The Backdoor Bailout
Jan 28, 2010
Posted by Jody Eisenman | Filed under Uncategorized
Back in 1835, the city of New York experienced a tremendous fire which destroyed almost 700 buildings in the area now known as the financial district. The total damage was estimated to be around $20 million, which would obviously translate to a large multiple of that in 2010 dollars. By and large, the companies were covered by a variety of insurance policies offered by 29 different companies. Unfortunately, 23 out of the 26 insurance companies could not meet their requirements and went bankrupt. The financial devastation to the businesses involved was severe, and thousands of New Yorkers were out of work. Lets flash forward to 2008. Over the decade, AIG discovered a new very profitable business, that of bond insurance. Lets say an institution bought a $100 million bond from General Motors. The institution becomes nervous over the prospect of GM possibly declaring bankruptcy and defaulting. For a few pennies on the dollar. They could go a company like AIG and buy an insurance policy on the bond. Should GM default (which ultimately happened), the institution would get paid the full face amount of the bond. AIG later expanded this coverage to real estate as well. These insurance policies were known as credit default swaps or CDS. At the time, AIG was only required to put up a very minute amount of the face value of the policy in escrow as collateral. As such, AIG’s earnings exploded, as the default levels were almost non-existent. However, as the financial crisis grew, it suddenly became apparent that the likelihood of default on some of these companies had increased dramatically. In addition, as the prices of these CDS shot up in value (CDS are actually traded in the open markets; thus one could actually own a policy on a bond without actually owning the bond at all!), AIG was now forced by the insurance regulators to put up much more collateral. These collateral payments were in the tens of billions of dollars. There was no possible way for AIG to either put this money up or raise it quickly. By the summer of 2008, AIG, one of the high flyers of Wall Street, was facing bankruptcy!
What did AIG do? They went running hat in hand to the government. Without much fanfare or debate, the US gave AIG an $85 billion dollar line of credit on September 16. In less than one month, AIG drew down over $70 billion on this credit line. In return, AIG gave up 80% of their company. Ultimately, these credit facilities were expanded to $123 billion. On November 10, AIG reported a third quarter loss of twenty four and a half billion dollars. This brought the total loss over the previous four quarters to $42.5 billion. Amazingly, this was just the appetizer. On March 2, 2009, AIG reported the largest quarterly loss in US history, a staggering $61.7 billion.
Now comes the fun part. As many questioned even then, why did the government rush to pump in such incredible sums of money into AIG? The answer, it seems, lies in the counter parties, or the institutions that bought the CDS from AIG. As revealed last March, these institutions included some of the biggest names in the financial world, including Goldman Sachs, Merrill Lynch, Societe Generale, Deutsche Bank and UBS. According to a fascinating report by Ranking Member Darrell Issa of California of the Committee on Oversight and Government Reform, the Federal Reserve Bank of New York (FRBNY) was asked by AIG to negotiate with the counter parties in November of 2008. This report can be found on www.scribd.com At this point, these institutions were about to go over Niagra Falls without a paddle. Therefore, they were not exactly in a favorable negotiating position. Negotiations lasted barely two days. The institutions were adamant on receiving 100 cents on the dollar, a posture that seems outrageous in the face of the maelstrom swirling around them. Amazingly, the FRBNY agreed. In the words of Tom Baxter, FRBNYs’ general counsel, “I don’t know why even bothered to ask”. They way I imagine the negotiations went were that the large banks told the FRBNY that if AIG was not bailed out pronto, there was a great likelihood that they (the banks) were going to go under as well. In which case, you could kiss our financial system goodbye.
Now, during this crisis, current Federal Reserve head Geithner was head of the FRBNY. He didn’t give up his post until he was confirmed in January 2009. Geithner admitted that he approved these 100% payments, but he denied that he agreed to bail out AIG because of the precarious position of the banks. On Wednesday, Geithner (and former Fed head Paulson) were grilled by congress. It seems that the FRBNY basically demanded that the 100% payout be left out of AIGs’ mandatory SEC filings. Geithner denied having a part in the cover up, which many believe strains the limits of credibility. In any case, more and more information is starting to leak out of this fascinating situation. Could this be the beginning of the end for Geithner? I will keep you updated.
