Fed Authorized 100% Payout by AIG on CDS

Wow, I should not be surprised, but this is a stunner nevertheless.

It had generally been assumed that the AIG payouts of 100% on credit swaps (when the insurer was under water and bankrupt companies do not satisfy their obligations in full) was the result of some gap in oversight plus traders at AIG exercising discretion (they were unhappy about bonus rows and had reason to curry favor with dealers, who were potential employers).

The article makes clear that AIG had been negotiating to settle on the swaps prior to getting aid from the government, and was seeking a 40% discount. The Fed might not have gotten that much of a discount, but there was clearly no need to pay out at par.

This massive backdoor subsidy to the likes of Goldman, DeutscheBank was authorized by Geithner while he was at the New York Fed.

From Bloomberg:

[Elias} Habayeb, 37, was chief financial officer for the AIG division that oversaw AIG Financial Products, the unit that had sold the swaps to the banks. One of his goals was to persuade the banks to accept discounts of as much as 40 cents on the dollar….

Beginning late in the week of Nov. 3, the New York Fed, led by President Timothy Geithner, took over negotiations with the banks from AIG, together with the Treasury Department and Chairman Ben S. Bernanke’s Federal Reserve. Geithner’s team circulated a draft term sheet outlining how the New York Fed wanted to deal with the swaps — insurance-like contracts that backed soured collateralized-debt obligations….

Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.

The New York Fed’s decision to pay the banks in full cost AIG — and thus American taxpayers — at least $13 billion. That’s 40 percent of the $32.5 billion AIG paid to retire the swaps. Under the agreement, the government and its taxpayers became owners of the dubious CDOs, whose face value was $62 billion and for which AIG paid the market price of $29.6 billion. The CDOs were shunted into a Fed-run entity called Maiden Lane III…

The deal contributed to the more than $14 billion that over 18 months was handed to Goldman Sachs, whose former chairman, Stephen Friedman, was chairman of the board of directors of the New York Fed when the decision was made…..

“In cases like this, the outcome is always along the lines of 50, 60 or 70 cents on the dollar,” [Donn] Vickrey [of financial research firm Gradient Analytics Inc.] says…..

One reason par was paid was because some counterparties insisted on being paid in full and the New York Fed did not want to negotiate separate deals, says a person close to the transaction. “Some of those banks needed 100 cents on the dollar or they risked failure,” Vickrey says.

As Vickrey indicates, the fact that this was a backdoor rescue means the Fed is acting as an extra budgetary vehicle of the Treasury. This is a violation of the Constitution and shows how patently false the Fed’s claims of independence are.

Update. Some readers have argued “The government was backstopping AIG, ergo it had to honor all contracts.” That argument is rubbish; AIG under Fed supervision stiffed other creditors. From a reader by e-mail:

Liddy sent a letter to Congress which gave a summary the losses at AIG. As I remember it it only 53% of the losses covered by the Fed resulted from activity at AIGFP. Of the 43% realized at the insurance subs a substantial fraction were losses on GIAs with state pension plans-including Californis and Virgina. The losses were in to the billions. Was the Fed suppose to pay 40 cents on the dollar to state pension funds while paying off foreign banks in full?

Now I know the argument goes something like “these were regulated subsidiaries, AIG FP was at the parent level.” Again, I don’t buy it. Creditors in distress who have not declared BK frequently renegotiate their obligations. As readers know well, even credit card issuers will lower the amount due by overextended individuals, and the Fed clearly had more clout here that a mere individual versus has with, say, BofA. The real issue is that the Fed BY DESIGN bailed out banks, including foreign banks, through a device not authorized by Congress.

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  1. Hugh

    I had heard about Geithner’s involvement but not the size of the haircut suggested. That was quite impressive. But it goes to show how in the bag Geithner is to the financial industry. Sockpuppet doesn’t even begin to cover it. At the same time, seeing how the Fed is structured to be run by the banks and for their benefit, this is no surprise. The Fed was always on more than dicey ground Constitutionally even before the current crisis, but with its entry into fiscal policy, both its unConstitutionality and profound conflicts of interest have only been magnified, as in the AIG case cited.

