No matter which way you look at it, the picture that is emerging of the Federal Reserve, as revealed by the ongoing probes into its AIG bailout, is singularly unflattering.
The explanations for its actions can only support one of two interpretations: that the Fed was a chump, taken by the financiers, or a crony, and was fully aware that it was not just rescuing AIG, but doing so in an overly generous way so as to assist financial firms in a way it hoped would not be widely noticed or understood. The problem with this sort of back-door subsidy, aside from its dubious propriety, is that at best, it’s sorta random (who benefits isn’t necessarily who is in most need or more deserving of help, just who happens to be lucky enough to be associated with AIG train wreck), and at worst, it rewards stupidity and duplicity.
For the Fed, if it was mainly engaged in “Fed as crony” behavior, that bodes ill for the central bank’s future, since it means it has been lying to the public as to why it did what it did. As investigators keep digging, for they will be certain to find evidence that the various explanations that the Fed has given for its actions will be at odds with its internal debates. If you think the Fed’s reputation is bad now, just wait to see what happens if it emerges that it was engaged in deception.
Although the focus of press and public attention has been the decision to pay out “100%”, this issue has not been framed as crisply as it should be. Remember, the underlying transactions were crap CDOs that the banks (or bank customers, a subject we will turn to later) owned, and on which the banks had gotten credit default swaps from AIG. The Fed in fact paid out WELL MORE than 100% on the value of the AIG credit default swaps by virtue of also buying the CDOs.
Recall the sequence:
1. Fed authorized $85 billion credit facility in September 2008
2. In early October, AIG pays out an additional $18.7 billion to its CDO counterparties, bringing their total collateral to $35 billion (against CDOs with a par value of $62.1 billion) So the dealers had already received 56% of par value at this point (remember, possession is 9/10 of the law).
3. In early November, it looks as if AIG will have to pony up more to its counterparties if it is downgraded, as it presumably will be once it releases crappy earnings. Resulting collateral calls might exceed the remaining amount of the $85 billion loan facility. Fed goes into panicked overdrive, decides of all its options for dealing with the AIG black hole, the best is to buy the CDOs, thus eliminating the need to worry about those pesky CDS.
What we need to stress here, before going into the chump vs. crony theories, is that buying the CDOs in order to terminate credit default swaps is not normal protocol. The Fed could have negotiated a cash settlement (which probably would have amounted to letting the counterparties keep the collateral, with some further adjustments based on the usual arm wrestling. This by the way, could have constituted a 100% payout on the credit default swaps (ie. the decision to pay out in full on the CDS was separate from the decisions to acquire the CDOs), but it would have left the banks with the CDOs. That would have been well short of $62.1 billion; all the dealers felt then that the CDOs had some value (while their marks also said that, dealers have been known to mark paper at unduly high prices to avoid reporting losses; with AIG’s credit-worthiness in doubt, the bankers’ accountants presumably required markdowns on the credit default swap hedges, which might give some banks an incentive to be less aggressive in reducing the value of their CDOs). That implies the credit defaults swaps themselves were worth considerably less than 100 cents on the dollar.
Buying the CDOs was an unnecessary step and increased the amount paid by the Fed, through AIG, to the counterparties. Moreover, the Fed has gone to unusual, even bizarre, lengths to keep matters regarding the CDOs themselves secret (a good bit of the discussion at the House Oversight Committee hearings on Wednesday today revolved around this issue; we’ve discussed previously why the Fed’s arguments for secrecy do not add up; we will return to this subject at later today at Naked Capitalism).
So let’s see how these theories stack up. Each has supporting evidence.
Fed as Chump
This viewpoint boils down to the old saw about poker: if you sit down at a poker table and you don’t know who the mark is, by definition, it is you.
