Richard Alford: AIG Redux – How the Fed Usurped Congress

Yves here. Richard Alford, a former New York Fed economist, provides his assessment of the AIG bailout in light of some of the revelations in the AIG bailout trial. While many of his arguments have merit, I want to quibble with a couple of them.

The first is the size of the actual amount taken by AIG and the reason for the drawdowns. At the time AIG hit the wall, the amount it needed was first estimated at $50 billion to cover its credit default swaps portfolio and $20 billion for its securities lending. The Maiden Lane III vehicle that the Fed created to take the CDOs had a $62.1 billion par value, so we can use that as a rough and ready value, and the securities lending bailout costs rose to roughly $50 billion. But consider: those two together get you to only a bit over $110 billion versus the peak lending amount reported as just shy of $185 billion. And some of that ~$110 billion includes laundering a bank bailout through AIG, by not obtaining haircuts on the CDS on the Maiden Lane CDOs. So where did that say $80 billion go? It might be commercial paper or medium term notes during the very worst of the crisis, although with the Fed supporting AIG, you’d think investors would be see its paper as fine. We’re conferring with some close AIG watchers and may write up a discussion of what that AIG black hole consisted of.

Second is that at the end, Alford adopts a “what matters is looking forward,” as in preventing future crises. Yes, but we are great believers in post-mortems, particularly in light of the George Santayana saying, “Those who do not remember the past are condemned to repeat it.”

By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side

The AIG bailout is in the news again. At the time of the bailout, I argued that while it was necessary, the Fed should not have played the role in the bailout that it did. Some of the testimony at the current trial suggests that a reassessment of the reasons for those positions is in order. However, nothing revealed at the trial to date has changed my mind about three crucial points:

• The AIG family of companies was experiencing a liquidity crisis and a number of its subsidiaries were insolvent.
• A default by any of the subsidiaries would have had systemic repercussions.
• The bailout as structured was profoundly anti-democratic. The Fed took actions that, at a minimum badly bent both the law and its legal mandate and should be reserved for the Judicial, Legislative and Executive branches of government.
These points are fleshed out below and an alternative course of action that would have avoided some of the bailout’s shortcomings is offered.

AIG was in financial difficulty and not simply because of the CDS positions at the AIG Financial Products subsidiary, but also because of losses at insurance subsidiaries. Numerous insurance subsidiaries of AIG had borrowed money using assets as collateral. They then used the borrowed money to buy MBS. In short, they had leveraged up and purchased real estate-based assets in order to enhance their returns. However, the prices for MBSs started to decline in earnest with the problems at Bear Sterns, and losses ensued. As part of the bailout, the Fed ultimately had to loan AIG approximately $185 billion against collateral (MBSs). The face value of the collateral was well in excess of the $185 billion. This occurred when there was virtually no market for those securities and AIG’s market capitalization was less than $20 billion. Some of the insurance subsidiaries also received necessary direct capital infusions as part of the bailout.

Losses at AIG subsidiaries had implications not only for policyholders, but for other counterparties, including numerous pension and employer-sponsored savings plans that had invested in AIG-sponsored GICs (guaranteed investment contracts), as well as investment banks and other financial institutions.

The financial problems were compounded by contractual arrangements. As standard practice, many financial contracts contained cross default clauses. Cross default clauses imply that if a firm defaulted with one counterparty, all the firm’s other counterparties had the right to act as if the firm had defaulted on them. In short, if one AIG subsidiary defaulted with a counterparty, the other counterparties would have acted to seize collateral, suspend payments, and initiate legal actions before other counterparties had. Further complicating matters, numerous AIG subsidiaries had guaranteed each other. Consequently, insolvency or illiquidity at one subsidiary implied problems for the other subsidiaries that had guaranteed its liabilities. When a single default could have generated cascading market wide uncertainty, there would have likely been numerous defaults. This would have been in addition to the shock of the failure of a large financial institution that had been rated AAA just days before.

