Why Did Fed Board of Governors Nix Guaranteeing AIG’s CDS?

More and more revealing pieces of the AIG bailout puzzle keep emerging as various subpoenas and FOIA requests extract more and more details.

One odd bit is why the Fed decided to take out the AIG credit default swap counterparties at par, rather than simply guarantee the contracts?

The Fed keeps protesting that the rescue was about saving AIG, how important it was to the economy (the FCIC testimony from Thomas Baxter, the NY Fed’s general counsel, goes on at some length to defend that idea), but the most logical explanation for this choice is the obvious one: the rescue was primarily a back-door bailout of big financial firms.

The New York Times has a story up tonight on this aspect of l’affaire AIG:

Although that rescue provided $85 billion, the company’s problems continued to grow, requiring it to deliver additional collateral to its counterparties. By late October 2008, A.I.G. had put up nearly $30 billion to satisfy the banks, about half the value of the mortgage bonds they held.

Amid this increasingly perilous situation, Fed officials discussed how to eliminate the risk of even more collateral calls, the internal documents show. One proposal involved the government guaranteeing the contracts; this meant the banks would no longer be able to demand collateral because the government would cover any losses on the mortgage bonds

Yves here. So why did this idea go nowhere?

Under this proposal, the $30 billion in collateral would have been returned to the insurer to help pay off some of its loan from the Fed….According to an Oct. 26, 2008, presentation by Morgan Stanley, an adviser to the Fed, Goldman would have had to return $7.1 billion to A.I.G. and Merrill, $3.1 billion.

Yves here. We are given other proximate reasons, which don’t add up:

The debate within the Fed centered on which part of the government could provide the guarantee, according to the documents. Staff at the Board of Governors told Fed officials in New York that a Fed guarantee “was off the table,” according to an e-mail message to Mr. Geithner and others on Oct. 15 from Sarah Dahlgren, the New York Fed official overseeing the A.I.G. rescue.

“We countered with questions about why it was so clearly off the table and suggested, as well, that perhaps this was something that Treasury could do,” Ms. Dahlgren continued.

Yves here. Why the knee jerk reaction? The NY Fed clearly didn’t buy the logic, and the ultimate solution, of the 100% payout, put more Fed monies at risk (any other course of action that kept the Fed from funding the purchase of CDOs, which is what happened, would have had a lower price tag). Or was it that the Board of Governors saw getting cash to the banksters as a principal aim of the AIG rescue, which would make anything that would make the counterparties return collateral unacceptable (note sports fans, here the NY Fed is doing a better job of trying to limit Fed exposure than the Board of Governors. This also supports the view that seeing the AIG rescue just as a Geithner/NY Fed issue misses the fact that for something this big and visible, the Board of Governors must have been involved in major decisions). So what did Bernanke know, and when?

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  1. vlade

    did you have a look at the “Payback time?” FT article?
    The reference to SCA is great (I missed that bit for a long time. DOH!). If ML/SocGen could accept VERY significant haircuts from them (ML got something like 14c in a dollar), then any arguments on “sancity of contract” is clear nonsense.
    The “if you don’t pay par you’re toast with rating agencies” is a clear miunderstanding (at best) as well. The contract (CDS)’s par was not the face value – unless the underlying CDOs were 0. The par was the MTM, which was not something anyone could easily calculate (all parties agree at least on that). Anyone can cancel the derivative contract at MTM (subject to the cpty agreement) without any rating agencies batting an eyelid, and anyone who says differently either doesn’t understand how things work or is deliberately misleading.

    Fed should have been able to force the buyout of the contract at the current MTM, which was +/- collateral already posted. CDS buyouts happen all the time, it’s how most of the prop traders realise PnL.