The Fed has long believed that the financial crisis was a liquidity event, that investors panicked, but the prices of securities of all sorts fell below “rational” levels. From Bernanke on down, the Fed has made various pronouncements taking up the theme that securities prices, particularly in the October 2008 through March 2009 time frame, reflected irrational despondence. Funny how once Greenspan dared admit in 1996 there might be such a thing as irrational exuberance, not only that turn of phrase, but the very concept, seems to have been expunged from permitted reasoning at the central bank. Not only does the Fed seem constitutionally unable to admit that it was asleep at the switch during the rise of a global credit bubble, but that cheap credit leads to overvalued assets. So asset prices will fall as cheap credit is withdrawn. The Fed has fought this process tooth and nail, believing it can validate asset prices by pulling the right levers (see here for a long-form version of this logic and my objections to it).
So why did they buy the CDOs? Get this: one argument is that they wanted the upside. Huh? That means:
1. They seem to have forgotten that where there is upside, there is also downside. They took a speculative position. This went well beyond what was necessary to deal with the AIG mess
2. They thought they had a better perspective on value than the banks themselves. This is staggering. They have NO idea how these deals are structured, no day-to-day involvement in the subprime, Alt-A, or commercial real estate markets. They are at a massive information disadvantage. The idea that the Fed could make a better trading bet than the banks themselves is a remarkable combination of hubris and stupidity.
While there might be reason to think that prices of liquid assets had overshot on the downside, assets like CDOs that don’t trade and are (in this case) priced on cash flows which reflect, among other things, expected defaults and loss severities, are quite another matter. And here, the Fed (its valuation claims to the contrary) looks to have gotten it badly wrong. Per Tom Adam’s analysis, at the time Maiden Lane III (the vehicle that bought the CDOs) was created, 19% of the portfolio had been downgraded to junk. Currently, it’s 93% below Baa3 according to Moody’s, the more conservative of the two major ratings agencies.
More confirmation of the “Fed as chump” theory comes via its reliance solely on BlackRock for advice on the CDOs, particularly once it had set up Maiden Lane III (and recall BlackRock is also managing Maiden Lane I, the Bear bailout entity, and Maiden Lane II, which was created to deal with AIG’s securities lending mess). I’d be curious to hear additional reader input, but I am told that private managers of portfolios of this size would have at least two portfolio mangers to give them different views and to compete. But the government would set its criteria for these assignments in such a way that Pimco and BlackRock were the only viable candidates. By contrast, there are asset managers and consultants that are not as large but are very skilled in the CDO space.
The Fed was also played by the French regulators, and perhaps their banks. One of the arguments for the Fed not pushing for a haircut on the credit default swaps, as other banks had accepted in dealing with a distressed insurer, was that French law prohibited it. But this was false, since Societe Generale and BNP Paribas took very large haircuts to close out credit default swaps with Ambac, another bond insurer.
Other examples of Fed naivete comes from e-mails recently made public as a result of the House Oversight Committee investigation: its surprise that AIG might have to make disclosures regarding the bailouts, its clumsy and aggressive efforts to keep matters under wraps, and its reluctant recognition that too many people were party to what went down to maintain secrecy.
Fed as Crony
Although we’ll set forth the fact pattern that gives credence to this notion, the most powerful support comes from the Fed’s seeming desperation to maintain secrecy, particularly around Maiden Lane III. The Fed’s arguments here do not hold up. In Congressional testimony today, the Fed, particularly the general counsel of the New York Fed, Thomas Baxter, argued that keeping transaction-level detail secret, was necessary to maximize value of Maiden Lane. As we have discussed earlier, and continue in more detail in a related post, that is bunk. And that begs the question of why the Fed is so insistent on holding the line here. While it may be imperial overreach and fear of starting down a slippery slope of disclosure, the Fed’s bobbing and weaving under the hot lights FEELS like a cover-up.
Moreover, the Fed has withheld information requested via subpoena from both SIGTARP and the House Oversight Panel. That says they are awfully keen to hide…something. That sort of intransigence is a red flag before a bull. The fact they hoped they could get away with it is troubling, and strongly suggests something is amiss.