  2. ndk

    This is a violation of the Constitution and shows how patently false the Fed’s claims of independence are.

    As if the revolving door between Treasury and the Fed over the last 50 years weren’t indication enough. I absolutely think of them as being conjoined entities, separate only when it’s convenient for operational reasons. As grotesque and, indeed, unconstitutional as their behavior is, I reserve special fury for the complicit and enabling behavior of the legislative branch.

    I think most of them believe their crimes are for the greater good of the country and world, which is far more troublesome and difficult to change than petty corruption. On a fundamental level, our institutionalized financial leadership truly believes they’re doing the necessary, if unpopular, things.

    Can’t get congressional approval for stabilization of the financial system, which you believe is in everybody’s best interests? Find a backdoor. Can’t get banks to forebear adequately on f’cked borrowers? Take the bank into receivership or Government ownership. Can’t recapitalize fast enough to keep banks afloat? Force FASB to modify accounting rules.

    It is, after all, for the good of the country.

    I have believed all along that any amount of bailing out would be insufficient. I’ve been surprised by and wrong about the amount of velocity asset prices could yet be given, but the performance of the underlying real economy has been all too predictable. I still don’t think any resuscitation will be possible when delivered by bubble (or unproven Keynesian stimulus).

    We’ll see what dark events it will take to break this ridiculous mentality and return the rule of law, honesty, and transparency to America and her capital markets. But curses upon our financial leaders for shattering so much of the belief in the basic fairness and community of America.

  3. ITDog09

    I’m a small business guy, but never took an accounting course, so excuse my ignorance in advance.

    However, it does appear to me that what these institutions did was figure out a way to more or less print their own money. Is that a valid view of this whole mess?

  4. Tom Maguire

    “It had generally been assumed that the AIG payouts of 100% on credit swaps (when the insurer was under water and bankrupt companies do not satisfy their obligations in full) was the result of some gap in oversight plus traders at AIG exercising discretion (they were unhappy about bonus rows and had reason to curry favor with dealers, who were potential employers).

    …The Fed might not have gotten that much of a discount, but there was clearly no need to pay out at par.”

    Generally assumed by whom?

    Once the government took over 79.9% of AIG with the stated intention of reassuring the world that its obligations would be honored, negotiators insisting that counterparties accept a discount had no leverage – Goldman et al could simply insist that AIG perform under the swap over time as per the original deal. Why would anyone accept a discount on a contract that is going to be honored in full?

    As to the notion that this was a give-away to Goldman – maybe not so much. Goldman claims (Accurately? Who knows?) that they had bought credit default swaps against AIG itself.

    *If* that is true, then it was *those* swap providers that were saved money when the government declined to default on the AIG swaps. I don’t think we have any idea who those providers were.

    And an interesting wrinkle is that the Fed was negotiating discounts with the wrong people. Goldman had no incentive to negotiate a discount, because that would not have been a default and wouldn’t be covered by their default protection counterparties. Goldman needed either a par settlement with AIG or a default event covered by their other protective contracts.

    1. ndk

      Explain why the Federal Government needs to offer enticements or incentives in order to get agreement from an organization that exists only due to strong-arming the taxpayer into backstopping their balance sheet and liberal handouts from the Fed. It’s not at all obvious to me.

    2. Yves Smith Post author

      The Fed stiffed other creditors, that’s why. I am adding this to the post, which was sent by another reader:

      Liddy sent a letter to Congress which gave a summary the losses at AIG. As I remember it it only 53% of the losses covered by the Fed resulted from activity at AIGFP. Of the 43% realized at the insurance subs a lsubstantial fraction were losses on GIAs with state pension plans-including Californis and Virgina. The losses were in to the billions. Was the Fed suppose to pay 40 cents on the dollar to state pension funds while paying off foreign banks in full?

