The AIG Bailout Revisited: Calculated Corruption or Miscalculated Risk Management?

by Malcolm S. Salter

How we tell stories matters. If we tell the AIG bailout story as an example of calculated corruption, we wring our hands about how best to reverse the declining legitimacy of 21st-century capitalism. And we write more rules and regulations, offer stiffer punishments for violations, and beg for more ethical leadership.

If, however, we tell the AIG bailout story as an example of miscalculated risk management, then our attention shifts to the sources of these miscalculations, such as existential fear of a total credit market collapse, and the ways in which we can better cope with such fears and uncertainties when trying to de-risk and restructure an entire industry.

The implications of the first telling are largely legal. The implications of the second telling are largely technical, managerial, and psychological.

Five years after considerable financial assistance was provided to the American International Group by the New York Fed and the U.S. Treasury, the AIG bailout story remains highly controversial.  But what is the “true” story?  And why is this story still so controversial?

Controversy over the bailout was present from its earliest days, starting in September 2008 when many members of Congress and allied non-interventionists raised their voices against the plan being put in place by the U.S. Treasury and the Federal Reserve Bank. These critics saw the bailout as an inexcusable breach of market discipline. Early complaints about the appropriateness of an AIG bailout were subsequently reinforced by the relentless public criticisms of Fed and Treasury officials by Neil Barofsky, who served as Inspector General of the $700 billion TARP program from December 2008 through March 2011 (Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street). Following Barofsky’s public criticisms was Simon Johnson, a former Chief Economist of the International Monetary Fund, who voiced his criticisms in a 2010 book (with James Kwak) documenting the power of Wall Street in the economic governance of nations (13 Bankers: The Wall Street Takeover and the Next Financial Meltdown). More recently, David Stockman, well known as the Director of the Office of Management and Budget under President Ronald Reagan, has attacked the bailout in his 2013 book bewailing the corruption of American capitalism (The Great Deformation: The Corruption of American Capitalism).

Simon Johnson’s and David Stockman’s criticisms of the AIG bailout mark a turning point in the conversation.. Both argue that American capitalism—and financial institutions in particular—hold the global economy hostage to private interests, as in the prelude and aftermath of the 2008 financial crisis, and that this control is in large part perpetuated through so-called “cronyism.” They also agree that the AIG bailout is a prime example of “crony capitalism” at work in America today — a calculated corruption of the political process whereby the success or survival of a business is dependent on the favoritism it is shown by the ruling government instead of being determined by a free market.

Today, bailout critics typically point to two problems: first, that warding off an AIG bankruptcy was totally unnecessary in the first instance as a bulwark against serial collapses of other financial institutions (so-called “contagion”), which could lead to a total shut-down of credit markets in the U.S. and abroad; and, second, that the bailout as eventually structured was a not-so-subtle cover for public subsidies to banks holding large amounts of depreciating securities (such as collateralized debt obligations) linked to the collapsing housing market, which were effectively insured through the  purchase of billions of dollars of credit default swaps (CDS) from AIG. For these critics, the AIG bailout story is just about as pure an example as there is of how cronyism and lack of transparency have corrupted American capitalism.

While the tumultuous context of the AIG bailout makes a definitive assessment of these claims difficult, contemporary critics do spotlight two pivotal questions that have not as yet been answered to many parties’ satisfaction:

  • Was federal assistance to AIG truly essential for financial system security?
  • Was the ultimate form of this assistance—most particularly, the government-sponsored repurchase of credit default swap contracts held by AIG’s customers at their par value—a misuse of public monies that served private interests at the expense of the public interest?

If the answers to these two questions are positive, then AIG should indeed be branded as a paradigmatic case of crony capitalism and the dishonor that goes with this label.

This may well be the case, but it is worth testing whether or not such a telling of the AIG bailout story is accurate. There is a big difference between (a) calculated corruption in the form of generous financial transactions put in place by the U.S. Treasury and the New York Fed for the benefit of large domestic and foreign banks deemed vulnerable to an AIG collapse and (b) unintended miscalculations by Treasury and Fed officials working in a state of existential fear to manage the risks of a global financial meltdown.