Now mind you, the Fed’s cronyism does NOT have to come about via corruption or other nefarious reasons (the stonewalling could be to protect Geithner and Bernanke; for instance, they could have given testimony that is contradicted by internal evidence). The Fed appears to be captured by the industry, so badly that it is unable to recognize how distorted its perspective has become. This means it will vociferously defend the industry and individual firms.
So what is sus about the Fed’s conduct? Consider:
1. The Fed’s unusual step of buying the CDOs provided nearly $30 billion more in liquidity to a small number of banks. To put that in context, the first of the Fed’s emergency rescue programs, the Term Auction Facility, was at its outset a $40 billion program open to a much larger universe of firms and provided 28 day loans, not a permanent transfer.
2. The insistence that the Fed was up against a hard deadline of November 10. In response to questions today, Baxter insisted that the Fed had to have a new program in place by November 10, because that was when AIG would announce earnings and a rating agency downgrade seemed inevitable, which would lead to more collateral calls.
But that is misleading. First, even if the rating agencies issued their downgrades that very day, the collateral payment was not due that day. There would be some sort of time delay, not long, but I would guess 3-5 days (I assume expert readers will advise me and I will revise the post accordingly). Perhaps more important, it is typical when parties are negotiating to agree on waivers. How hard would it be for the Fed to obtain a waiver if it were negotiating an exit from the AIG CDS? Answer: not very if good faith negotiations were under way. At worst, the Fed could have had AIG make a partial collateral payment out of the remain credit line while discussions continued.
3. The Fed had done nothing to understand the CDS market or prepare for a crisis. Many observers believe the reason that Bear was not allowed to fail was that it was a significant counterparty in the credit default swaps market, that letting any big CDS player go could produce a domino effect, creating a wave of counterparty failures that would lead to systemic collapse. Aside from the backlash against the Bear rescue, Lehman was presumably dispensable despite its larger size because it was not as big a participant in the CDS game.
Since the CDS market was obviously a major source of risk and firms that were big CDS players (Merrill, Morgan Stanley, UBS) were seen as vulnerable, it would seem to be Job Number One of the Fed/Treasury to do some meaningful investigating to see how big the risks were and do some contingency planning (don’t even try telling me the Neel Kashkari “break glass” memo mentioned in Sorkin’s Too Big To Fail amounted to “planning”. You can’t plan if you don’t understand the terrain. And the “plan” was clearly too high concept to be useful when the dominoes did start to fall).
Now of course, preparation for an investment bank bankruptcy, which would lead (among other things) to a hard look at the credit default swaps market; failure to do so could fit the “Fed as chump” theory, that the authorities dropped the ball, big time. But the powers that be have shown a remarkable lack of interest in real diagnostics throughout. By contrast, the Bank of England, twice a year, puts out a Financial Stability Report than runs rings around anything I have seen the Fed prepare. When UBS got itself in so much hot water that it needed a rescue, the Swiss Banking Federation made it conduct an internal investigation (conducted by outside parties) and make two reports: one to the public, in the form of a report to shareholders that was very detailed, and an even more extensive one to the authorities.
The lack of interest in either post-mortems or planning suggests that the Fed does not want to know. And who would that lack of curiosity benefit? The Fed itself (as in not exposing past policy failures) and of course, the industry (not exposing incompetence and misconduct).
If that is not a misguided set of (implicit) priorities, I don’t know what is.
4. As we discuss separately (the new post on this will be up later today), the Fed keeps trying to keep transaction-level detail on Maiden Lane III under wraps, even though its arguments defending this action make no sense. That suggests there must be other reasons. One is that ML III is really not doing so well, despite valuation reports that say otherwise; the second is that digging into the transactions would be embarrassing to the Fed or the counterparties themselves.
