If AIG and the other Big Banks had fallen, would it have doomed the whole economy?
by Frank Thomas and John Lawrence
Frank has eloquently argued “Yes” here in Part 2 and continued here in Part 3 of our examination of the financial crisis of 2008. Part 1 dealt with Republican economic philosophy over the last 30 years which had produced disastrous results for the economy leading up to the crisis.
This week John argues that AIG should have been allowed to fail and that this would not have affected Main Street banks or the banking activities of average Americans. But the real question is ‘If American taxpayers and the Fed had not given billions of dollars to AIG and the other large banking institutions, would they have indeed failed or would they, on the other hand, have survived quite nicely even without the bailouts?’
What’s clear in the financial crisis of 2008 is that Washington rescued Wall Street while abandoning Main Street.
The government under the direction of Treasury Secretary and former CEO of Goldman Sachs, Henry Paulson, and later Treasury Secretary Timothy Geithner (former President of the privately owned Federal Reserve Bank of New York on whose Board Jamie Dimon CEO of JP Morgan Chase sat) held the most reckless casino contracts made by rich investors inviolable paying out 100 cents on the dollar to them while considering the contracts entered into by homeowners and small business owners mere irrelevancies.
Neil Barofsky, former Inspector General in charge of Oversight of TARP, the $700 billion taxpayer funded bailout, has accused the whole Wall Street enterprise of fraud. He has said that he focused on criminal rings made up of corrupt lawyers, mortgage brokers, notaries, loan officers, appraisers, and various and assorted other insiders, virtually the whole Wall Street crowd.
Mortgage brokers lied to potential borrowers about the amounts of their payments and what they would be when their ARMs (Adjustable Rate Mortgages) reset. Brokers were paid incentives to get borrowers who qualified for a prime loan to instead take a more expensive higher-interest-rate subprime loan.
The worse the mortgage was for the borrower the better it was for everyone in the mortgage business. Regulators had abandoned any pretense of regulating and looked the other way.
When this edifice built on fraud started to collapse in 2008, Treasury Secretary Henry Paulson serving under George W Bush ran around Washington with his hair on fire and demanded that Congress pass a bill immediately giving him $700 billion to be used at his own discretion with no strings attached. In addition to taxpayer money the Federal Reserve ponied up $7 trillion of fiat money that it just created out of thin air with a few mouse clicks.
On October 13, 2008 with Bush still in office, Paulson called a meeting of nine big Wall Street banks and forced them to take $125 billion which he parceled out to them even though some of them didn’t want it and didn’t need it. Richard Kovacevich, CEO of Wells Fargo, didn’t want to take the money. Paulson forced him to take it.
Can you imagine if your banker called you in and said “We are going to pay off your mortgage whether you like it or not.” That would never happen but here was Hank Paulson forcing CEOs of big Wall Street banks to take billions of dollars. Kovacevich said “I believe the TARP decision of forcing people to take money they didn’t want or didn’t need was one of the worst economic decisions in the history of the US.”
The biggest recipient of TARP cash, Goldman Sachs, has maintained it had no exposure to AIG. Between the collateral AIG posted and other assets on their books, Goldman claimed to have fully hedged any counterparty risk.
Was it necessary to save these institutions by throwing money at them? And was it worth it not to bail out the homeowners underwater on their mortgages insuring that all contracts between homeowners and banks should be honored in order not to encourage moral hazard? Moral hazard is simply the fear that letting people off the hook will encourage shoddy behavior in the future.
As it turned out, the moral hazard incurred was on the part of the fraudsters on Wall Street who were showered with money and allowed to get right back to the business of screwing people secure in the knowledge that they would never be held accountable because they were ‘too big to fail.’
AIG was essentially a huge insurance company insuring that all the bets that Wall Street was making on derivatives were good. When these bets turned out to be bogus, AIG had to pay up and couldn’t. It was similar to a run on the bank.
