Harvard Business on AIG: The Secret Bailout

By Bob Pozen

When an insolvent AIG paid out $165 million in executive bonuses, the public was outraged. But that is peanuts compared to the $62 billion AIG has quietly paid out to settle its obligations with some of the world's largest banks. Last week, the details of this settlement were finally disclosed.
The financial products subsidiary of AIG had sold these banks a huge volume of credit default swaps (CDS) — obligations of AIG to pay the full face value of designated bonds if the issuers were to default. Many of these bonds were backed by mortgages, whose values deteriorated sharply during the summer of 2008. In response, AIG executives tried to persuade these banks to settle its CDS obligations at a 40 percent discount to the face value of the relevant bonds.
Then, on September 16, 2008, the federal government took over almost 80 percent of AIG's stock in return for an $85 billion line of credit, which was later increased to over $180 billion in other loans and investments.

During the first week of November, 2008, the Federal Reserve Bank of New York — with the current Treasury Secretary Timothy Geithner as its then president — took over the negotiations with the large banks owning CDS contracts with AIG. After a week of negotiations, the New York Fed instructed AIG to settle these CDS contracts by paying the full face value of all the relevant bonds — $62 billion, as compared to their then market value of less than $30 billion.
In my view, these $62 billion in AIG payments were unjustified gifts to sophisticated investors, who had made an error of investment judgment in choosing a weak counterparty for their CDS contracts. The choice of appropriate counterparties is a critical component of risk management at all financial institutions. Even the vice-chair of the New York Fed admitted that the payments "will reduce their incentive to be careful in the future."

Moreover, no one disclosed the existence of these huge payments by AIG until March of 2009, when the US Senate Banking Committee pressed for some details about the AIG settlement. More information emerged last week in a report by a federal auditor, who wrote that the New York Fed "refused to use its considerable leverage" to negotiate discounts with AIG's counterparties. According to Janet Tavakoli, an expert on structured finance, "There is no way they should have paid at par (face value). AIG was basically bankrupt."

If the New York Fed had threatened to put the financial products subsidiary of AIG into bankruptcy, the counterparties would probably have agreed to settle their CDS contracts with AIG at 70 or 80 cents on a dollar. After filing for bankruptcy, the AIG subsidiary would have been allowed to repudiate all its CDS contracts subject to a court-approved reorganization plan. Most investors would accept discounts to settle CDS contracts now, rather than roll the dice in a lengthy legal proceeding.

Since federal officials have not explained why they chose to pay in full instead of negotiating discounts, we can only speculate. One theory is that the US Treasury wanted to provide financial assistance to foreign banks suffering the fallout of the American credit crisis. These foreign banks received roughly $40 billion of the $62 billion in payouts from AIG. Perhaps this was an indirect way to achieve the US Treasury's objective since Congress would not authorize a direct bailout of foreign banks.

There are conspiracy theories as well. Some observers point out that Stephen Friedman, the chairman of the New York Fed, is a director of Goldman Sachs. Goldman received almost $13 billion in settlement from AIG and Friedman bought 50,000 shares of Goldman shortly after the federal takeover of AIG. Goldman claims that it was fully hedged against any losses if AIG had failed, but the reliability of these hedges has been questioned by the federal auditor.
Why do you think the New York Fed acted the way it did in dealing with the large exposure of AIG to CDS contracts on mortgage-backed bonds? What do you think the Fed could or should have done instead?

Bob Pozen is a senior lecturer at Harvard Business School and the author of Too Big to Save? How to Fix the US Financial System


The above originally appeared at HarvardBusiness.org