The AIG bailout is in the news again. At the time of the bailout, I argued that while it was necessary, the Fed should not have played the role in the bailout that it did. Some of the testimony at the current trial suggests that a reassessment of the reasons for those positions is in order. However, nothing revealed at the trial to date has changed my mind about three crucial points:
• The AIG family of companies was experiencing a liquidity crisis and a number of its subsidiaries were insolvent.
• A default by any of the subsidiaries would have had systemic repercussions.
• The bailout as structured was profoundly anti-democratic. The Fed took actions that, at a minimum badly bent both the law and its legal mandate and should be reserved for the Judicial, Legislative and Executive branches of government.
These points are fleshed out below and an alternative course of action that would have avoided some of the bailout’s shortcomings is offered.
AIG was in financial difficulty and not simply because of the CDS positions at the AIG Financial Products subsidiary, but also because of losses at insurance subsidiaries. Numerous insurance subsidiaries of AIG had borrowed money using assets as collateral. They then used the borrowed money to buy MBS. In short, they had leveraged up and purchased real estate-based assets in order to enhance their returns. However, the prices for MBSs started to decline in earnest with the problems at Bear Sterns, and losses ensued. As part of the bailout, the Fed ultimately had to loan AIG approximately $185 billion against collateral (MBSs). The face value of the collateral was well in excess of the $185 billion. This occurred when there was virtually no market for those securities and AIG’s market capitalization was less than $20 billion. Some of the insurance subsidiaries also received necessary direct capital infusions as part of the bailout.
Losses at AIG subsidiaries had implications not only for policyholders, but for other counterparties, including numerous pension and employer-sponsored savings plans that had invested in AIG-sponsored GICs (guaranteed investment contracts), as well as investment banks and other financial institutions.
The financial problems were compounded by contractual arrangements. As standard practice, many financial contracts contained cross default clauses. Cross default clauses imply that if a firm defaulted with one counterparty, all the firm’s other counterparties had the right to act as if the firm had defaulted on them. In short, if one AIG subsidiary defaulted with a counterparty, the other counterparties would have acted to seize collateral, suspend payments, and initiate legal actions before other counterparties had. Further complicating matters, numerous AIG subsidiaries had guaranteed each other. Consequently, insolvency or illiquidity at one subsidiary implied problems for the other subsidiaries that had guaranteed its liabilities. When a single default could have generated cascading market wide uncertainty, there would have likely been numerous defaults. This would have been in addition to the shock of the failure of a large financial institution that had been rated AAA just days before.
At the trial, it has been asserted that there were viable private bids for AIG. While it is possible that numerous parties had an interest in AIG or parts thereof, given the disagreement about the size of the losses at AIG (estimates ranged from $40 billion to almost $100 billion) as well as the complicated corporate structure and the cross guarantees, I cannot see a responsible entity making a firm non-contingent bid in anything like the time frame required-especially without some sort of a US government guarantee.
In short, a public sector-financed bailout was required because of the uncertainty and the market disruptions that defaults by AIG would have caused.
The financial crisis also precipitated a number of other non-bank bailouts. The structures of the bailouts of GM, Chrysler and both Fannie and Freddie are of relevance in assessing the AIG bailout. The structure of the bailouts of the automobile companies and the two GSEs were specified in legislation. The Fed played no role in the GM and Chrysler bailouts, and only a minor role in the Fannie and Freddie bailouts.
In the case of AIG, public money supplied by the Fed was used, but Congress played no role in setting the terms and conditions. Furthermore, Paulson has testified that he (and presumably Treasury) played no role in setting the terms of the bailout.
Given the Congressional involvement in the other bailouts, the use of public monies and de facto nationalization of a private company in the case of AIG, the absence of any Congressional role in setting the terms and conditions of the bailout raises red flags. Defenders of the Fed’s role in the AIG bailout have argued that the risk to the economy was too high and that Congress could not have acted quickly enough, however Congress was able to pass the legislation establishing the conservatorship for Fannie and Freddie in an expedited fashion.
What explains the difference between the GSE bailouts on the one hand and the AIG bailout on the other? While people will disagree, the most logical explanation is that it was politically advantageous for sitting Congressmen to enact bailouts for the GSEs (and the auto companies), while it would have been a political negative to support a bailout for AIG despite the probable systemic repercussions.
Hence the argument for the Fed’s involvement in the AIG bailout is based on the premise that Congress would be its dysfunctional self. While these defenders of the bailout hail the Fed for stepping in when the Congress would not have able to act, the bailout implicitly required the Fed to engage in activities previously exercised by Congress and the Executive branch.
In assuming a power previously exercised via the legislative process, the Fed acted as an enabler, allowing the Congress to avoid its responsibilities. The enabler role was not new to the Fed. The Fed, by asserting that monetary policy alone could guarantee full employment and price stability, also allowed the Congress and the Executive branch to avoid the responsibility for designing and implementing sensible fiscal, Dollar and trade policies, as well as maintaining a robust financial regulatory regime.
The bailout also involved the Fed taking actions well beyond its historical role. It had never closed down a bank or taken responsibility for managing or restructuring any firm. The FDIC has had the responsibility for managing failed banks. Furthermore, many observers wanted the Fed to act as bankruptcy judge in haircutting the claims of selected classes of creditors. However, it is not the role of a central bank to act as bankruptcy judge: picking winners and losers among claimants to assets of insolvent banks or financial institutions.
Paulson, the then Secretary of the Treasury, also asserted in testimony that the terms of the bailout were punitive and were set by the Fed. This position was supported by Geithner in his testimony. If, on the one hand, it was clear that AIG, including insurance subsidiaries, was about to fail a market test and go into bankruptcy, then how was allowing the then current owners to own retain 20% ownership of an ongoing firm punitive? On the other hand, if AIG was viable, what justified taking an 80% ownership interest in it?
More importantly, it is not proper for the Fed, or any governmental agency, to in effect try, convict and decide on the punishment for acts that were not prohibited by law or regulation. Some argued that punishment was deserved and served a social goal, i.e., reducing moral hazard. However, national security is a social goal, but it would be inappropriate for the NSA to make decisions about steps to promote national security, e.g., widespread wiretapping, if not permissible under the law and without oversight from the Congress or the courts.
The bailout could have proceeded in a more transparent and democratic fashion. The Fed could have had required a letter of agreement from Treasury (and/or from the Congressional leadership) stating that the Fed was proceeding with provided liquidity against appropriately hair-cutted-collateral, while Congress and the Executive branch specified terms of the bailout or conservatorship. This would have allowed the bailout to go forward and would have provided any interested parties with avenues of appeal via the legislative process. It would also have placed the ultimate responsibility for the terms of the bailout where they belong: in the political sphere.
During crises, decisions have to be made quickly and with incomplete and flawed information. The bursting of financial bubbles will, by their very nature, give rise to crises and decisions that will in hindsight appear less than optimal, even foolish.
Avoiding or preventing the next bubble is more important than ex post analyzing the failures in the response to the prior bubbles. The post-crisis second-guessing of decisions made during the crisis has drowned out a more import discussion. The Fed and the other regulators learned a lesson at great expense during the 1980s. The lesson was that it is better to avoid bank failures and crises than clean up after them. A more productive discussion would focus on how they forgot that lesson.