Frank Thomas: The Rescue of AIG in 2008 was the Right Decision
Part 2 of a multipart series, Frank will continue his “Yes” answer in Part 3, John will give his “No” answer in Part 4. Part 1 can be found here
by Frank Thomas and John Lawrence
In his book, The Great Deformation, David Stockman presents a broad “no prisoners taken” indictment of our systemic social-financial-political maladies or ‘deformations.’ I share his view we have descended to a gamed, distorted system where almost “nothing is working”coherently that can save it from the next Boom-Bubble-Bust implosion unless there is fundamental change.
Stockman’s Austrian libertarian advice is that government should stop governing. Back to the pre-Roosevelt Carter Glass era of financial discipline under the gold standard and the Fed operating as a passive banker’s bank, making loans and accepting deposits. Bad government and pernicious Keynesian economics are core causes of our present ills that justify a turnabout to self-correcting “unfettered market capitalism” of Hoover, Coolidge and everyone before them … this is farfetched, to put it mildly.
Stockman’s brave new world of a self-policing system of unfettered market policies free of government interventions and strict financial regulations – a radical idea with no hard numbers on the human costs, job losses, business failures – is ironic. This is just what we have had a good taste of over the last thirty years! And all it has brought us is a world of energized greedy forces and financial wizards who can burn the house down and make a fortune at it!
Given Stockman’s deep anti-government, anti-Keynesian mindset, it’s no surprise he favored letting AIG and major banks fall. In his words: “despite creating lots of job losses and lots of pain lasting for a generation … this action would create lessons, it would create discipline … new firms would grow out of the remnants of AIG, Goldman Sachs, Morgan Stanley, etc. … bank bailouts were unnecessary … the Main Street banking system was never in serious jeopardy … the money market industry wasn’t imploding.”
These presumed ‘gospel truths’ need to be viewed against what actually took place in financial markets during the bubble crisis times of 2006-08. I shall leave it to the reader to decide whether the Congress, Fed, and Treasury acted appropriately in bailing out AIG at a point in time the economy was entering a mini-depression and the worldwide financial industry was under exceptional strains from many directions.
Why Did The Fed Recommend Rescuing AIG?
Ben Bernanke gave a ‘right to-the-point’ answer to this question on CBS TV March 10, 2009 – the essence of which he repeated to the Committee on Financial Services, House of Representatives March 24, 2009.
“Of all the events and all the things that we’ve done in the last 18 months, the single one that makes me the angriest, that gives me the most angst, is the intervention with AIG. … Here was a company that made all kinds of unconscionable bets. Then, when those bets went wrong, they had a – we had a situation where the failure of that company would have brought down the financial system. … In deciding to rescue AIG, the government worried that if it did not bail out the company, its collapse could lead to a cascading chain reaction of losses, jeopardizing the stability of the worldwide financial system .”
(Note: “Wrong” says Stockman as regular bankruptcy would have worked for all the mega financial institutions … we didn’t need Goldman Sachs, Morgan Stanley, Bear Stearns because Main Street banks didn’t own toxic assets like securitized mortgages (CDOs) and credit default swaps (CDSs).
David Stockman: “We Should Have Let The Market RIP, AIG Fall … and Lived With The Consequences”
In the 2nd half of 2008, global markets were experiencing unprecedented, multi-dimensioned financial pressures and a worldwide loss of confidence. In Bernanke’s words to the Committee on Financial Services March 24, 2009:
“I will describe why supporting AIG was a difficult but necessary step to protect our economy and stabilize our financial system. …The Federal Reserve and the Treasury agreed that AIG’s failure under the conditions then prevailing would have posed unacceptable risks for the global finance system and for our economy”
(Note: “Wrong” says Stockman who casually dismisses as extreme fears the catastrophic implications and global ‘contagion’ from an AIG failure in 2008 – “There will be lots of pain … but let the market rip and live with the consequences”).
What were the extraordinary financial risks that had been building up during 2005-08?