Should AIG have been allowed to fail? David Stockman, Reagan’s former budget director, says that that isn’t even the point. He maintains that they wouldn’t have failed even if TARP and the Fed hadn’t bailed them out. Certain investors would have taken a haircut but AIG could have withstood those blows and remained in business. Paulson’s ‘hair on fire’ bailout at taxpayer expense had more to do with saving investors’ and speculator’s hides than in saving the banking institutions themselves.
In his book, “The Great Deformation“, Stockman says:
“For me, AIG was the skunk in the woodpile. After twenty years on Wall Street I knew that the giant, globe-spanning AIG and its legendary founder, Hank Greenberg, had once been viewed as not simply the gold standard of finance, but as sweated at the very right-hand of the financial god almighty. And then, in a heartbeat, AIG needed $180 billion – right now, this very day, to keep its doors open? Worse still, this staggering sum of money – the size of the Departments of Commerce, Labor, Energy, Education, and Interior combined – had been ladled out as easy as Christmas punch: Bernanke just hit the “send” key on his digital money machine.”
And Hank Greenberg even threatened to sue the Federal government because he didn’t think the terms for the bailout were favorable enough to AIG!
Stockman maintains that Main Street banks were never in any jeopardy. Small business loans would still have been available, and ATMs would have continued to function. Frank argued that some 400 small banks failed during this crisis, but that only represents about 5% of the total number of banks in the US. The large preponderance of banks and credit unions remained in business and would have remained in business even if no bailout occurred.
“There was never a remote threat of a Great Depression 2.0 or of a financial nuclear winter, contrary to the dire warnings of Ben S. Bernanke, the Fed chairman since 2006. The Great Fear — manifested by the stock market plunge when the House voted down the TARP bailout before caving and passing it — was purely another Wall Street concoction.
Had President Bush and his Goldman Sachs adviser (aka Treasury Secretary) Henry M. Paulson Jr. stood firm, the crisis would have burned out on its own and meted out to speculators the losses they so richly deserved. The Main Street banking system was never in serious jeopardy, ATMs were not going dark and the money market industry was not imploding.”
John Carney argued in 7 Reasons AIG Should Be Allowed To Die that insurance policy holders were protected by AIG’s insurance subsidiaries. Also losses to derivative counterparties would have been best addressed by infusing capital directly into the banks that needed it.
Serious consideration should have been given to forcing AIG’s partners in derivative transactions, which were mainly buyers of credit default swaps from the company, to take a substantial haircut. Not allowing AIG to fail created a moral hazard that as much as guarantees that any large banking institution is for all intents and purposes a branch of the Federal government.
After Lehman Brothers failed in September 2008, the government decided to draw the line at AIG which was next in line to go under. Stockman maintains that, if AIG had been allowed to fail, it wouldn’t have caused a chain reaction or a financial doomsday. “In fact, none of the bailouts were necessary because the meltdown was strictly a matter confined to the canyons of Wall Street.”
The failure of these Wall Street institutions would not have infected the Main Street banking institutions; the ‘contagion’ had no basis in fact. Moreover, Stockman maintains that even without a bailout AIG would not have gone out of business.
AIG’s assets were parceled out to subsidiaries all over the globe. Its $800 billion balance sheet consisted of high grade stocks and bonds that were domiciled in a manner that invalidated the “contagion” theory. The crisis had nothing to do with AIG’s assets i.e. its survival as an institution; it had to do with AIG’s CDSs (credit default swaps) which could have been readily liquidated in bankruptcy without affecting AIG policyholders.
Grandpa’s life insurance policy would not have been affected. The money given to AIG was not designed to save the masses from harm but in reality to save the asses of a few dozen speculators.
So the huge amount of taxpayer money given to AIG was not to protect Main Street; it was to bail out speculators 100 cents on the dollar. The evidence shows that each and every Wall Street institution that received money could have withstood the AIG hit so that the bailout was all about protecting short term earnings and current-year executive and trader bonuses.
Stockman sums it like this: “In short, there was no public interest at stake in preventing AIG’s demise. Indeed, the bailout’s primary effect was to provide a wholly unwarranted private benefit at public expense; namely the shielding of highly paid bank traders and executives who had exposed their institutions to embarrassing losses from taking the fall that was otherwise warranted.”
