How the Fed Bungled AIG's Rescue, Enriched Bankers and Screwed Taxpayers

From The Business Insider, Oct. 27, 2009:

It is by now well known that the banks on the other side of credit default swaps sold by AIG got paid out at par when the government bailed out the insurance giant.

But what isn't as well known is that by deciding to pay AIG's counter-party in full, the Federal Reserve was reversing months of work AIG executives had done to convince the banks to take a haircut on their positions.

In the months leading up to the bailout of AIG, the chief financial officer for AIG's financial products unit worked day and night and through the weekends to work out a deal with the banks that had purchased $61 billion of credit default swaps from AIG. AIG was trying to get the banks to accept as little as 40 cents on the dollar to retire the swaps.

Typically, a counter-party to a firm rapidly running out of cash might expect somewhere between 50 to 70 cents on the dollar to close out the obligations. Citigroup agreed last year to accept about 60 cents on the dollar from New York-based bond insurer Ambac Financial Group Inc. to retire protection on a $1.4 billion CDO.

But when the New York Fed stepped in on September 16, 2008,with an $85 billion credit line for the company, those negotiations ground to a halt. Beginning early in November, a team lead by Tim Geithner at the New York Fed took over negotiations with the banks. Geithner’s team offered the banks 100 cents on the dollar.

Bloomberg reports that the documents were similar to those drafted by AIG, except for one crucial detail.

Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.

The New York Fed’s decision to pay the banks in full cost AIG -- and thus American taxpayers -- at least $13 billion. That’s 40 percent of the $32.5 billion AIG paid to retire the swaps. Under the agreement, the government and its taxpayers became owners of the dubious CDOs, whose face value was $62 billion and for which AIG paid the market price of $29.6 billion. The CDOs were shunted into a Fed-run entity called Maiden Lane III.

According to a quarterly New York Fed report, the value of those $29.6 billion in securities declined in value by about $7 billion as of June 30.

So why did the Fed pay out so handsomely even though a better deal for taxpayers was already in the works? We'd guess it was financial panic. In the wake of the collapse of Lehman Brothers, the government was worried that the financial system was on the verge of collapse. It fearred making banks take a haircut on the AIG swaps would leave them with insufficient capital. In short, it was a covert bailout of the banks.

The biggest winners here include Goldman Sachs, which got $14 billion, as well as Societe Generale and Deutsche Bank.

No doubt regulators would say that paying full price was necessary. But it was not.

A far better move would have been to transparently bailout firms that needed the additional capital instead of doing it in an under-handed way. Even better would have been to have forced those firms with too much exposure to AIG to seek out new capital in the markets, possibly converting debt to equity and wiping out existing shareholders. Goldman Sachs claims that it didn't need the AIG bailout bucks to survive--a claim whose truth we'll never actually know because of the bungled operation of the bailout.

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