Derivatives allow the sharing or redistribution of risk. BUT, they can blow up in a BIG way by the high leverage and non-transparent buildup of risk inherent in derivative CDO/CDS contracts – especially when used recklessly such as tools for speculation which can lead to taking on too much risk. Non-transparency, opacity, extreme complexity, counterparty risk are the primary risks in the OTC [Over the Counter] derivatives market. The opacity and complexity caused by financial entities interlinked by a large number of non-transparent derivatives contracts means the default of one party could cause severe damage to the credit soundness of its counterparties leading to a broad market disruption. As stated in a joint Treasury and Financial Services Authority paper on CDS trading, “ The private nature of contracting with limited public information, the complex web of mutual independence, the difficulties of understanding the nature and level of risks increase uncertainty in times of market stress and accordingly pose risks to financial stability.”
- In Sept. 2008, Lehman Brothers’ default was the first example of a major counterparty failure to meet obligations on its debt and CDS derivatives. Lehman’s $600 billion bankruptcy broke all world records and led to the failure of other institutions that had substantial derivatives exposure. Financial tremors erupted globally on fears of systemic defaults becoming extreme. Lehman exposed the systemic weakness of having many counterparty credit risks that were not fully transparent nor given much attention. To correct this, CDS risk mitigation techniques have been initiated, e.g., bilateral netting and overcollateralization of swap liabilities as effective ways to address counterparty credit risks in CDS markets. Also, a “central clearing house” proposal for CDS transactions is a sound step in making these transactions more transparent.
- Fueling the fear of ‘financial contagion’ was the spreading of toxic asset risk and threat of bankruptcy to Freddie Mac, Fannie Mae, Washington Mutual, Ambac – right when employment, new jobs, disposable income and GDP growth were plummeting. The placing of Freddie Mac and Fannie Mae under conservatorship added to the tension in financial markets.
- Another factor at the root of the 2008 financial crisis were U.S. accounting rules for reporting derivative risk from mortgage securitizations (CDOs) and credit default swaps (CDSs). U.S. accounting rules, unlike those in Europe, allowed banks to report a much smaller portion of their total derivatives risk. This reporting omission enabled banks to erase trillions in assets and keep trillions of mortgage-linked bonds or derivative liabilities off their balance sheets. This intensified the non-transparency and inadequate control of derivative products. Fortunately, corrections to this reporting omission have been made. Major U.S. financial institutions are now reporting their full notional and net derivative exposure on the balance sheet. Hopefully, this move away from opaque, non-transparent financial statements will ensure banks are more cautious in using derivative instruments in a manner that doesn’t explode in their faces in times of distress.
- Mortgage securitizations kept off the balance sheet became a costly shock when banks had to repurchase home mortgage loans sold to special investor vehicles on a huge scale. Also, AIG’s derivatives contracts required large collateral payments if its AAA credit rating was downgraded as it was in Sept. 2008 – causing a massive liquidity squeeze. This and AIG’s huge CDS positions led to a reported $99 billion loss in 2008. To stabilize the situation for large Wall Street firms making markets in CDS contracts, the Treasury decided to extend to AIG a secured credit facility of $85 billion. This exploded to $182.5 billion after the insurer couldn’t pay banks on derivatives tied to those home mortgage loans. In exchange for this financial investment, taxpayers secured a whopping 92% ownership of AIG!
- AIG’s $1.8 trillion notional derivative risk exposure was intricately connected with financial parties worldwide, including 21 auxiliary holdings and millions of policy holders who were also counterparties. The insurer ended up owing multibillion dollar payments to Merrill Lynch, JP Morgan, Bank of America, Goldman Sachs, Citigroup – in all, 80 companies and municipalities including major European banks like the Deutsche Bank, Societe Generale of France, UBS of Switzerland, Barclays of Britain, etc. (Barclays and Citigroup were customers of AIG’s securities lending program, not derivatives). Government due diligence analyses of the books confirmed the potential breadth of losses were stupendous – posing a dangerous chain reaction that Stockman downplays but Congress, the Fed and Treasury did not! Officials feared the sheer market shock from an AIG failure would precipitate a global financial breakdown of systemic proportions. So this was another reason why government officials decided to bail out AIG and by doing so, its major counterparties who had taken on enormous, irresponsible CDO risks.