4. A look at transaction detail (that is, the stuff the Fed has been desperate to hide), and counterparty exposures (which we have put together, not just CDS counterparty, but lead bank on the CDO, which in a surprisingly large number of cases is different than the CDS counterparty), suggests at a minimum pervasive patterns of really abysmal counterparty risk maangement amongst the AIG counterparties; notably, massive Goldman exposure, along with apparent efforts to conceal it. Thus the reluctance of NY Fed to disclose information about the counterparties begins to look like a possible case of regulatory capture. Or maybe, yet another case of credulity of experts.
As much as the Fed seems awfully eager to close this chapter, enough parties with subpoena are taking interest that l’affaire AIG is going to be scrutinized in exhaustive detail. The dirt will come out. Given the Fed’s past record on disaster planning, if there is something serious they are hiding, they are likely to be inadequately prepared for the blowback.
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As Yves says here:
The lack of interest in either post-mortems or planning suggests that the Fed does not want to know. And who would that lack of curiosity benefit? The Fed itself (as in not exposing past policy failures) and of course, the industry (not exposing incompetence and misconduct).
Any amount of being a chump where one has arrogated such power and “expertise” has to be voluntary. So the chump concept and evidence are enfolded into the corruption thesis.
An organization like the Fed, or a cadre like Bernanke, simply has no right to be “naive” or “gullible”, and therefore no right to be considered as such.
The result is corruption, so the process was corruption. You will it by commission or by omission, the result is the same, the guilt is the same, it should be dealt with the same.
“The explanations for its actions can only support one of two interpretations: that the Fed was a chump, taken by the financiers, or a crony”
No, three.
I assert that the FED was venal AND stupid.
Agree.
Chumpy crony. Why settle for one when you can have best of all worlds?
We need to have commercials during the Super Bowl similar to the old miller light commercials – Less filling, tastes great.
Pan to a tavern, where a heated discussion of the Federal Reserve ensues:
One side – Chumps!!!!!!!
The other side – Cronies!!!!!
Fresno Dan enters…gentlemen, drunks, economic bloggers and blowhards – your both right!
two points:
i think an important part of the fed’s rationale for intervening in aig, which you do not address, is the idea that by its very intervention the fed would help stabilise the financial markets and therefore turn around the value of the assets it was buying. i am not saying whether or not this view was justified (the jury is still out on whether the market rally of the last few months will go hand-in-hand with a sustained recovery of fundamentals a la soros reflexivity), but it does provide a good faith explanation of the fed’s decision to take delivery of the underlying loans that goes beyond the “fed is chump” argument – i.e. only the fed was in a position to intervene in a way that would solve the systemic crisis, and therefore it was smart to buy the loans and benefit from the upside resulting from its own actions. of course, this does not in any way explain the subsequent cover-up behaviour.
my second completely unrelated point is that i think there is an interesting angle that has not yet been considered. goldman has been telling anyone who cares to listen that for their own part they were quite indifferent about the aig rescue, because they had already hedged their aig exposure in the market. if we took this claim at face value, it has the interesting implication that perhaps we should look through goldman (in the same way we already look through aig) to see who the real beneficiary of the rescue was.
bena,
The Fed may have believed that argument, it goes to “irrational despondence,”: but it is sorely misguided as far as these assets are concerned.
1. These purchases were before the Fed had decided on QE.
2. Far more important, these instruments, once they become troubled are NOT interest rate sensitive (what the Fed can manipulate) but credit sensitive. We covered that issue in our earlier posts on ML III valuation. One proof of this is that while a lot of debt instruments have shown nice gains since acute phase of the crisis and the Fed’s QE, the ABX indexes in the lowest-rated categories have barely budged.
was the real beneficiary these guys?
http://www.carlyle.com/
Let’s see.
1. Greenspan leaves the Fed and becomes a shill for PIMCO.
2. The NY Fed is owned by its member banks, which earn a 6% cumulative payment yearly from it.
Chump?
No.
Crony?
For sure.
