we could still just let AIG fail).

    But, to address the concerns of those who fear some financial Armageddon the US government could offer to purchase stock from the counterparties (e.g. Goldman) equivalent to the money they would otherwise have received from AIG.

    This idea (offering to support the counterparties by purchasing their stock) apparently did not occure the the Treasury secretary at the time, who just so happened to be – you guessed it, Hank Paulson, the former CEO of Goldman Sachs.

    Gosh, I wonder why Paulson wanted US taxpayers to pay off his old company in cash (as if they owed Goldman the money) instead of offering to purchase stock in Goldman? I just can’t figure it out. :-)

    And, I wonder why the mainstream media is so obsessed with the AIG bonuses, instead of the more obvioius large scale rippoff that continues to unfold as I write this.

  29. It takes more than a soundbite to explain the AIG scandal…AIG bonus issue is a no brainer.

    The only way the AIG scandal will be addressed by the media is if the Justice Department sets an investigation in motion. In an audit of Goldman was done using values from Sept 14th prior to Lehmans demise and the free money train that passed through AIG, it would be the defining truth of whether or not Lehman failing benefited Goldman (and all of it’s affiliates and subsidiaries) or not. It is CLEAR that NOT taking AIG into receivorship benefited Goldman, and i don’t understand either, why no one except a hand full of people around the country, even noticed what how unsavory (euphamism) the “Lehman/AIG/switchtobankholdingdompanies/and finally TARP 1 dole outs ” look until the bonus issue broke.

  30. There appears to be a fair amount of indirection (“smoke and mirrors”) regarding the true center of the credit default swaps crisis. Two important points:

    1. Robert Rubin, ex-employee of Goldman Sachs, assists Alan Greenspan in deflecting important regulation of derivatives. Citigroup’s balance sheet swells with CDS during his tenure.

    2. In the fall of 2008, Goldman Sachs becomes so desperate for cash that they pay Warren Buffet a guaranteed 10% /annum on a $5 billion cash investment.

    Goldman Sachs wasn’t making any money by underwriting IPOs during 2007-2008.They were orchestrating deals facilitated by elaborate swaps. AIG is proving to be the ashtray filled by other players. Congressional investigations should examine this series of deals.

  31. I wonder if there would be any comment on the article of March 18 (www.globalresearch.ca) by F. William Engdahl. It it titled “Getting Tough” with Predator Financial Institutions” in which he discusses AIG …
    and the Politics of Deflection”?URL of this article: http://www.globalresearch.ca/index.php?context=va&aid=12787

    In a discussion with economist Myron Scholes, he reports that Scholes says derivatives traded over the counter should be shut down completely. Speaking at York University Stern School of Business recently, he uoted Scholes as saying: “the solution is really to blow up or burn” the over-the-counter market and start over. He included derivatives on stocks, interest rate swaps and credit default swaps that should be then moved into regulated markets.

    The idea is simple and not that radical. A US law banning OTC derivatives and moving them to regulated exchanges would end a colossal ‘shadow banking’ fraud. Banks would not lose much more than already, but the world financial system would get back to ‘normal.’ OTC derivatives are unregulated precisely to hide risk and enable fraud by the banks. It is past time to end that. There is where the US Treasury and other Governments must focus, not on meaningless ‘transparency’ calls or trading bonus ‘justice.’

  32. In regard to my last post, there should be an open quote preceding the words leading the second para: The idea … apologies …

  33. Two more (anti-tunneling) suggestions to raise revenues and reduce the size of banks, insurers etc.

    1. Ban OTC derivatives trading and tax derivatives traded on exchanges. Very cheap to collect through existing institutions. Also enables better transparency.

    2. Require large financial institutions to be less leveraged than their smaller competitors.

    Note: Do it as fast as the 90% TARP compensation tax was done. Then, afterwards, sit down to discuss only the numbers and time frames with those involved.

  34. Why bail-outs at all. After all is America not the mantle holder the cheif cheerleader of Capitalism. And more importantly what does insurance have to with Capitalism. As investors you invest and through your investments you arrive at insurance one might say you diversify for example take positions in index funds per say.

    The bottom line here is this world has reached a pseudo Capital system for all now to stand witness for this has been going on for a very long time. I will call it the insured Capitalist HAHAHAAAA.

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