  5. Bonesetter Brown

    Zero Hedge originally broke this story (posted here at NC if I recall correctly) and suggested the Treasury’s involvement:

    “What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner’s (and thus the administration’s) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.”

    Nice to see Bloomberg confirmation.

  6. MyLessThanPrimeBeef

    I can see Michael Moore’s next movie – Capitalism…A Reciprocating Back-Scratching Story.

  7. vasra

    This begs the question:


    Why would anybody who has to pay for somebody else’s failures does NOT want to negotiate a better deal, or in fact abandons a deal already partially negotiated?

    What was the WIN here for Treasury or the FED?

    Is it *only* because “the international banking cabal” runs the whole universe and has Fed + Treasure in their pockets?

    Or is there some other, more specific and believable reason?

    Somebody who is from outside banking, but has done negotiations fails to understand the logic of Fed/Treasure here.

    Were they pressured? What was their upside? Downside?

    Somebody needs to do more digging on this.

    The other possibility is of course, that the news discovery here is not very accurate and no haircut was forthcoming to begin with.

  8. carol

    I recall at that time media stories about frantic phone calls from Societe General to Christine Lagarde, and from Lagarde to Paulson.

    How constitutional is it for the FED to shift taxpayers’ money straight out of the country?!!
    Remember, not only to SocGen but to a bunch of other EU banks as well.

    e.g. Fro:m 1 Oct. 2008
    “We now know that it was French finance minister Christine Lagarde who begged Mr Paulson to save the US insurer AIG last week. AIG had written $300 billion in credit protection for European banks, admitting that it was for “regulatory capital relief rather than risk mitigation”. In other words, it was underpinning a disguised extension of credit leverage. Its collapse would have set off a lending crunch across Europe as banking capital sank below water level.”

    1. Hugh

      It is important to remember that a lot of those regulatory relief swaps are still on AIG’s books and were not part of the par payments.

  9. LeeAnne

    There is entirely too little being said about the role of the Bank for International Settlements in all this.

    Grayson’s questioning of Bernanke emphasized the issue of FED authority to distribute 1/2 $Trillion loans? swaps? That line of questioning elicited a Bernanke response about the 14 European central banks involved and listed in his report with no mention of the 57 Bank of International Settlements (BIS) supposedly concerned with speculation in the markets.

    Organizations of this kind make decisions that bypass elected representatives.

    Bernanke lied when he testified that the FEDs authority to do this was clear and used often. Grayson, having done his research, pointed out that the first time it was ever done was late in 2007 and eventually reached more than $500 Billion.

    From <a href="http://en.wikipedia.org/wiki/Bank_for_International_Settlements"&lt;


    “The Bank for International Settlements (BIS) is an international organization of central banks which “fosters international monetary and financial cooperation and serves as a bank for central banks.” [1] It is not accountable to any national government. The BIS carries out its work through subcommittees, the secretariats it hosts, and through its annual General Meeting of all members. It also provides banking services, but only to central banks, or to international organizations like itself. Based in Basel, Switzerland, …”

    “As an organization of central banks, the BIS seeks to make monetary policy more predictable and transparent among its 57 member central banks. While monetary policy is determined by each sovereign nation, it is subject to central and private banking scrutiny and potentially to speculation that affects foreign exchange rates and especially the fate of export economies. Failures to keep monetary policy in line with reality and make monetary reforms in time, preferably as a simultaneous policy among all 57 member banks and also involving the International Monetary Fund, have historically led to losses in the billions as banks try to maintain a policy using open market methods that have proven to be unrealistic.”

    Goal: a financial safety net
    “… The BIS has historically had less power to enforce this “safety net” than it deems necessary. Recent head Andrew Crockett has bemoaned its inability to “hardwire the credit culture,” despite many specific attempts to address specific concerns such as the growth of Offshore Financial Centres (OFCs), Highly Leveraged Institutions (HLIs), Large and Complex Financial Institutions (LCFIs), deposit insurance and especially the spread of money laundering and accounting scandals.”