Under the Fed as crony heading what do you make of the HuffPost piece that says it was all about Goldman? It posits that Goldman was on the hook for the SocGen CDS if AIG went down and that Deutsche Bank’s piece was sold to them by Goldman only after it was clear the govt was baling AIG out (in a shammy transaction to reduce the optics of the total Goldman number).
Scott,
There are a lot of assertions in his piece that are just plain wrong.
For instance, he gets all high and might re the payouts made by AIG on October 7 and contends AIG didn’t have to make them, they happened only because the Fed had kicked out Willmustad and installed a Liddy, who had ties to Goldman. That is just 100% inaccurate. There were collateral calls under the CDS, if AIG had refused to pay, the counterparties could declare them in default and put AIG into bankruptcy. That is what this whole exercise was meant to avoid, an AIG BK.
He is also wrong re Deutsche. The BlackRock memo makes very clear that AIG entered into those trades with Deutsche as a means of obtaining financing. This was internal, for the AIG’s eyes only. AIG would have been well aware if the position had changed hands. BlackRock is clear that the Deutshce trade was to benefit AIG, and it seems to be pre bailout.
As for SocGen and Goldman, Goldman had already collected significant collateral from AIG and its marks were more aggressive than anyone else’s. Yes, Goldman in theory had some exposure to SocGen, but Goldman also had CDS on AIG and was collecting collateral payments on them as AIG was being downgraded. In an AIG BK scenario, its CDS on AIG probably would have failed due to cascading counterparty defaults, but up to that point, there is no evidence of counterparty default, hence no evidence of Goldman being exposed.
One thing for sure …
Either way, they deserve to be sacked!!
Can America wake up to the fact that it has a bunch of nincompoops setting economic policies…
One thing for sure …
Either way, they deserve to be sacked!!
Can America wake up to the fact that it has a bunch of nincompoops or crooks setting economic policies…
What is becoming very clear from all this is that Goldman was in a heads we win, tails we win, position, and that Goldman was willing to knee-cap the entire financial system, American people be damned, to get their money. We want our money. We want our money! And they got it.
It was RANSOM paid to Goldman. No other way to look at it. The Fed and the players were sophisticated enough to know that Goldman would push AIG to the brink and would win twice-over, perhaps draining other counterparties on CDS bets on AIG’s failure. The Fed knew the collateral damage would be extensive, but Goldman? Goldman was the damaged-be-damned, we want our money!
Yves,
Thanks for this piece. Very nice sysnopsis of the known salient facts.
What I saw in watching most of Geither and some of Paulson is a lot of dissemblement. Paulson’s better at it than is Geithner.
The fixation on non disclosure is more than intriguing. I see it as a clear indication that there has been malfeasance which may, or may not have been criminal. There is no other good reason for stonewalling.
Correct me if have this wrong; the Fed’s mandate to act as a lender of last resort is entirely dependent on the Bagehot premise of quality collateral and a very high interest rate. Acquisition of the CDOs is the undertaking of an equity position. I believe that it can be held that that is illegal.
My conclusion is that your two premises point to a probable third which is that those in control were both stupid and engaged in the exercise of cronyism. In the scenario I see developing it is not so much that GS is the target as that GS is the stalking horse. I see this event as a case of market participants engaging in an unwitting conspiracy by the fact that they each shared common objectives. In retrospect such events take the appearance of having been willful when in fact the conspiarcy arises because of the shared common objectives. There need not be communication between the parties to establish the conspiracy, their trading actions alone establish the consiparcy. This gives rise to the desirability of maintaining wide participation
in the operation of market.
I also believe that at some point the history of this occurance will be recorded as an idealogue blunder of stunning stupidity and hubris.
I also noted that what has not been tabled in the inquiry is the consideration that AIGFP had committed a massive tort and potentially a fraud. To me it is equally important to realize that the AIG derivative contracts were subject to negotiated settlement and that the fact that AIG could not honor the contracts leads to the question as to the representations that AIG made in executing the contracts.