And even though the big speculators recouped a hundred cents on the dollar, homeowners were wrongfully foreclosed on and forced to take a settlement of as little as $300 in return for losing their homes. The TARP program was supposed to help troubled homeowners struggling with their mortgages by writing down the principals, lowering interest rates, lowering monthly payments or all of the above.
However, only a small fraction ($1.4 billion according to Barofsky) of the $50 billion allocated to help homeowners avoid foreclosure was actually spent while the funds expended to prop up the financial system totaled $4.7 trillion.
Stay Tuned – Next time – Part 5: The Role of the Federal Reserve and European Central Bank
John Lawrence
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John,
You’ve summarized extremely well the “tough case” approach” to the AIG fiasco. We only differ on the timing of the “the market tough haircut” treatment that should have been given out. The multiple economic-financial system breakdowns occurring simultaneously made an AIG failure extremely dangerous.
Stockman’s arguments for ” letting AIG and other banks fall and live with the consequences,” … “AIG’s CDSs could have been liquidated in bankruptcy without affecting AIG policyholders or the financial system in general,” … AIG’s high grade stock and bonds were domiciled in a manner that invalidated the ‘contagion’ theory,” etc. ignore the terrible economic interconnected casino climate that had built up over 2003-08.
It’s amusing to hear Stockman’s “Let the Market rip” chorus, while he also acknowledges that an AIG bankruptcy and that of other banks “would lead to lots of pain lasting a Generation.” A generation in time is conservatively defined as 25 years! That sounds like Stockman is saying AIG’s massive straying from conventional insurance products indeed presented Systemic Risk to the broader financial system!
My problem with Stockman’s thesis arises from three major fault lines:
1. He trivalizes the layer upon layer of economic and financial breakdowns steadily building up panic factors and loss of confidence in the stability of the financial system during 2006-08, e.g., massive withdrawals of money market funds severely disrupting commercial paper markets; broad-based decline in home prices; accelerating mortgage defaults; cascading fall in values of mortgage-based securities; near collapsing mortgage giants Fannie Mae and Freddie Mac; sinking of stock and bond markets in which insurance firms were heavily invested (particularly in bonds); failure of Lehmans, exploding elimination of jobs; sharp curtailing of new bank loans; collapsing of credit markets; etc. … ALL coming together and peaking in 2008!
2. He trivalizes the extraordinary size, scope and global dimensions of AIG’s diversion into risky securities investments and insurance for sub-prime mortgage securities. AIG exploited its triple-A rating acquired from its traditional insurance business to run up a huge insurance hedge fund business worldwide with NO collateral for its more risky security investments AND CDS contracts. AIG’s largely unregulated parent holding company and its Financial Products subsidiary departed on a grand scale from the world of property and casualty insurance into the more obtuse, dangerous world of insured financial products.
Stockman is right that runs on traditional life insurance firms have been rare and short-lived in past times. The inherent prudent match between conventional long-term insurance obligations and long-term cash inflows has led to little ‘contagion’ risk in the standard insurance business. However, AIG’s risky product digression into the combined collateral demands from Financial Products’ counterparties AND the liquidity shock of securities lending in stressful times caught the firm in a ‘double death spiral’ … where national and global problems in the Financial Products’ CDS activities exacerbated the problems in securities lending and vice versa.
Even worse, regulators in many states, regulators in the 130 countries AIG operate in, the Office of Thrift Supervision (OTS) over the AIG parent holding company were flagrantly unaware of the depth of new non-traditional insurance risk exposure being aborbed by AIG … and its SYSTEMIC interconnectedness. Doubts about the values of AIG’s guaranteed investment contracts for pension funds, municipalities, and other entities could have spread to other life insurance firms. AIG had at that time 81 million life insurance policies with a face value of $1.9 trillion globally. Huge worldwide figures!
To quote a report by the International Association of Insurance Supervisors:
“AIG was so interconnected with many large commercal banks, investment banks, and other financial institutions through the relationships on credit default swaps and other activities such as securities lending that its potential failure had created systemic risk.”