  10. RebelEconomist

    I agree; this is outrageous, especially considering that Stephen Friedman was Chairman of the Board of Directors of the New York Fed at the time. But I do not quite understand what “par” means in this context; perhaps someone can explain. Assuming that these swaps were CDSs on some third counterparty, with a protection fee payable by Goldman negotiated before the financial crisis, but for the riskiness of AIG itself, they would have had positive value to Goldman – which I would describe as having a value ABOVE par. If the Fed bought out Goldman at this price – ie as if AIG had a state guarantee – that would make no sense, since the point of rescuing AIG was to ensure that the credit support it was providing did not just disappear. But the high investment bank earnings from this period suggest that this is indeed what was done. It seems that, rather than waiting for the bailout to ease financial stress and reduce the market value of the swaps, the Fed closed them out at the most disadvantageous time.

    1. Yves Smith Post author


      If Goldman was keeping its books correctly, the AIG swaps should have been written down to reflect the downgrades (remember they were downgraded before hitting the wall).

      I agree payout at par is not well defined here, but most super senior tranches on CDOs written on subprime bonds went to zero. Those that didn’t are trading at 20 cents on the dollar. But yes, in those cases payout should only be 80 cents, not 100 cents, and if it was 100 cents, you are absolutely correct. And I don’t know if pricing of those CDO tranches (the ones widely held by investment banks and banks) was that impaired by Jan-Feb either.

      I have been trying to track this down for a while. but there were some CDO programs by Goldman and DeutscheBank (Abacus and Start) to lay off their subprime risk a la 2007-2008. There was simply not enough protection writing capacity ex AIG (meaning monolines in aggregate) for GS et al to have shed subprime risk without AIG eating a lot (meaning the “oh weren’t they smart for shorting subprime” was likely done in part or in whole via AIG. The declaration that AIG stopped insuring subprime seems to come from Cassano in the WaPo, and he has lied to analysts, I don’t consider him credible. Even if AIG has made a statement, they might also be playing the lawyer hairsplitting game, that writing guarantees on subprime bonds is somehow different than guaranteeing AAA tranches of CDOs which consist 80% of BBB subprime bond tranches). But I don’t have a smoking gun….yet.

      1. Skippy

        Every thing you just alluded too, is the bile in the back of my throat that will not go away.

        Skippy…Sweaty TNT been there, done that. I would rather do EOD in the sandbox than mess with that stuff, especially when everyone is taking out insurance on me and the TNT.

      2. pebird

        You got that right, I couldn’t make sense that GS could be fully-hedged against AIG’s failure – despite what was leaked in the press. They may have been hedged, but there would have been no one to collect from.

        As much as greed played a role in this – AIG was a HUGE global domino.

  11. alfred B.

    Geithner steals from all Americans and gives to his rich bankster friends…..he has been doing it all along since his days at the Fed. Larry Summers, another Obama darling is also a top-of-the-line swindler. And please do not get me started on JPMorgan’s Jamie Dimon, a master thief….

  12. eh

    It had generally been assumed…

    Assumed by whom?? Yves, I think this is one of the most incomprehensible things you’ve ever written. On the contrary, I thought it was “assumed” by most people that the payouts were done at the direction of Bernanke et al, and deemed necessary at the time, e.g. due to ‘too big to fail’ thinking (to be generous), or just plain corrupt cronyism/socializing of losses (to be somewhat less generous, and probably closer to the truth).

    1. Yves Smith Post author


      I have been in contact with people on CDO desks, you are not correct here. Assumption on Street had been that no one was minding the store, and traders had incentive to go path of least resistance. I’ve heard that for some time.

      In fact, the argument could be made that the hope was to have this look like oversight rather than a decision, to have plausible deniability later. Negotiating would take a management directive (parameters re what acceptable timing and settlement terms were). Simply saying “we want to unwind the swaps” would insure a least resistance outcome, particularly since traders at AIG were pissed at that time.