At the trial, it has been asserted that there were viable private bids for AIG. While it is possible that numerous parties had an interest in AIG or parts thereof, given the disagreement about the size of the losses at AIG (estimates ranged from $40 billion to almost $100 billion) as well as the complicated corporate structure and the cross guarantees, I cannot see a responsible entity making a firm non-contingent bid in anything like the time frame required-especially without some sort of a US government guarantee.
In short, a public sector-financed bailout was required because of the uncertainty and the market disruptions that defaults by AIG would have caused.

The financial crisis also precipitated a number of other non-bank bailouts. The structures of the bailouts of GM, Chrysler and both Fannie and Freddie are of relevance in assessing the AIG bailout. The structure of the bailouts of the automobile companies and the two GSEs were specified in legislation. The Fed played no role in the GM and Chrysler bailouts, and only a minor role in the Fannie and Freddie bailouts.

In the case of AIG, public money supplied by the Fed was used, but Congress played no role in setting the terms and conditions. Furthermore, Paulson has testified that he (and presumably Treasury) played no role in setting the terms of the bailout.

Given the Congressional involvement in the other bailouts, the use of public monies and de facto nationalization of a private company in the case of AIG, the absence of any Congressional role in setting the terms and conditions of the bailout raises red flags. Defenders of the Fed’s role in the AIG bailout have argued that the risk to the economy was too high and that Congress could not have acted quickly enough, however Congress was able to pass the legislation establishing the conservatorship for Fannie and Freddie in an expedited fashion.

What explains the difference between the GSE bailouts on the one hand and the AIG bailout on the other? While people will disagree, the most logical explanation is that it was politically advantageous for sitting Congressmen to enact bailouts for the GSEs (and the auto companies), while it would have been a political negative to support a bailout for AIG despite the probable systemic repercussions.

Hence the argument for the Fed’s involvement in the AIG bailout is based on the premise that Congress would be its dysfunctional self. While these defenders of the bailout hail the Fed for stepping in when the Congress would not have able to act, the bailout implicitly required the Fed to engage in activities previously exercised by Congress and the Executive branch.

In assuming a power previously exercised via the legislative process, the Fed acted as an enabler, allowing the Congress to avoid its responsibilities. The enabler role was not new to the Fed. The Fed, by asserting that monetary policy alone could guarantee full employment and price stability, also allowed the Congress and the Executive branch to avoid the responsibility for designing and implementing sensible fiscal, Dollar and trade policies, as well as maintaining a robust financial regulatory regime.

The bailout also involved the Fed taking actions well beyond its historical role. It had never closed down a bank or taken responsibility for managing or restructuring any firm. The FDIC has had the responsibility for managing failed banks. Furthermore, many observers wanted the Fed to act as bankruptcy judge in haircutting the claims of selected classes of creditors. However, it is not the role of a central bank to act as bankruptcy judge: picking winners and losers among claimants to assets of insolvent banks or financial institutions.

Paulson, the then Secretary of the Treasury, also asserted in testimony that the terms of the bailout were punitive and were set by the Fed. This position was supported by Geithner in his testimony. If, on the one hand, it was clear that AIG, including insurance subsidiaries, was about to fail a market test and go into bankruptcy, then how was allowing the then current owners to own retain 20% ownership of an ongoing firm punitive? On the other hand, if AIG was viable, what justified taking an 80% ownership interest in it?
More importantly, it is not proper for the Fed, or any governmental agency, to in effect try, convict and decide on the punishment for acts that were not prohibited by law or regulation. Some argued that punishment was deserved and served a social goal, i.e., reducing moral hazard. However, national security is a social goal, but it would be inappropriate for the NSA to make decisions about steps to promote national security, e.g., widespread wiretapping, if not permissible under the law and without oversight from the Congress or the courts.

