Commentary by Jonathan Weil
It turns out the decision to make the banks whole wasn’t AIG’s. It was made by
the Federal Reserve Bank of New York, back when its president was the current
U.S. Treasury secretary, Timothy Geithner, and its chairman was Goldman Sachs
director Stephen Friedman. (Friedman resigned from the New York Fed in May,
after the Wall Street Journal reported he had bought more than 50,000 shares of
Goldman stock following AIG’s takeover.)
Before AIG was seized, its executives had been negotiating for months with the banks, trying to get them to accept discounts of as much as 40 cents on the dollar, Bloomberg reported, citing people familiar with the matter.
Then, late in the week of Nov. 3, the New York Fed took over the negotiations with the banks from AIG, together with the Treasury Department (at the time run by former Goldman boss Henry Paulson) and Chairman Ben Bernanke’s Federal Reserve Board. Less than a week later, the New York Fed instructed AIG to pay the counterparties in full, Bloomberg reported.
By SERENA NG and CARRICK MOLLENKAMP
The Federal Reserve Bank of New York caved into demands by American International Group Inc.'s trading partners that they be paid in full for complex securities they had insured with the company, saving some of the world's biggest banks from potentially large losses, according to a government audit.
The audit, which was conducted by the special inspector general for the Troubled Asset Relief Program faulted the New York Fed for not using its leverage as the regulator of some of these banks to get them to accept lower prices for more than $60billion in credit-market bets, which were tied to souring mortgage-linked securities that had fallen in value. The banks that were paid off in full included Goldman Sachs Group Inc., Merrill Lynch and large French banks Société Générale and Calyon, which were represented by the French bank regulator in negotiations with the New York Fed last November, the report said.
Factors affecting efforts to limit payments to AIG counterparties
The Fed, in a letter accompanying the report, said it "acted appropriately" in its dealings with AIG's counterparties. It said its intervention in the insurer "was designed to prevent a system-wide collapse and achieved that end" by protecting the interests of AIG's insurance policyholders, debt holders, retirement plans, municipalities and other entities. It couldn't use its leverage as a regulator because it was acting on behalf of AIG, the Fed argues.
The audit provides a window into a bailout effort that has been shrouded by a lack of disclosure and questions over why the U.S. government in effect funneled tens of billions of dollars to the U.S. and European banks that were AIG's trading partners.
In November 2008, less than two months after the New York Fed first bailed out AIG with an $85 billion credit line, the insurer was still bleeding cash to meet calls for collateral from its trading partners. To halt the cash outflow, the government revamped the bailout package and created a company called Maiden Lane III, which bought complex mortgage-linked securities from U.S. and European banks to cancel insurance contracts that were forcing AIG to post collateral. The banks were effectively paid par, or 100 cents on the dollar, for those securities, which had declined significantly in value due to rising home-loan defaults.
The audit found that AIG's trading partners played hardball with the government and refused to agree to any discounted trades with the New York Fed and AIG. The financial firms claimed they contractually were due the full value of the securities and that they had a fiduciary duty to their shareholders. They also had another ace to play: Since the government already had shown its hand and made clear it wouldn't allow AIG to go bankrupt, the trading partners "had a reasonable expectation that AIG would not default on any further obligations."
The report acknowledged challenges the regulators faced, including insistence by most of the banks and a French bank regulator that they be paid in full. But the report said the refusal of the Federal Reserve and New York Fed "to use their considerable leverage" as banking regulators in negotiations "made the possibility of obtaining concessions from those counterparties extremely remote." The Fed says it needed to treat all of AIG's U.S. and foreign counterparties equally and to compel banks to take haircuts "would have been a misuse" of its supervisory authority.
The New York Fed's lack of leverage had its roots in decisions the central bank made earlier in the fall. Amid the mid-September 2008 collapse of Lehman Brothers Holdings Inc., the New York Fed was confident that the banking industry itself would solve AIG's problem, the report said. On Sept. 15, the day Lehman entered bankruptcy proceedings Timothy Geithner, now the Treasury secretary and then New York Fed president, tried to mobilize a consortium of banks to ante up a $75 billion loan for AIG. That effort fell apart, leaving the New York Fed scrambling. On Sept. 16, it agreed to lend AIG as much as $85 billion on terms similar to what the private sector had been planning. The package was later modified to ease the financial burden on AIG.
Before the New York Fed stepped in, AIG had tried unsuccessfully to get banks to accept less than full payment to cancel swaps it had written. The New York Fed took over the negotiations in early November and contacted eight large banks about the possibility of accepting haircuts on their positions.
There were few takers. Large U.S. banks, including Goldman and Merrill, refused to accept concessions because they would have to realize those amounts as a loss, the report said. Goldman maintained that it was hedged in the event AIG couldn't pay it. The French bank regulator, which negotiated with the New York Fed on behalf of two large French banks, also refused to negotiate concessions, the report said. Only one bank – UBS AG – said it was willing to accept a 2% haircut. The New York Fed decided that the most effective way to stop the cash bleed at AIG was to buy out the securities at par and cancel the swap contracts.
Mr. Geithner told the inspector general that "the financial condition of the counterparties was not a relevant factor" in the government's decision to effectively make the banks whole on their positions.
A Treasury spokesman said the report "overlooks the central lesson learned from the unprecedented steps taken to support AIG...that the federal government needs better tools to deal with the impending failure of a large institution in extraordinary circumstances."
The New York Fed ultimately lent $24.3 billion to Maiden Lane III to finance its purchase of $62 billion in securities from AIG's counterparties, which kept the collateral they had earlier received from AIG to compensate for market value declines. At end September, its outstanding loan to Maiden Lane III was $19.3 billion, while the portfolio was valued at $23.5 billion.