- Another system risk is that “AAA” rated firms, like AIG, were presumed to be safe. They didn’t have to post any collateral to the practically unlimited derivatives they were allowed to create out of thin air.
- Other potential risk exposures tied to an AIG failure were specified by Ben Bernanke before the Committee on Financial Services, U.S. House of Representatives March 24, 2008. In Bernanke’s words:
- AIG would have likely been put into rehabilitation by their regulators leaving policy holders facing considerable uncertainty about the status of their claims. AIG’s insurance subsidiaries had considerable exposure to AIG’s Financial Products unit that would have weakened them if the parent company went bust.
- State and local agencies that had lent $10 billion to AIG would have suffered losses.
- Workers whose 401(k) plans had purchased $40 billion of insurance from AIG to insure a stable fund value against a decline in value would have seen that insurance disappear.
- Global banks and investment banks would have suffered losses on loans and lines of credit to AIG and on derivatives with AIG’s Financial Products unit. The banks combined exposure here was $50 billion.
- Money market mutual funds holding approximately $20 billion of AIG’s commercial paper would also have taken losses, exacerbating direct effects of a default on AIG counterparties.
- Once begun, a financial crisis can spread unpredictably. For example, Lehman’s default on commercial paper caused a major money market fund to “break the buck” and suspend withdrawals, igniting a general run on prime money market mutual funds and in turn causing severe stress in the commercial paper market.
- Uncertainties about the safety of insurance policy products could have led to a run on the broader insurance industry by policy holders and creditors.
- Market financial participants knew that many institutions had large exposures to AIG. Its failure would have led market participants to pull back more from commercial and investment banks – escalating even more pressure on those institutions.
- Finally, a very critical point raised by Bernanke was that federal bankruptcy laws do NOT sufficiently insure the orderly resolution (e.g., dissolution) of nonbank financial institutions when a failure poses substantial systemic risks. Lacking this no federal agency could put AIG into conservatorship or receivership to unwind slowly to protect policyholders and impose appropriate losses on creditors and counterparties. Also, no federal agency could provide capital to stabilize AIG. However, the Federal Reserve did have the authority to lend on a fully secured basis, consistent with its emergency lending authority provided by Congress and the Fed’s responsibility to provide financial stability.
As Ben Bernanke concluded,
“ It’s unlikely that the failure of additional major firms could have been prevented in the wake of a failure of AIG. At best, the consequences of AIG’s failure would have been a significant intensification of an already severe financial crisis and a further worsening of global economic conditions … conceivably resulting in a 1930s-style global financial and economic meltdown.”
Stockman downplays the dire situation and multiple interlinked global risks that would have greatly worsened in the aftermath of an AIG failure in late 2008. Is it any wonder that no economist of any standing favored letting AIG go bust and allowing the market to find its own level – knowing full well the wholesale financial chaos, millions out of work, collapse in economic activity and the housing market that was taking place? Bernanke and other officials did NOT want to save AIG … but saw it as the lesser of two evils.
Coming to AIG’s aid bought time for subsequent actions by Congress, the Federal Deposit Insurance Corporation and Treasury to avoid failures of other very important financial institutions. In spite of this effort which resulted in saving AIG, over 400 smaller banks still went bankrupt –contrary to Stockman’s claim that Main Street banks would not be unaffected by an AIG failure!
The Fed oversaw the winding down of AIG’s Financial Products unit and the restructuring and divesting of risky derivative assets. AIG management was given time to execute this derivative risk reduction strategy in an orderly manner in order to find the right counterparties with offsetting exposures. This approach minimized an asset “fire sale” while AIG was eliminating 93% of its derivatives exposure!
Go To part Three
John Lawrence
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All in all an excellent, erudite analysis of the situation, Frank.
I have a few quibbles though which maybe could be cleared up by more elaboration.
You say: “To correct this, CDS risk mitigation techniques have been initiated, e.g., bilateral netting and overcollateralization of swap liabilities as effective ways to address counterparty credit risks in CDS markets. Also, a “central clearing house” proposal for CDS transactions is a sound step in making these transactions more transparent.”