The bailout could have proceeded in a more transparent and democratic fashion. The Fed could have had required a letter of agreement from Treasury (and/or from the Congressional leadership) stating that the Fed was proceeding with provided liquidity against appropriately hair-cutted-collateral, while Congress and the Executive branch specified terms of the bailout or conservatorship. This would have allowed the bailout to go forward and would have provided any interested parties with avenues of appeal via the legislative process. It would also have placed the ultimate responsibility for the terms of the bailout where they belong: in the political sphere.

During crises, decisions have to be made quickly and with incomplete and flawed information. The bursting of financial bubbles will, by their very nature, give rise to crises and decisions that will in hindsight appear less than optimal, even foolish.

Avoiding or preventing the next bubble is more important than ex post analyzing the failures in the response to the prior bubbles. The post-crisis second-guessing of decisions made during the crisis has drowned out a more import discussion. The Fed and the other regulators learned a lesson at great expense during the 1980s. The lesson was that it is better to avoid bank failures and crises than clean up after them. A more productive discussion would focus on how they forgot that lesson.

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  1. sd

    Let’s be clear, AIG did not fail – capitalism failed. I remain unconvinced that AIG deserved a bailout. In fact, at this point, capitalism very much deserves to take its losses on the chin like the rest of us mere mortals. If that causes systemic failures, than that’s the fault of a system that needs more regulation and not the fault of the American taxpayer who foots the bill.

    1. MRW

      The taxpayer didn’t foot the bill, taxes don’t pay for anything. That money is extinguished.

      The Fed (according to Randy Wray’s grad students who calculated it) doled out $29 trillion to banks and financial institutions, domestic and foreign. And none to taxpayers, no relief, who were ignored except for that laughable stimulus. Ordinary people lost their homes, their retirement money, their hard-earned wealth, because of what people like Alvarez, Greenspan, Summers, Rubin, chain-saw Gilleran (sp?) did, or failed to do. The Fed and Congress failed to make restitution, and still does.

      1. Carla

        This is not over. It is not in the past. Ordinary cities are sinking. The budgets of public school systems and public libraries are being slashed. Police and firefighters are being laid off. Arts organizations are going bust.

        And yes, my friends and family members have lost jobs, health insurance, self-respect and hope.

        The response is: well, what are you going to do? There just isn’t enough money.

        Thanks a lot, Masters of the Universe.

        1. weinerdog43

          No it is most certainly not over. Many of us have neither forgotten, nor forgiven. When this blows up again, and it will, there may very well be pitchforks and nooses for the masters of the universe. Roosevelt saved them once before. I don’t see another Roosevelt on the horizon.

          1. Nathanael


            They’re creating Russian Revolution / French Revolution conditions. Why? It’s stupid.

  2. scraping_by

    The bursting of financial bubbles will, by their very nature, give rise to crises and decisions that will in hindsight appear less than optimal, even foolish.

    Because it’s never happened before? Please.

    The lesson of the 1980’s S & L crisis wasn’t that preventing insolvent banks from collapsing was better than resolving them afterwards, it was that with a real process in place, personal responsibility gets assigned up to and including bankers going to prison. An outcome devoutly to be wished for.

    The New Deal regulation scheme was specifically designed against the feckless and fraudulent behavior that leads to financial market crashes. The failure of regulation caused by crackpot economic theology insures corner cutting and worse. Even the anti-government terrorists who’ve wormed their way into Congress acknowledged, albeit tacitly, that restrictions on behavior were a needed part of recovery.

    An insolvent AIG was rescued by a sweetheart deal done behind closed doors. A financial firm made insolvent by sly and stupid speculation is the same old story. Instead of the obvious, workable remedy, insiders broke the law to avoid consequences. Only thing not standard is the propaganda fog covering it up.

  3. Blurtman

    Change you can believe in. Timmy Geithner, Lawrence Summers. “Here’s the dirty little secret – no crimes were committed by Wall Street.” – President Obama, Leno show, two months after starting first term, zero investigations.

