Elliott Spitzer got it wrong, as did Paul Krugman, and countless bloggers. The popular narrative -- that Tim Geithner needlessly favored the interests of banks over those of taxpayers -- does not withstand close scrutiny. No one noticed that Inspector General Neil Barofsky's report on the AIG bailout excluded key facts that explained why Geithner's options were forestalled.
Everyone agrees that Geithner's decision to pay certain banks 100 cents on the dollar for their toxic assets was distasteful, if not enraging. The banks who benefitted very possibly did not have clean hands. Most likely they underwrote the same collateralized debt obligations, or CDOs, that AIG insured through credit default swaps. And those same banks probably ignored signs that the CDO investments, which were repackaged subprime mortgages, werefatally flawed. (It's too bad Barofsky never investigated those CDOs.) But the law gave the banks the upper hand, and a continued stalemate in negotiations would have exacerbated AIG's liquidity crisis. So, for the same reasons that politicians cut deals with Kim Jong-Il or Joe Lieberman, Geithner held his nose and paid money to make the problem go away.
Credit Ratings and Financial Weapons of Mass Destruction
Warren Buffet presciently anticipated the Hobson's Choice back in 2003, when he characterized all derivatives as financial weapons of mass destruction. As Buffet explained, whenever a derivative obligation goes out of the money, that company's liquidity may harmed by margin calls, or calls to post cash collateral. In October 2008, one month after the U.S. government signaled it would do whatever it took to keep AIG afloat, the insurance behemoth continued to hemorrhage cash, precisely because of collateral calls on its credit default swaps. That's when the New York Federal Reserve, then headed by Geithner, was brought in to staunch the bleeding.
The cash drain was accelerated by downgrades from the rating agencies. Many of AIG's swaps were subject to ratings triggers, which increased the level of mandatory cash collateral whenever AIG's ratings went down. Prior to March 2007, when AIG entered into these deals, its AAA rating exempted it from collateral posting requirements. Right after September 15, 2008, when Standard and Poor's downgraded AIG from AA- to A-, the company turned over $14.5 billion in cash to its trading partners. By the end of that quarter, the downgrades caused a $32.8 million loss of liquidity. If the rating agencies had imposed further downgrades, AIG's cash collateral calls could have exploded. Barofsky's report, which notes that Geithner's concern about ratings downgrades, fails to mention the cash impact of those potential downgrades.
Geithner's bottom line was that he wanted to preempt further downgrades by S&P and Moody's. A long protracted dispute with the banks would have created fear in the marketplace and at the rating agencies. Geithner had no leverage over the rating agencies. The cash downside from a ratings slide was much bigger than the $27 billion that might be paid out to the banks, who were already holding $35 billion in cash collateral.
Why Bankruptcy Was Never A Viable Threat
Of course, by October 2008, AIG's ratings were, for all intents and purposes, a fiction. Without the support of the U.S. government, AIG was probably insolvent. But the company's value in a bankruptcy scenario was hard to discern, because of a 2005 change in the law that made derivatives even more dangerous. Spitzer overlooks this change when he argues that the government could have used the threat of bankruptcy against the banks. He writes:
The counterparties had the contractual right to refuse the terms, throw AIG into bankruptcy, and suffer the consequences. In a workout context, the entity with cash--here, the government--can set the terms, and the other parties can either accept those terms or walk over to bankruptcy court.
The bankruptcy code was designed so that no single creditor can jump to the head of the line. Once a company files in court, everyone -- trade creditors, landlords, bondholders - must wait for an orderly resolution of all debt obligations. Even if a bank extends a cash-secured loan, that cash security is held by the bankruptcy estate. But creditors who holding derivative contracts get special treatment. They can immediately liquidate their contracts and move against any collateral outside of bankruptcy. This inconsistency in the law was a major reason why the Lehman bankruptcy turned out to be such a disaster. And it's why everyone knew that an AIG bankruptcy was never a viable option.
It's also why Geithner could never impose the threat of bankruptcy against the banks who held the credit default swaps. Even if AIG were to file for Chapter 11, the bankruptcy judge could not easily go after the cash collateral that the banks were already holding.
Spitzer overlooks this point in his fiery admonition of Geithner:
Geithner suggested he could not use the threat of AIG's default in the absence of a federal bailout to get concessions from AIG's creditors. Why not?
That is exactly what the government did with the auto industry, and rightly so. The entity providing financing to a near-bankrupt institution must always seek contributions from everyone else at risk. The fact that the Fed had a strong predisposition against letting AIG go into bankruptcy didn't mean the Fed shouldn't have used every opportunity to wrangle concessions from the other parties.
Except the government was able to attain concessions from GM's and Chrysler's creditors precisely because those companies were going into bankruptcy. The essential element for an expeditious bankruptcy plan is that all the creditors of a certain class get equal treatment. But it's almost impossible to get quick agreement on the fair value of CDOs protected by credit default swaps because there's no cash market for CDOs. It's easy to figure out the value of an oil swap or a euro swap, because oil and euros are bought and sold every day. But there is no active market for exotic CDOs. The valuation is done by analogy. The banks would have litigated the amounts of their claims for years.
Geithner Had No Sway Over the Shadow Banking System
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