      The usual rule is never assume malice when mere incompetence will suffice as an explanation. Look at how the authorities were asleep at the switch on the AIG retention bonuses in the period between elections and the inauguration. Thus that theory WAS plausible.

      1. tinbox

        I’m with eh. The Fed doesn’t even regulate insurers, why would they have intervened at all if not on behalf of their constituents–the banks? It always appeared that the AIG bailout was intended to funnel money to bank counterparts. Why else would they circumvent the legal and logical process of bankruptcy? Obviously, bankruptcy was an OK outcome for some large entities that week.

        This news is merely confirmation. And I cannot believe that the ramifications of avoiding bankruptcy in regard to bonuses did not occur in real-time to Geithner. No way.

  13. Kreshnik Bejko

    Someone help me here: didnt Bloomberg allude some time ago that the New York Fed is a private entity?

  14. Allen C

    “Creditors in distress who have not declared BK frequently renegotiate their obligations.”

    Yes…not uncommon. The rot of the smelly fish intensifies.

    We could use some first world law enforcement.

  15. Timbo

    This should not surprise anyone.

    AIG financial spent the better part of a decade spraying the market with underpriced bond insurance. Goldman and many others levered up and bought both the bonds and the insurance. Arbitrage pure and simple less counterparty risk. To hedge that, they, and many others shorted the stock.

    In a panic, the Fed makes everyone good. AIG stock goes to zero, CDS insurance pays out in full. Goldman stock rallies. Homerun.

    To boot, 71 year old Stephen Friedman (former Goldman chair and on the Board of New York Fed), scooped 50,000 shares of Goldman stock at an average price of about 70$, before the news of AIG’s bailout was made public. It proceeds to rally a hundred bucks. Chump change to him (5 mil), but I mean, he needed some walkin around money man! Couldn’t resist.. its in the blood.

    I’m all for takin risk and makin big$$$, but come on.

    Anyone make a case this is not what occurred?

    Business as usual. And this is one story, one incident. Hows the sayin go? There’s never just one cockroach in the kitchen. Tip of the iceberg as far as i’m concerned.

    High science. Artwork. Poetry. Robbery. Congrats Goldman.

    Don’t worry taxpayer. You won’t even feel it. Your kids will pay it off.

    1. K Ackermann

      I personally think it goes even deeper.

      Does it make any sense that a company which is balls-deep in the risk business would not hedge their book?

      AIG owns the world record for biggest losses. Just bad dumb luck? I don’t think so. They are still alive.

  16. Allen C

    We all (i.e. anyone with reasonable knowledge) freaked when they paid the tab at 100. Give me a break. The more we read, the more it smells.

    What more do we need? Do we need some deity to point out a blinding glimpse of the obvious?

  17. Allen C

    “I’m all for takin risk and makin big$$$”

    This is the problem people. Folks in a financial intermediary role are continually dissatisfied with the margin, so they risk the ENTIRE financial system with excessive leverage to earn outrageous compensation. And when it all fails, they force a bailout. This is a RICO case!

    1. Timbo

      “I’m all for takin risk and makin big$$$”

      Let me rephrase that.

      We are a nation of entrepenurial risk takers.

      This behavior does not qualify.

      Agreed – RICO material.

  18. mitchw

    Couldn’t the FED have been motivated by getting money to all the other institutions AIG had insured. What would have happened to Germany and France if DB and SG’s balance sheets had snapped? Who would have wanted to risk it?

    1. Yves Smith Post author

      The point is this shouldn’t have been the Fed’s decision to make. Even though the Fed can in theory just print money to make up for losses, Willem Buiter argues that doing so will interfere with the Fed’s price stability mandate. So if losses are high enough (and at the rate the handouts are going, that looks likely) the rescue was an extralegal budgetary commitment.

      1. timmy g

        But yves, how could they have done anything else?

        At that time, before tarp, there was no one else to aid in the stability of the entirety free market system. They had to step in.

        Now if the fed had more power, for instance the power to reverse gravity, we clearly would have had a different outcome.

        But what about the ots? They were not given the express power to reign in AIG, they were busy watching banks.