3. He trivalizes fact, that given the enormous confluence of exigent and unusual financial circumstances prevailing at the time, a disorderly failure of AIG and other major banks would have been devastating. For, as Bernanke and Geithner stated, no effective bankruptcy framework existed for an orderly winding down of a firm of AIG’s type and size. As Secretary Timothy Geithner reported to the House Committee on Oversight and Government Reform on Jan. 27, 2010:
” No legal tool was available to handle an AIG failure, comparable to the one available to the Federal Deposit Insurance Corporation for managing the orderly wind-down of a troubled bank. In particular, we did not have the ability to quickly separate the stable underlying insurance businesses from the complex and dangerous financial activities carried out primarily by the AIG parent holding company (and its Financial Products subsidiary operating in Ct., London and Paris). … None of the agencies with supervisory authority over AIG — the OTS, insurance commisioners, or regulators in Ct., London, Paris — had any tools to help directly meet the funding requirements of AIG. And no one in the federal government had a mechanism , as we do for banks, to provide for the orderly dismantling, selling, or liquidating of a global, non-bank financial institution like AIG.”
At the worst economic time with world repercussions since the Great Depression, three options were thoroughly evaluated by government officials and experts: (1) let AIG default on contractual obligations (2) continue to lend AIG money to meet its obligations (3) restructure contracts to stop the hemorraging and potentially recover the government investment for taxpayers.
Options one and two were unacceptable. Option one was refused because of feared systemic economic consequences elaborated at length by Bernanke and company.
Option two was refused because it meant more taxpayer exposure and more AIG debt which would further hurt its credit rating and its viability. Option three was accepted and has been largely successful. Almost all TARP funds are recovered as well as $182 billion in taxpayer rescue funds … both with a profit. AIG has practically eliminated its CDS business and is back to traditional insurance ‘business as usual.’
Concerning Stockman’s idea of forcing counterparties like Goldman Sachs and other investors to take a “haircut,” the Fed tried to negotiate counterparty concessions to no avail. But, given the economic climate, there was no capacity or willingness for a group of private firms to provide the resources necessary without government assistance. In Geithner’s words:
“If we had sought to FORCE counterparties to accept less than they were LEGALLY entitled to, (editor’s note: besides causing extended counterparty lawsuits) market participants would have lost confidence in AIG and ratings agencies would have downgraded AIG again. This could have led to the firm’s collapse, threatened our efforts to rebuild confidence in the financial system, and meant a deeper recession, more financial turmoil, and a much higher cost for American taxpayers.”
What all this comes down to is that Bernanke and company did NOT want to save AIG. BUT the scale of AIG’s losses, the force of the financial storm hitting the rest of the financial system in 2008 — compounding risk and panic factors — made it far too risky to let AIG fall.
Frank, a very knowledgeable and eloquent rebuttal. You make your case very well. I just question why speculators and investors had to be bailed out a hundred cents on the dollar and why banks such as Goldman Sachs and Wells Fargo were forced by Paulson to take TARP money that their CEOs didn’t even want. It is well known that Geithner was afraid to take any course other than giving banks all the money they wanted. He and Bernanke seemed to err on the side of showering the banks with money rather than to making them pay any price whatsoever for their blatant irresponsibility and fraudulent activity. Also these watchdogs of the casino economy had nothing whatsoever to say as homeowners were foreclosed on and gypped out of their homes and when the HAMP program never materialized to help them in any significant way. They were very much on the sides of the big banks because they were creatures of that milieu, but considered the plight of homeowners and mortgagees to be small potatoes.
John,
The entire “too Big to Fail” trap ruled the day in AIG’s rescue for all the unique but ugly reasons mentioned in our writings. But it should NEVER happen again for all the reasons you allude to!! If AIG becomes the template for “moral hazard.” to save the irresponsible speculators again, it’s the end of American democracy.
Our core sickness is a monetary-fiscal system structurally broken in favor of the vested interests … who ultimately make politicians their captive vested protectors and the disinvested, discarded ‘common man’ an ‘everyman.’ It’s called plutocracy.