Are you referring to the Dodd-Frank legislation which was supposed to address the inadequacies of the banking system? My understanding is that the financial lobbies have watered down Dodd-Frank to the point that it is virtually worthless insofar as restraining the wild speculation that led to the problems in the first place. The main problem was that none of these institutions in particular AIG were adequately collateralized to deal with the situation that ensued. Regulators weren’t regulating. The rating agencies were rating junk stuff as AAA.
Goldman Sachs let John Paulson design a product they knew was going to fail, then sold it to their unwitting customers, then bought some of it themselves and insured it with AIG. Thus AIG was on the hook to pay both Paulson and Goldman for junk that they designed to fail and their payoff was the credit default swaps they bought from AIG. Paulson made $5 billion on the deal and Goldman came out smelling like a rose. This is money that either taxpayers paid to Goldman and Paulson or the Fed printed for fraudulent activity on Goldman’s and Paulson’s part.
You say: “Another system risk is that “AAA” rated firms, like AIG, were presumed to be safe. They didn’t have to post any collateral to the practically unlimited derivatives they were allowed to create out of thin air.” Right on. It was a problem of insufficient collateral and lack of regulation. And it’s still going on.
You say: “Workers whose 401(k) plans had purchased $40 billion of insurance from AIG to insure a stable fund value against a decline in value would have seen that insurance disappear.” Stockman disagrees on this point. He maintains that all Main Street insurance claims such as life insurance, business insurance and (I believe) 401ks would have been paid. It’s just the speculators and investors who would have been hit hard.
You say: “In spite of this effort which resulted in saving AIG, over 400 smaller banks still went bankrupt –contrary to Stockman’s claim that Main Street banks would not be unaffected by an AIG failure!” As far as I can determine there are about 7000 banks in the US. If 400 failed that’s about 5%, not a particularly significant number.
Bernanke said: “ It’s unlikely that the failure of additional major firms could have been prevented in the wake of a failure of AIG. At best, the consequences of AIG’s failure would have been a significant intensification of an already severe financial crisis and a further worsening of global economic conditions … conceivably resulting in a 1930s-style global financial and economic meltdown.” The point is that Stockman maintains that AIG never would have failed even if taxpayers and the Fed hadn’t given it $180 billion. He maintains that the Financial Products Division was sufficiently ring-fenced from AIG’s subsidiaries so that this wouldn’t have happened. However, contagion can result from sheer panic even if not justified by the facts.
You say: “The Fed oversaw the winding down of AIG’s Financial Products unit and the restructuring and divesting of risky derivative assets.” Isn’t “winding down” essentially paying off investors and speculators with taxpayer and/or Fed money all the bets that AIG had insured couldn’t go bad? And they were paid 100 cents on the dollar!
This article is based on a lot of research and shows a comprehensive grasp of a very complex situation. Great work, Frank!
John,
Thanks for your penetrating questions, John. Excuses for my lengthy reply.
For an up-to-date description of Dodd-Frank Act derivative swap and collateral regulations applying to OTC derivatives instruments risks see, Davis Polk —
“An Asset Manager’s Guide to Swap Trading in the New Regulatory World,” March 11, 2013. The CFTC (Commodity Future Trading Commission) and SEC (Securities Exchange Commission) have divided jurisdiction over swaps of all kinds. The CFTC has the dominant CDS regulating role as almost none of the SEC’s rules on security-based swaps have been adopted to date. So I wouldn’t go so far as to say the Dodd-Frank Act is dead or “worthless,” although I agree the insider bank powers are doing their best to make this and the next crash a virtual reality (as I discuss in Part 3).