        Mr dugan has also brought this up with respect to other non-bank lenders.

        Now, it may seem that all of the above authority should be contained within the treasury, but in fact it was not. But then again I am not really a banker. Remember that I was working for the fed at the time.

        Timmy G.

  19. Jonathan Dean

    John Hempton made the point at the time (in blog comments somewhere that I can’t now find) that the payments made by AIG on CDS to Goldman were, in large part, to Goldman -clients- and not to Goldman itself, which, if true, seems to be an important nuance that the MSM (obviously) and the blogosphere (disappointingly) has not factored in.

  20. Richard Kline

    The whole function of the Paulson-Geithner Stealout was, is, and presumably will be to make good _the losses of private speculators_ with public money, i.e. giveaways at public expense. There was no expectation of a ‘lender’ of last resort. Oh, some firms not well connected or liked, they got ‘loans’ or are let fail. Big ones with lots of well-paid friends, they got public money to walk away with. What we have is not regulatory capture: that phrase presumes that there is ‘regulation.’ What we have is state-capture, where private parties have so insinuated themselves into the institutions and functions of the government financial process that they can literally write their own ticket. We will see a lot more of this in the immediate future because, frankly, it has worked so well for the winners they won’t hesitate to push the button of the ‘pay me’ machine again.

  21. RebelEconomist

    I think that this is how it works:

    Settlement of these CDS contracts involves the protection buyer selling the insured bond (a CDO) to the protection seller at par (as opposed to being cash settled) – I think that the Bloomberg article is misleading when it says that AIG “paid the market price” (for the CDOs). Thus AIG / Maiden Lane III does own the bond and can benefit from any increase in its value as (if?) the financial crisis eases. However, because AIG’s credit was impaired before the Fed stepped in, Goldman would have had to accept less than par for the bonds to close out the swaps then. So the gain to Goldman is essentially accounted for (there may be some second order interest rate gain or loss involved in paying par) by the reduction in counterparty risk when the state bailed out AIG.

    It seems to me that, morally, Goldman owes the US taxpayer $14bn. I dare say some countries would find ways of incentivising them to make a voluntary contribution.

  22. Siggy

    AIG is a grand scandal and as more information as to what transpired becomes available, it is my belief that we may apprehend the true nature of the great tragedy that has occurred. It is my view that AIG perpetrated a massive fraud in that it wittingly sold contracts that it could not honor. The scope of the fraud is both domestic and international. What ocurred and is ongoing is an ill-considered effort to unwind what were fraudulent trades.

    To this point in time, the discussions being presented seem to omit explanations as to what happened to the swap part of the CDS contracts. That is, the swap contract is: an untoward event occurs, I give you the failed paper, you pay me some stipulated amount. What happened to the failed paper? It may have some value, if only as curio wallpaper.

    The Treasury’s motivation in interceding appears to be to protect the ‘primary dealer’ banks. When viewed in that context, the argument can be raised, with some authority, that the preservation of the Treasury’s ability to finance the operation of the Federal Government was at risk.

    This whole fiasco appears to me to be a variant of LTCM redux.

  23. Michael

    I seem to recall at the time the issue was that collateral calls were the cause of the liquidity crisis at AIG.

    It wasn’t clear that AIGs CDS liabilities would eventually bankrupt AIG, although it looked likely. Most of the CDS still had many years to run.

    The collateral calls were the killers. It seems to me that once the FEDs guaranteed AIG, AIGs counterparties had a weaker hand to play in demanding collateral.

    All the Fed had to do was remind the counterparties that the US govt doesn’t need to put up collateral and the Feds would have retained some leverage. GS et al would still have the CDS on their books with a guarantee from govt owned AIG. There was no reason I can see why they needed to close them out at all, never mind at 100cents.

  24. Michael

    One other point.

    I’m pretty sure the way it worked was the Fed paid 100 cents and counterparties returned collateral posted to date.
    At the time of the transaction that would have cost the feds (net) current marks on the CDS.

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