Global Crisis Blog

How Geithner Bungled the Bailout of AIG and Wasted $182 b.

By Shlomo Maital

On Oct. 3, 2008, the U.S. House of Representatives passed legislation authorizing the U.S. Treasury  to spend up to $700 billion ” to preserve home ownership, and promote economic growth.”  The authorization was given in a single vague line in a complex Act, The Emergency Stabilization Act,  an act that was defeated once and passed only after desperate pleas by the Treasury and the U.S. Fed that a financial meltdown would result if it did not pass.

A report [1] by the blue-ribbon U.S. Congressional Oversight Panel (whose role it is to oversee the bailout of US banks and companies with taxpayer money) reveals a massively hasty and poorly-designed bailout program, implemented in panic, that has wasted many billions of dollars in taxpayer money and may have done more harm than good.  The Panel members include Richard H. Neiman, Superintendent of Banks for the State of New York; Damon Silvers, Director of Policy and Special Counsel of the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO); and Elizabeth Warren, Leo Gottlieb Professor of Law at Harvard Law School.    According to this report:

At its peak, American International Group (AIG) was one of the largest and most successful companies in the world, boasting a AAA credit rating, over $1 trillion in assets, and 76 million customers in more than 130 countries. Yet the sophistication of AIGs operations was not matched by an equally sophisticated risk-management structure. This poor management structure, combined with a lack of regulatory oversight, led AIG to accumulate staggering amounts of risk, especially in its Financial Products subsidiary, AIG Financial Products (AIGFP). Among its other operations, AIGFP sold credit default swaps (CDSs), instruments that would pay off if certain financial securities, particularly those made up of subprime mortgages, defaulted. So long as the mortgage market remained sound and AIGs credit rating remained stellar, these instruments did not threaten the companys financial stability. The financial crisis, however, fundamentally changed the equation on Wall Street. As subprime mortgages began to default, the complex securities based on those loans threatened to topple both AIG and other long-established institutions. During the summer of 2008, AIG faced increasing demands from their CDS customers for cash security – known as collateral calls – totaling tens of billions of dollars. These costs put AIGs credit rating under pressure, which in turn led to even greater collateral calls, creating even greater pressure on AIGs credit. By early September, the problems at AIG had reached a crisis point. A sinkhole had opened up beneath the firm, and it lacked the liquidity to meet collateral demands from its customers.  In only a matter of months AIGs worldwide empire had collapsed, brought down by the companys insatiable appetite for risk and blindness to its own liabilities.

AIG sought more capital in a desperate attempt to avoid bankruptcy. When the company  could not arrange its own funding, Federal Reserve Bank of New York President  Timothy Geithner, who is now Secretary of the Treasury, told AIG that the government would attempt to orchestrate a privately funded solution in coordination with JPMorgan Chase and Goldman Sachs. A day later, on September 16, 2008, FRBNY abandoned its effort at a private solution and rescued AIG with an $85 billion, taxpayer-backed Revolving Credit Facility (RCF). These funds would later be supplemented by $49.1 billion from Treasury under the Troubled Asset Relief Program (TARP), as well as additional funds from the Federal Reserve, with $133.3 billion outstanding in total.

The total government assistance reached $182 billion.

What was wrong with the way Geithner structured the bailout? The panel’s members observe these faults:

1. The government failed to exhaust all options before committing $85 billion in taxpayer funds. There were many untried options that could have saved a lot of money.

2. The rescue of AIG distorted the marketplace by transforming highly risky derivative bets into fully guaranteed payment obligations. Talk about “moral hazard” — AIG shareholders keep the profits, if there are any, and the U.S. taxpayer bears the loss, if the bet doesn’t pay off.   A lot of companies and individuals would love to have THAT deal.

3. Throughout its rescue of AIG, the government failed to address perceived conflicts of interest. People from the same small group of law firms, investment banks, and regulators appeared in the AIG saga in many roles, sometimes representing conflicting interests.

4. “Even at this late stage, it remains unclear whether taxpayers will ever be repaid in full. AIG and Treasury have provided optimistic assessments of AIGs value. As current AIG CEO Robert Benmosche told the Panel, “Im confident youll get your money, plus a profit.” The Congressional Budget Office (CBO), however, currently estimates that taxpayers will lose $36 billion.

5. “The government’s actions in rescuing AIG continue to have a poisonous effect on the marketplace.” The market now assumes there are businesses “too big to fail”.  This will have a massive distorting effect on capital markets in the near and distant future.   And it may prove wrong.  Taxpayer anger at the waste of their money on AIG may indeed cause companies in future to be allowed to fail, when perhaps they deserve a bailout.

[1] Congressional  Oversight Panel , June 10 2010: “The AIG Rescue, Its Impact on Markets, and theGovernment’s Exit Strategy”, Submitted under Section 125(b)(1) of Title 1 of the Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343.