I am currently exploring the latter possibility—that both the initial bailout decision and the subsequent structure of the bailout was a much more complicated phenomenon than characterizations of corruption, collusion, and crony capitalism suggest. I am attempting to argue that the lingering controversies over the bailout are not a result of the corrupt behavior of public officials but rather the result of impromptu and highly improvised risk management by officials who had never before experienced or tried to manage such a risk to the global financial system and who were conditioned by their professional training, deeply embedded world view, and current responsibilities to focus on the worst-case scenarios following a fast-approaching AIG collapse. Public officials no doubt made miscalculations and missteps; but where miscalculations were made, they should not be confused with corruption.

My initial reading of the unfolding crisis in 2007-2008 suggests that federal assistance to AIG was indeed essential to preserve financial system security, as argued at the time by Fed and Treasury officials. I also see that there is little reason to believe the bailout was purposively designed as a cover for the subsidization of AIG’s counterparties (mainly large banks) with which principal decision makers for the government had long-standing personal relationships and, in the case of Treasury Secretary Henry Paulson, a prior financial relationship that created significant personal wealth.

However, the eventual form of the federal assistance, which unfolded in four separate transactions from September 2008 to March 2009 in response to changing conditions at the company and in the capital markets, appears more problematic because AIG’s counterparties in the credit insurance business—mainly large domestic and foreign banks—received what now looks to be very generous treatment from the government during the bailout. This treatment has been seized upon by bailout critics who passionately argue that government officials with long histories and deep connections in the finance industry promoted this generous treatment, and that such treatment is a perfect example of corrupt “crony capitalism” at work. Critics also point to a lack of transparency in SEC filings about the identity of AIG’s counterparties, payments made to them by AIG, and the compensation of AIG officials. (N.B., Davis Polk, the New York Fed ‘s lawyers, reviewed and approved all draft SEC filings.)

Fair enough, but the crony capitalism claim deserves careful examination. A plausible counter-argument is that claims of blatant cronyism in the AIG transaction are overblown and, indeed, inaccurate. Rather than a planned campaign by Treasury and Federal Reserve officials to use public monies and credit facilities to protect and obfuscate the private interests of banks with which these officials had nurtured long-standing relationships, the form of the bailout strategy can more accurately be seen as reflecting a set of assumptions about the nature of systemic risk to the global financial system and the menu of possible remedies, both of which had become deeply ingrained in the world view of Fed and Treasury officials during decades of work with the finance industry. These assumptions (and related fears) were reinforced by many months of mounting evidence and accompanying anxiety over the vulnerability of the financial system to a major “readjustment.” They inevitably shaped officials’ understanding of what was “the right thing to do” while trying to manage rapidly emergent and shifting risks. In hindsight, mistakes may have been made. But rather than a classic case of cronyism, collusion, and corruption, I see the AIG bailout as a case of impromptu and highly improvised risk management under conditions of extreme anxiety over possible outcomes.

I say this fully realizing how tempting it is to assume the worst about crony capitalism in the AIG bailout when Timothy Geithner, president of the New York Federal Reserve Bank, and Henry Paulson, Treasury Secretary under President Bush, were in the saddle. After all, Paulson was the former chairman and CEO of Goldman Sachs, a major recipient of significant government aid in the course of the AIG bailout, from 1999 to 2006; his staff at the Treasury included many former Goldman Sachs veterans—for example, Robert Steel, Steve Shafran, Neel Kashkari, Dan Jester, and Ken Wilson; Geithner’s chief of staff was an ex-Goldman partner; and Geithner’s board of directors include many of Wall Street’s most influential players. In addition, the cronyism charge is bolstered by the fact that in the heat of AIG’ worst troubles, the New York Fed hired Morgan Stanley, later itself a recipient of public monies, to advise on the AIG bailout. Finally, certain details of the bailout program related, most specifically, to the government-financed buyback of credit default swaps from AIG’s counterparties at par value (when the counterparties’ insured mortgage-backed securities were falling in value) have raised a firestorm of complaints. But these outwardly incriminating facts do not seem to fit with the career paths, public service aspirations, conflict of interest controls, and risks of public humiliation for high-ranking Treasury and Federal Reserve Bank officials.

Telling the AIG bailout story fully and clearly requires a detailed description of the multi-step transaction that unfolded over many months in a largely incremental fashion. Strangely enough, not all the facts of this highly technical transaction are clear or understood five years later. Similarly, few folks realize that by the end of 2012, four years after the bailout was initiated, the Treasury reported an overall positive return of $22.6 billion on the $182.3 billion committed by the government to stabilize AIG during the financial crisis.