The growth of derivatives exploded after the Glass-Steagall Act was repealed and replaced by the Gramm-Leach-Bliley Act. Latter further incentivized banks to grow faster, take on more risk and reckless leverage. In short, banks were turned into OTC derivative brokerage houses. Result? The notional value of commercial bank and holding company derivatives skyrocketed from $34.8 trillion and $38.0 trillion, respectively in Q4 1999, to $200 trillion and $174 trillion, respectively in Q4 2008. Five times higher! By Q4 2010, these same figures rocketed further to $241 trillion and $312 trillion, respectively! Almost 8 times higher! This trend was without question extremely shocking risk news to Bernanke and company.
And banks like JP Morgan, Bank of America and Citibank were using a VaR risk ratio that showed little market risk involved in their trading of a massive amount of derivatives. In 2008, all three banks reported a market risk VaR of 0.03% of their equity or a paltry $493 million against $168 trillion in combined derivatives outstanding at notional value. Here comes the shocker. Under the 2008 TARP agreement, all three banks received $115 billion in their liquidity crisis, yet they claimed, based on their internal VaR risk calculations, there was only $493 million at risk with their derivatives. They were off by over 99%! This also revealed extreme non-transparency and lack of understanding of true derivative risk exposure and serious liquidity squeeze in times of distress.
I feel one cannot blame deregulation as the sole cause of excessive risk undertaken by banks. The banks’ own self-regulatory failure, greed, and terrible risk management also were also big factors … not to omit the Fed’s keeping interest rates too low, too long and government’s promoting of home ownership.
Derivatives were so unregulated, however, that corruption erupted. For example, a number of derivatives sellers bought a credit agency’s AAA rating, facilitating low to no collateral backing and minimum transparency of risk exposure. This was exemplified by Goldman Sach when its CDOs were given an AAA rating by a credit agency. Soon thereafter, Goldman entered CDSs with AIG and even shorted their own exotic financial product so they would get paid and profit handsomely when their garbage-packaged CDOs went bad. Goldman used its VaR market risk calulation correctly and ended up making tons of money and receiving a “backdoor” bailout of $13 billion from AIG that came from taxpayers, as you say John. On the positive side, AIG has repaid taxpayers the $13 billion, and Goldman has repaid its $10 billion TARP loan.
As for Stockman’s claim that Main Street banks would not be affected by an AIG failure, the FDIC closed 465 banks between 2008 and 2012 … 322 in 2008-10 alone versus only 10 banks failing in prior 5 years! In September, the receivership of Wash. Mutual Bank was the largest bank failure in U.S. history. If AIG had failed, Bear Stearns, Merrill Lynch, and hundreds more Main St. banks would have certainly failed as a big number had entered into the poorly underwritten home mortgage business to be competitive with other banks. Many Main St. banks were saved as well as the savings of depositors by the Emergency Economic Stabilization Act of 2008 which raised the limit of FDIC insurance per depositor from $100,000 to $250,000.
“If we had Let AIG fail, the crisis would have burned out on its own and given the speculators the losses they deserve.” With these words, Stockman trivalizes the HUGE sheer shock effect and cumulative potential losses from the layer upon layer of diverse risks at play worldwide in 2008 … while simultaneously contradicting himself with the words, “Of course, there would be lots of pain for a generation.” Yes, speculators will get the losses they deserve, and what the hell, while the middle class will lose also, it’s used to pain.
The winding down, restructuring and divesting of AIG’s derivative risk exposure was the government price for saving AIG and in turn the nation from a more devastating financial cost to taxpayers. AIG’s risk divesture and back to core business has been a success. And the process helped restore financial stability — Bernanke’s main goal in this worst of crises since the Great Depression. I do not favor bailouts, but the AIG case carried an extraordinarily high domino risk of financial and social Armageddon.
The financial industry is now forewarned that there’s no longer a taxpayer lifeline when things go awry. Legislation has been passed that does not protect financial institutions from failing on grounds of being “too big to fail.” If the strict enforcement of a new regulatory regime for pro-actively controlling and making supremely transparent structured financial derivative products is undermined, then we will get what we deserve in the next titanic financial chaos.
This warning I share with Stockman as well as his cynicism we probably won’t learn from the hard lessons given. But, in my view, this in no way means the Fed, Treasury and Congress should therefore have accepted the enormous risk of an immense global financial blowout by letting AIG go down in 2008.