    1. vlade

      Thinking about it, it’s even more clear that it was bank bailout rather than AIG bailout.
      The only reason why the banks would not let AIG to buy-out of the contracts at MTM (which, as I said was collateral already posted +/- something small) would be because they believed the contract would gather value.
      If AIG went bust, the cpties woudl get to keep the collateral as that would be the debt of AIG to them – but the contract would be cancelled and there would be no further appreciation.
      Thinking about it some more, paying 100% of the notional on CDS is almost unheard of, even Lehman paid something like 96% on dollar. 100% would mean that the CDO was well and truly bust with 0 value, with no hope of recovery of anything at all, ever (could be, but in that case Fed’s “we will make money on it” is a clear knowing lie).
      If Fed really wanted to so something, an easy an be novate the CDSes to the Fed. Fed should even be able to tell the banks to F*ckoff in regard to collateral (entity who can print the money needing to post collateral as a credit mitigation device? pull the other one).
      This would well and truly bail out AIG – it would give it back the collateral posted to GS& co (30+bn is not something to be sneezed at), it would give 100% safe party to the banks, keep the contracts in place and be less costly to the taxpayer at the same time.

  2. fresno dan

    At one point, I believed the EMT (efficient market theory). I also believed that our system had some degree of a meritocracy (not complete, but some people got to the top because they had real accomplishments) and that the people who ran these financial instituions (banks, the FED, Treasury) must know what they are doing.
    Well, finance is not science. Many of these CEO’s have admitted that they simply did not know how this stuff worked. Undoubtedly, many are also venal. Listening to Paulson, you realize he was just a salesman – he might as well have been selling aluminum siding.

    Even more disturbing is the total market illogic. How is it possible that people still buy stock in companies where it has been revealed that the people who work there don’t know what they are doing (or worse, they do know!!!), take the profits and pay almost all of it in bonuses?
    Our finance system has a lot more to do with tradition, indotrination, and societal signals, than any objective rational evaluation of what is happending.
    Saying we should not disturb the market is liking saying we should listen to the rantings of the metally ill.

  3. Carter

    Simple. The Fed is not empowered to issue guarantees. It is limited by statute to making loans that are secured to its satisfaction. Rightfully, were a guarantee to be issued it should be done by the sovereugn (aka Treasury)

    1. vlade

      if fed could buy CDOs and stuff them into SPVs, it could novate the contracts and stuff them into SPVs. Still cheaper and more efficient.

      1. MichaelC

        What did Bernanke know and when? is todays 64k question.

        Geithner’s recusal argument points to Bernanke as the decision maker.

        At first blush Geithner’s recusal is absurd.

        But then, Paulson points to the NYFed as the mastermind. The NY FR Bank Board points to the NY Fed (Geithner) operating under the Fed Reserve Board of governors direction.

        Yet Geithner ‘recuses’ himself.

        The only way that’s remotely plausible is if Geithner was acting at Bernanke’s direction. The governors at the Fed Board claim their objections were overruled by the Fed Chairman.

        It looks to me like all fingers point to Ben.

        Or they’re all lying.

        On the guarantees, the long term cost of an explicit guarantee probably outweighed the cost of letting the counterparties keep the cash.

  4. RC

    When all this first happened I mused that the Bailout that was upfront televised from the Fed was just a distraction and that the Banks really didn’t need THAT money but it distracted the public from the real bailout thru AIG. All carefully orchestrated and kept relatively quiet by MSM.Nothing but criminal behavior.

  5. Siggy

    The bailout of AIG was, and continues to be, a pass thru event intended to protect and preserve the network of primary dealer banks.

    The fact that it occurred points to the ineptitude of the Fed. What also appears to be in operation is the fact that the ill-thought policies and their inept execution have brought us to this point. The basis for this whole crisis is found not in the details of the AIG sham bailout, it is found in perfidious deregulation, the exercise of monumental hubris and outright theft.

    It is becoming increasingly clear that a massive fraud has been perpetrated. When the hell is the Justice Department going to initiate an inquiry and a set of prosecutions?

  6. deepsouthdoug

    Another good article on AIG/Paulson/NYFed on Huffington by David Fiderer titled:

    How Paulson’s People Colluded With Goldman to Destroy AIG And Get A Backdoor Bailout

    It’s a connecting the dots article and gets into reasonable speculation as to what Paulson’s motives might have been:

    ‘If Paulson actually spoke what was on his mind at the time, the words would have been something like this:

    “So if we don’t bail out AIG, then Goldman takes a $15 billion hit to its equity and faces shareholder lawsuits for actions taken under my watch. And Willumstad, the new AIG CEO who joined management after all these toxic CDOs were booked, will find it very convenient to also point the finger of blame at Goldman. [Willumstad joined AIG’s board in April 2006, and became CEO in June 2008.] The AIG bankruptcy trustee might even sue Goldman for making fraudulent claims about the CDOs, the same way that HSH Nordbank sued UBS and M&T Bank sued Merrill.