        1. blurtman

          Thanks for providing a link to the transcripts. I did paraphrase a bit. Here is an excerpted quote: “Here’s the dirty little secret, though. Most of the stuff that got us into trouble was perfectly legal.”

          Note that the president had conducted absolutely no investigation of Wall Street fraud at this point in April 2009. He had just taken office. And he repeated similar claims in speeches after the Leno show.

          So one might conclude he was a messenger, or perhaps, a paid PR man for Wall Street.

          1. TedWa

            While even Bush wanted strings attached to the bailouts, Obama insisted there be none at all. Wall St’s own Manchurian candidate.

  4. pgrommit

    It’s too bad no one has tried to paint the AIG mess in a way the public could understand better. At least focusing on one part of the “backdoor bailout” would do the trick. If I understand it correctly, it went like this:
    AIG was a bookie for the big banks, taking bets on the mortgage market crashing. AIG seemed to think that since U.S. house prices NEVER go down, it could print money by taking in all bets that were offered, by selling CDS (credit default swaps) to the banks who wanted to insure their MBS portfolios against loss. Then when the market did crash, AIG was on the hook to pay off far more in bets than they could cover. That’s when the Fed (Geithner, et al) stepped in, making sure that, among others, a French bank (Societe Generale), a German bank (Deutsche Bank) and the Treasury Secretary’s former firm (Goldman Sachs) were paid in full with U.S. taxpayer funds of more than $40 billion.

    That would surely allow anyone to have a grasp of at least one small part of what amounted to the biggest swindle, and transfer-of-wealth, in history. And I would defy ANY politician who was up for re-election to defend it.

    1. lyman alpha blob

      It’s even more crooked than that though –

      “… selling CDS (credit default swaps) to the banks who wanted to insure their MBS portfolios against loss…”

      They did sell CDS for that purpose however you didn’t necessarily have to own the underlying security to take out CDS insurance. Imagine if you could take out homeowner’s insurance on your neighbor’s house. And then burn it down.

      1. Blurtman

        Bingo! So what the AIG bailout did, as well as shoring up CDS “insurance” for those who actually had MBS positions, was to pay off gamblers’ positions. That is, as you point out, to pay off folks who held naked positions, did not own MBS, and knowing that the market would crash, just invested in CDS’.

        And worse. I package dodgy mortgages into MBS. I know they are dodgy because I also own a mortgage servicing company, like Litton, for example. I package these dead mortgages into MBS, bribe Moody’s to rate then AAA, and sell these toxic pieces of sludge to dupes, making tons of money. And as I know that they will crash, I also take out CDS’ on them, and make even more money. What, I have so thoroughly poisoned my insurer AIG that the company can no longer pay? I know, I’ll get those suckers the taxpayers to pay my bets, and so I can buy yet anther home in the Hamptons. Winning!

        1. Nathanael

          You’ve left out the part where you don’t actually package the mortgages into the MBS — because that would be expensive paperwork. Instead, you just say you’ve done so, and shred the paperwork.

          …then when the time comes to foreclose, you forge the documents.

          The comprehensiveness of the criminality is breathtaking. There is nothing honest going on at the major banks — *everywhere you look* there’s another scam being operated.

      2. Ulysses

        ‘Imagine if you could take out homeowner’s insurance on your neighbor’s house. And then burn it down.”
        This, in two sentences, perfectly captures the rapacious, completely morally bankrupt attitude of today’s Wall St. predators!

  5. Jackrabbit

    I’ve taken issue with Alford many times because he strikes me as more apologist than reformer.

    He will often appear to criticize the Fed but then proceed to obfuscate and excuse with clever arguments and pointing fingers. Here he employees the classic “hindsight is 20/20” BS. I have come to see such slight of hand as a hallmark of neolibs. He is marginally better than a Fed shill for whom the Fed’s having saved the economy! after 2008 means far, far more than the failings before and after. (PS They didn’t ‘save’ the economy, they stabilized it, and they did so principally by throwing money at the problem via back door bailouts).