Once the basic facts of the bailout transaction and subsequent implementation are laid out, the two questions noted above need to be carefully addressed. Was the bailout truly necessary in the first instance? Would an AIG bankruptcy actually lead to “deadly contagion” in the form of cataclysmic financial failures of large, systemically important banks? For this first set of questions to be answered satisfactorily, we need to look into the specific situations of one or two leading banks: What would have been the likely impact on a bank like Goldman Sachs or Merrill Lynch of the loss of protection (via CDS contracts) on bonds, mortgage backed securities, and other assets insured by AIG and held on its balance sheet? What would be the financial impact of losses of 20 or 30 percent on any AIG paper or other loans held on a bank’s balance sheet? What proportion of a bank’s existing capital base would such potential losses represent? How much impairment of the capital base of a large bank like Goldman Sachs does it take to cause an immediate shutdown of access to overnight repurchase agreements for all trading banks, which is one definition of a total financial collapse?

Next, the claim of cronyism surrounding the government-sponsored repurchase of credit default swap contracts held by AIG’s customers at their par value needs to be investigated. Of particular interest was why Treasury Secretary Timothy Geithner, who was still head of FBNYC in September 2008, allowed AIG to pay clients the full value (par) of AIG-issued CDS contracts when (a) the bonds and other insured securities like CDOs had fallen so significantly in value, (b) other mortgage-bond insurers had been able to strike deals on similar contracts at reduced prices, and (c) when, prior to the bailout, AIG had been negotiating in an attempt to get its counterparties (bank customers) to accept as little as 60 cents on the dollar. To some observers, AIG’s payments—funded by government-extended credit—were no less than a bailout of Wall Street, and Goldman Sachs in particular. Indeed, a report prepared by the House Committee on Oversight and Government Reform refers to these payments as a “backdoor bailout of AIG counterparties.” (Paulson was still Treasury Secretary.) In this sense, the committee report echoed the finding of Neil Barofsky, the special inspector general for TARP, that the Fed “refused to use its considerable leverage” to negotiate better terms. Barofsky’s finding was later roundly criticized by the New York Fed.

At hearings held by the aforementioned House Committee in January 2010, an important report commissioned by the New York Fed and prepared by the BlackRock asset management firm in 2008 came to light. The BlackRock report fueled House Committee interest by demonstrating on the basis of its modeling of AIG counterparty derivative positions and related investment strategies that without harried pressure from the New York Fed, AIG would probably have been able to strike a better settlement with its most important counterparties and save a lot of public money. In particular, the BlackRock study suggested that Goldman Sachs was, prior to the bailout, willing to take a haircut on its AIG CDS payouts (i.e., taking something less than the par value of the relevant credit default swaps).

Apparently, this was a possibility for Goldman (but not for the other top counterparties) because Goldman had sold off its entire CDS-insured CDO book of business—thereby leaving very little CDO risk on its balance sheet. In this way, Goldman was essentially “an AIG conduit.”

Whatever leverage Goldman had in bargaining with the Fed over the repurchase of AIG-issued CDS, it was successfully mobilized. Like Goldman, neither Merrill Lynch nor Société Générale budged on price. (Deutsche Bank’s position remains unclear.}  The open question, of course, is how each of these counterparty banks were able to gain such remarkable leverage over the New York Fed in structuring the terms of the AIG stabilization program.

Secretary Geithner responded to the BlackRock report and similar analyses that revealed counterparties’ capacity to accept less than par value on their AIG-issued insurance contracts by testifying to the Congressional Committee, “If we had tried to force counterparties to take less than they were entitled, AIG would have collapsed. There were no better alternatives.” But is this correct? We can only know by discovering and analyzing other alternatives that the Fed considered and rejected.

Much work remains, if only to “set the record straight.”  But more than this, if we as a nation, influenced by inaccurate story telling, end up mistaking abundant of caution and existential fear for corruption and crony capitalism (and all the venality that this label connotes), then the chances of attracting and retaining truly knowledgeable and honest men and women from the private sector and academia to high-stakes and inevitably controversial positions in the public sector will diminish considerably—to our collective disadvantage. Henry Paulson, who refused multiple invitations from President Bush to become his Treasury Secretary, along with his bailout partners at the Washington and New York Fed, may not have been the best possible person from business and academia to contain the unfolding financial crisis. But it is difficult to imagine many more than a dozen or so other qualified, deeply committed individuals for that job at that time.