I have seen reports that indicate that there were 44,000 such contracts. At what point in the execution of those contracts was it self evident that AIG was incapable of honoring the contracts. Moreover, from what I heard yesterday no one seems to be very clear, or concerned, as to whether AIGFP was a separate subsidiary corporation or a department within the AIG corporation.
Enjoy your work and hope that you will keep insights coming.
So Yves, I like where you’re going with the ‘Chump vs. Crony’ narrative.
I’m going to raise a different point, tho’. Much of the discussion of l’affaire AIG has centered around “Who authorized the giveaway?” Geithner, Bernanke, who? To me, that’s not the relevant question. A better one is, “Who proposed the payout at par?” Who came up with the idea? When all the fingerprints are speced, this is who I think we’ll find had their hand upon the cashbox: GS, Merrill, Morgan Stanley, UBS. That is, the beneficiaries of the steal came up with the idea and the Guvmint guys went for it, whether with a wink and a nod or a blink and a quiver. Since we’re speculatin’ on the peculation, I’m of the opinion that one or more of them—GS one supposes—said something to the effect of “We don’t think we can prevent an event if we don’t get complete payout.” And Paulson, Geithner, Bernanke and their inner ring just pulled out the public checkbook and said, “How much do you need?” No attempt to value the positions. No attempt to negotiate. No attempt to regulate. No attempt to get a receipt, really. . . . And we’ll find that those CDSs, while bad, weren’t so bad _then_ to justify either the claim of incipient ‘eventuation’ or the Government rush to give billions to malefactors fo great wealth. As lond as nobody can do the forensics on what the positions were at the point the pass-throughs were authorized, we can’t really tell if ‘it was necessary’ or whether ‘the fix was in.’ So naturally, all parties to l’affaire are desparate to keep the positions from public view.
I suspect that the alpha banks essentially told the coves at the Guvmint to pay them off, and the confirmation suits just did as they were bidden. There was a panic alright: the Guvmint types were panicked—by the sharps. And only too willingly.
YS:
I’ve posted on this issue extensively. In my less than humble opinion, the Fed, headed by Zimbabwe Ben (ZB, 1590 SATs, more than I got) was a crony. It is inconceivable to me that ZB didn’t know he was bailing out the Vampire Squid. If nothing else, Henry Paulson told him.
This is great, btw…
Marcy Kaptur chews out Tim Geithner over AIG:
http://www.youtube.com/watch?v=JtwVRM0OG58
What a weasel. I’m no mind-reader, but I know a liar when I see one…
Third possibility: one part chump, one part crony and one part panicked. They may have felt that they didn’t have the time on their side. How many deals have impossible deadlines to meet with such a rush to close that some docs have to be redone after close?
Large financial institutions know how to game the regulators and often the regulators are either too unsophisticated to know they are being gamed and/or know they are being gamed but for political reasons go along with it. Rightly or wrongly, the regulators/government identify likely survivors and/or institutions that have to survive and then assist them openly or covertly. Like any banker, the Fed really doesn’t want to do deals in the open. Perhaps it will in the future.
Yves ,
I think you should add this as item 2a in your sequence fact set.
In MLIII GS settled only 13.9 of its 22b CDS into MLIII.
The remaining $6 billion (as of 3/09) are financial bets Goldman made with AIG. Mr. Viniar said Goldman has received $4.4 billion in collateral from AIG on those trades to reflect the market decline, indicating the underlying assets are valued at roughly 27 cents on the dollar.
For these trades, “we have derivatives with [AIG] and derivatives on the other side,” Mr. Viniar said. He said many of the trades stemmed from Goldman clients that wanted to make market bets.
http://online.wsj.com/article/SB123756518992096521.html (March09)
(At least 2.5b of this was paid between 9/08 and 12/08).
The 100c debate, is focused only on that portion that ended up in MLIII.
The lesser noticed fact is that the bailout guaranteed AIGs continued performance of the remainder of its CDS portfolio.
