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Oct 27 2009, 5:30 pm by Daniel Indiviglio
At this point, I don't think that many doubt that taxpayers are generally not on the better end of the deal when it comes to government bailouts. Still, an article today on Bloomberg accentuates this belief. It explains how the New York Federal Reserve gave banks that had credit default swaps (CDS) with AIG 100% par value to retire the derivatives, essentially ignoring the market value. This is disturbing for a few reasons.
Background
First, a let me provide a little background for anyone who is unfamiliar with the situation I'm referring to. During the height of the financial crisis, the U.S. government bailed out AIG to the tune of $85 billion (eventually, that number would grow to around $182 billion). A portion of that bailout money ended up going to large banks including Goldman Sachs, Merrill Lynch and others. Some were even foreign banks.
These banks got some of AIG's fresh capital because they had CDS with the insurer. Those derivatives served as hedges on collateralized debt obligations (CDOs) that ended up losing a great deal of value when the mortgage market collapsed. As a result, AIG owed the banks a lot of money based on those CDO losses. Goldman, for example, was provided around $14 billion by AIG.
That's somewhat understandable. The reason AIG needed so much money was because it had to pay obligations like this. After all, it's an insurance company. So the idea that its customers would want what they're owed based on insurance agreements is obvious. CDS are essentially a kind of insurance. That such distributions were paid is just part of what had to be expected when the government decided to bail out the insurer.
The Government's Deal
But the government decided to do something odd. It decided to pay the banks the par value for what it would have cost to retire those derivatives instead of the market value -- what AIG would have paid without government involvement.
The New York Federal Reserve Bank stepped in and told AIG to do this. It should be noted that current Treasury Secretary Timothy Geithner was the president of the New York Fed at that time. Bloomberg says he took over negotiations, which led to this result:
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.
So why did government officials accept par? According to Bloomberg (who quotes financial researcher Donn Vickrey):
Banks' Gain Is Taxpayers' Loss
Clearly, those banks were thrilled to get 100 cents on the dollar. But taxpayers obviously got a raw deal. Retiring these derivatives should only have cost AIG somewhere in the ballpark of 50 to 70 cents on the dollar, according to Bloomberg sources. That represents a 30% to 50% loss to taxpayers, assuming AIG doesn't pay the government back in full.
It also makes for a backdoor bailout. If these institutions needed par value to survive, then they should have sought a direct bailout from the government. After all if AIG didn't need a bailout, these institutions would have gotten market value for the CDS, and consequently, been forced into a direct bailout anyway. By collecting payments in this manner, they skirted the official process. And what's more: they don't need to pay the government back for the premium they got.
It's AIG's Loss Too
Of course, there is one party who this deal was worse for than taxpayers -- AIG. In theory, AIG is supposed to pay the government back all of the bailout money it got. Many people, including myself, doubt that will ever happen. But AIG does owe the government for this "at least $13 billion" overpayment. That will make it even harder for AIG to dig itself out of the hole it's in.
The Cherry On Top
One last juicy tidbit, via Bloomberg:
I certainly hope that those shares were purchased after it had already been made public that Goldman was to receive full par value for what it was owed on its CDS with AIG. If it was between the time of the AIG takeover and that information being publicly released, then, well, you can draw your own conclusions of whether Friedman's stock purchase was ethical.
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Whay hasn't anyone at AIG been prosecuted? AIG sold insurance that they never intended to cover. It seems like outright fraud to me. Why aren't any "journalists" covering this?
Goldman has always maintained that they were hedged against an AIG collapse. I wish congress or a regulator would make them disclose who these hedges were with so the public could know if Goldman would actually take a material loss on an AIG failure.
Whay hasn't anyone at AIG been prosecuted?
Um... because what they did wasn't a crime.
AIG sold insurance that they never intended to cover.
They did intend to cover it - they just assumed the losses would be much lower than they were. That's a bad business decision but not a crime.
AIG sells term life insurance safe in the knowledge that 98% of the policies will expire without a payout. If a plague were to hit and 1/3 of the policy holders died that would also bankrupt AIG.
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