    “But if we bail out the company, there’s still no guarantee that Goldman can recover on the CDOs. And Willumstad can still point the finger at Goldman. So before we agree to anything we’ve got to get rid of Willumstad ASAP and replace him with someone who will make sure that Goldman’s interests are being looked after. Let’s use Ed Liddy. He’s a Goldman board member, so he will never disclose anything that makes Goldman look bad. If he wants to preserve the value of his Goldman stock, he’ll discreetly pay off the CDOs before anyone figures out what’s happening. So I decided Willumstad’s replacement will be Liddy, beginning tomorrow, and I don’t give a damn that my unilateral decision to change CEOs overnight is a complete travesty of corporate governance or government accountability. Our story will be that we are replacing the management that created this mess.”

    How do I know that this was on Paulson’s mind and that these were his motivations? As noted at the beginning, the guys at Goldman are very smart, and they knew that the CDO settlement was a zero-sum game. Remember, AIG was Goldman’s biggest client and the issue of collateral postings had been in dispute for over a year. Up until June 2008, Ken Wilson was CEO of Goldman’s Financial Institutions Group. There is absolutely no way that Wilson did not know what was going on with AIG’s management, and that Goldman, not Willumstad was primarily culpable for building up the CDO portfolio.’


  7. psychohistorian

    Where is the outrage?

    Where are the investigations?

    Where are the questions about buying Ben’s silence with this heavily politicked vote tomorrow?

    What does Ben know and when did he know it? I expect that many in the Senate don’t want the public to know.

    It does make me smile to know that even if helicopter Ben gets reappointed, this is not the end of the collapse of the American economy….just more lipstick on the way down.


  8. Dave

    I am not mistaken, but isn’t the CDO identified as ALTS 2005-2A A1 on the released list of Maiden III crap bought at par by Bernanke et al. the same as the one rated B- with a negative watch by S&P? (See Page 3 of 5 of the List of Derivative Transactions release by ISSA today 1/27)

    From S&P:

    CUSIP Search Results: 02149WAA5
    Issue Description: US$1.5 bil Altius II Funding, Ltd.
    Entity: Altius II Funding, Ltd.
    Debt Type: SRSEC
    Class: A-1
    Maturity Date: 01-Dec-2040
    Rating Type Ratings Rating Date Credit Watch/
    Outlook Credit Watch/
    Outlook Date Ratings Group
    Local Long Term B- 28-Aug-2009 Neg 28-Aug-2009 STANDARD
    Local Long Term NR 10-Nov-2005 PRELIMINRY

    The taxpayers paid over $1BILLION for this crap. There’s no way it’s going to be worth 10 cents on the dollar.

    What am I missing? Someone? Anyone?

    1. Yves Smith Post author

      I’ve said in various posts that:

      1. Severely distressed CDOs are fetching AT BEST 20 cents on the dollar, in many cases, zero. And for this crap, market values have been a better predictor than model values

      2. Just a superficial look says valuations not credible (ie, the CDOs are still overall throwing off cash at a rate that can only be due to principal paydowns, mainly of the best stuff in the CDO, via refis. So what remains is lesser in amount and worse in quality. Yet Fed is claiming value of what remains has risen. And they bought it at 47 cents on the dollar.


  9. joebhed

    It’s probably just me but watching Geithner on the tube he seemed to barely hold himself back from telling the stupid congressman that if he asked one more irrelevant question, Geithner was going to get up and walk out, resigning his position, the result being the global financial collapse of twenty-ten – and it would all be on him. So, STFU.

    I believe it was Soddy, again, that warned us:
    “The future of democracy and its power to govern itself depends very largely upon sufficient people getting clear ideas of money from the standpoint of the community.”

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