GS is just one example, ML and others had positions that didn’t get folded into MLIII.
Why would the Feds put themselves in this position just to protect GS’s “client bets”?
18 months later there’s not a peep about these trades.
It’s time to expand the question of why GS etc got paid at 100c. on MLIII, to include:
“Why the hell does the govt continue to fund payments on these other CDS?”
They’re only discussing the con that MLIII is going to make money, (if Yves would only shut up with her irritating valuation questions)
And ignoring these other positions which look like they really will end up paying 100c, at the rate the GS swaps are deteriorating.
Where do we look for any disclosure on these positions. They don’t appear in the shortfall list since those are the MLIII CDOs only.
Since these seem to represent as great a danger as the MLIII CDOs, indeed they were heading to zero faster than the MLIII trades, why the deafening silence on these?
Maybe because no one asked them that question.
Michael,
We are well aware of the “missing” $6 billion; they are Abacus trades, synthetic CDOs. It is remarkably difficult to get any information about them. We also have documented the gaps between the positions that were known to be causing stress to AIG as of November 07 vs. the ones that wound up in ML III. The missing Abacus trades are far and away the biggest gap.
Yves, You need to correct your timeline. The AIG bailout began in September 2008, not 2009.
Good discussion here. Following yesterday’s testimoney from Timmah, we are asked to believe that everything they did was done to protect the public. Everything. Thus, if the public loses $60 billion on this deal it is because our broker (the Fed) is an insane risk-taker and wholly incompetent to conduct any business on behalf of the people of the United States. If that what you want us to believe Tim, then why haven’t you resigned?
“So why did they buy the CDOs?”
Another possibility: They wanted to avoid supporting CDS that were not protecting the value of real assets. Don’t know that this was the best way to do it, but at least by insisting on the transfer of the CDOs, they didn’t end up paying off purely speculative positions.
I just read MichaelC after writing this paragraph. To argue in favor of the Fed’s decisions: If you accept that it was necessary to honor the terms of the CDS contracts to avoid an EoD and keep AIG out of BK, then at least they managed to do this without providing an official government guarantee of the speculative positions.
Another related issue (that Richard Alford has also raised): Why did Treasury refuse to act as the fiscal agent of the government in the bailout and push that position on the Fed? And why did the Fed accept this situation?
I have trouble with this “avoiding a guarantee” issue; I have no doubt a clever investment banker could have come up with a structure that for legal purposes was a lending facility but achieved the same outcome as a guarantee.
The outcome chosen, to pay out 100%, not simply on the CDS, which was the extent of AIG’s liability, but the CDOs as well, is just not defensible. How is a solution “better” when the economic consequences are what you would see in a worst case scenario?
Yves the first several paragraphs are excellent.. One more opine on any site appearance changes, several sentences in those paragraphs would really jump off the page if they were in color, say royal blue or verdent green. Color us all thankful for your many hours of work and we look forward to your book. Cheers.
The story Geithner and Bernanke (and Hank Paulson) tell is that they did everything, however personally repugnant it was to them as dedicated stewards of public funds, to keep the entire financial system from collapsing. And they are sticking to this story no matter what. People who study the details know they did so many things that had nothing to do with saving the world, both during the early days when they were shoveling money out the door into their friends’ limos and later when they started hiding their tracks and working to preserve Wall Street’s ability to pull off new scams in the future, that the only real question is whether they are crooks or cronies. Nevertheless, most Americans, including people I know and like, believe the end-of-the-world comic book version, in which life as we know it was preserved by three superhero geniuses–a nerdy professor from Princeton who understood financial collapses better than anyone else on the planet and two financial wizards with nerves of steel who were on loan from Wall Street. People hear versions of this story every day, from people they trust, from Time Magazine and the New York Times, from Paul Krugman and Brad DeLong and Mark Thoma, from Barack Obama and Larry King and, probably, from Oprah. More than sixty U.S. Senators are about to endorse this version of reality. What can you do?
