by Frank Thomas and John Lawrence
Was the Congress, Fed, and Treasury Rescue of AIG the Right Decision in 2008?
Frank Thomas says "Yes." John Lawrence says "No."
David Stockman: “We Should Have Let The Market RIP, AIG Fall … and Lived With The Consequences”
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).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.