    If Alford is soooo very concerned about proper functioning of government then why hasn’t he forcefully criticized the new ‘bail-in’ regime set up by Dodd-Frank? whereby the Financial Stability Oversight Council (FSOC) can allow TBTF systemically important institutions to overcharge their customers if they deem this regressive TAX (smart money will flee early) to be necessary for financial stability? Doesn’t the implicit moral hazard that this system establishes actually promote financial instability? (In much the same way that the government backstop did previously.)


    If Alford is soooo very concerned about ‘avoiding or preventing the next bubble” then why hasn’t he forcefully criticized Summers, Krugman (and other prominent economists) for their vocal (and/or implicit) support of bubbles? Google: “Alford, Summers, bubble” and listen to the crickets.

    In fact, in September 2010, Alford asserted:

    Economists have every right to hold any opinion about markets that they choose, they have every right to express it, and they have every right to be agnostic about any or every policy or issue. However, as economists they have no responsibility except to themselves and their careers.

    Alford then went on to take the Fed to task for not taking a more cautious approach. However, he reserves his reproach soley for the Fed as an institution – never mentioning Greenspan (or Bernanke) – who, NC readers will recall, was presented with ‘price to rent’ analysis that clearly indicated that housing was in a bubble (Greenspan/Bernanke ignored it). Accountability of institutions but no accountability for the people that run them or influence them?

    There is no doubt that Alford knows that Krugman and Summers are not just any economists. They influence policy much more than most AND they are explicitly advocating for a policy that Alford seems to recognize as disastrous.

    Greenspan famously admitted that his ‘model’ of how the world words was broken. If I was in a charitable frame of mind, I’d say that Alford suffers from a similarly flawed ‘model’ of the world where individual interests are just part of markets or noise and are thus discarded. But I know that Alford knows – as we all do by now – that cronyism and the revolving door corrupt markets and institutions. Anyone that (studiously!) ignores this is NOT helping to reform but helping to undermine reform.

    H O P

    1. Jackrabbit

      In the recent post about Krugman, one or two commenters said that he was essentially the best we we’ve got – TINA! Likewise, one might say that Alford is better than most because many economists don’t/won’t criticize the Fed.

      But criticism and policy prescriptions that toe the establishment line only serve to buttress that establishment. Lip service to litmus tests, sacred cows, and TINA orthodoxy are not likely to lead to positive results.

      Reforming the Fed means reforming its governance structure and our political system. “Critics” – no matter how well-meaning they may appear to be – that make excuses, point fingers, or argue for superficial reforms or ‘improved’ policy making, actually just muddy the waters (knowingly or unknowingly) and stifle real reform.

      As the joke goes, “everything is fixed”. So I don’t hold out much hope that there will be any real reform until there is another crisis.

    2. Nathanael

      I like Alford — did you catch his criticism of the NSA?

      Alford’s motives seem quite clear to me: he wants to go back to the world of the 50s or 60s, where finance was a respectible profession. I don’t think this is going to happen. But if you see things from that point of view, you see where he’s coming from.

    3. Moe Tkacik

      Yeah this guy is a total shill. I can’t tell you why, but AIG definitely got gang-raped here, first by the Street and then by the Fed and the media. How many CDO managers do you want to bet deliberately started stuffing 06 and 07 vintage collateral into AIG insured 04 CDOs when the monolines began to fail?

  6. Jay M

    Aren’t financial derivatives in first position now in BK? Chide me if I’m wrong, but wasn’t this wrought when Glass-Steagle got the old shiv into the middle body.

  7. Joe W

    AIG was bailed out so that the Fed wouldn’t have to bail out the banks whose conduits were guaranteed by AIG. Much easier to point fingers at “shadow banking” than to be exposed as the regulator that invented the capital and liquidity rules that incentivized the behavior to begin with and provided the lax supervision that allowed it to grow to systemic proportions. Classic CYA

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