Love your analysis. Sounds like the reality I know. I’m still wondering whether there is a story in Lehmann investments in solar, its demise and the apparent feudal domination of Goldman Sachs, including the AIG thing.
Paulson the former chair and CEO of Goldman and Lloyd Blankfein, the current CEO of Goldman, occupied two of the seats at the table deciding AIG’s fate back during the weekend of the 13-14 September 2008. The fix was in then but the meltdown of Lehman got in the way of the AIG payoffs for about a month. Neither Geithner nor Bernanke had a problem with Blankfein’s presence although it represented a massive conflict of interest.
Re Point 3. in What’s sus about the Fed’s conduct
You say,
Now of course, preparation for an investment bank bankruptcy, which would lead (among other things) to a hard look at the credit default swaps market; failure to do so could fit the “Fed as chump” theory, that the authorities dropped the ball, big time.
AIG wasn’t an investment bank bankruptcy. It was a bankruptcy of an entity whose products were exempt from the Bankruptcy Code. This was unprecedented.
In 2005 Congress expanded the special derivative provisions of the Bankruptcy Code to exempt credit derivatives from key provisions of the Code, with little or no consideration of the larger implications of credit derivatives for chapter 11 policy. Effectively, ISDA (i.e the banks) controlled a critical bit of the Bankruptcy Code.
A huge CDS counterparty bankruptcy hadn’t been tested or adequately planned for. When Lehman failed ISDA wasn’t ready to handle it and had to move quickly to set up the settlement protocols. We need to evaluate their role as well when reviewing the Feds response. ISDA representatives must have been in contact with the Fed, so it’s difficult for me to imagine the Fed didn’t include the derivatives bankruptcy effects in their decision to bail out AIG.
The exemption is currently being challenged in a court case regarding Lehman. There is uncertainty whether the exemption will hold.
http://www.ft.com/cms/s/0/9a70a64e-0ae2-11df-8a26-00144feabdc0.html
As for planning , this is from the March 09 Treasury Press Release describing the Request for Resolution Authority.
The trustee of the conservatorship or receivership would have broad powers, including to sell or transfer the assets or liabilities of the institution in question, to renegotiate or repudiate the institution’s contracts (including with its employees), and to deal with a derivatives book
I don’t know what broad powers to deal with a derivatives book means exactly but Treasury apparently didn’t have them in 9/08.
http://www.ustreas.gov/press/releases/tg70.htm
Michael,
With all due respect, as indicated in the post, conventional wisdom as to why Bear had to be rescued was that its failure would take down the CDS market. While I have no way of knowing whether that indeed was the reason for the decision to rescue Bear, it remains the most credible theory.
It was also well know at the time of the Bear failure that other institutions were vulnerable. It would thus make sense to understand the nature and magnitude of the risks involved.
Any serious assessment of the health of the major investment banks in 2008 would have involved an examination of the CDS exposures; that would have to be a top priority. And that in turn would lead to AIG. The powers that be would not have been caught as flat-footed as they were and (hopefully) would have come up with better remedies.
The time pressure led to a failure to consider additional options, for instance, a partial payment out on the CDS, followed by a BK (I am not recommending this as an option, merely pointing out this would create a way to have a limited payout on the CDS). A holding company BK was rejected out of hand, but that appears due in large measure to the inability to assess the ramifications.
The fact that Geithner has subsequently requested a special resolution authority (and note the failure to address the CDS bankruptcy issues) is proof of the wildly deficient investigation and planning. It was obvious that the authorities lacked both tools and information as of the Bear collapse. But they did not address fundamental issues, and kept attacking symptoms as they arose.
By contrast, within 10 days of the 1987 crash, Ronald Reagan appointed the Brady Commission to investigate and make recommendation. This crisis took place in OTC markets which were and are illiquid and opaque, even harder to understand, which makes getting a proper diagnosis even more important.