Could the government have struck a tougher deal with financial institutions owed money by AIG? The report made public this week by Neil Barofsky, special inspector general for the Troubled Asset Relief Program, concludes it certainly could have.
But the report also makes clear that it is hard to come up with effective responses to such crises if you don’t have agreed-upon rules beforehand.
American International Group, one of the world’s largest insurance companies, had contracted with other financial institutions, including behemoths like Goldman Sachs and Citigroup, to insure the value of hundreds of billions of dollars of complex mortgage-backed securities.
By September 2008, it was clear many such securities were worth far less than their nominal value. AIG did not have the money to make good on its guarantees. If it failed to do so, the firms that had paid AIG for its guarantees would suffer enormous losses. Given the tottering state of global finance as a whole, a default by AIG would have triggered toppling-domino failures of investment banks, commercial banks, insurance companies and investment funds around the world. Public and private pension plans would have realized large losses. The global economy might have collapsed more brutally than it did in 1929-1933.
The U.S. Treasury and Federal Reserve intervened, with the Fed pumping billions into AIG, essentially taking over the company, and paying its obligations 100 cents on the dollar. Thus the institutions owed money by AIG came out unharmed, whereas they would have lost large sums, if not gone bankrupt, if AIG had gone under.
The fact the Fed did not force these firms to accept partial payment, thus reducing the amount of public money used, is what Barofsky criticizes now. He is right. Ideally, AIG’s creditors should have been forced to take a “haircut” of at least 10 to 20 percent.
But Timothy Geithner, then president of the New York Fed and now U.S. Treasury Secretary, also is correct in responding that the world economy teetered at the edge of an abyss in the fall of 2008. Quick, decisive action was needed to avoid economic catastrophe. There were no rules on conducting such financial rescues and no time to quibble. Prolonged negotiations and bluffs would have further alarmed already panicked financial markets.
There were no rules for such takeovers because the government always had implied would never implement such rescues. This resembles the debate over whether making condoms available to adolescents increases their sexual activity. Just as some believe providing condoms promotes fornication, so writing rules for financial rescues would encourage risktaking. It would be one more step in propagating the belief that some institutions are too big for the government to allow to fail.
Now it is too late. The big mistake was letting the financial situation get to a point where we stood on the edge of an abyss. How badly we erred in pulling the economy back is secondary.
Perhaps we do need explicit rules going forward. The moral hazard issue of encouraging future risktaking is moot. The frantic bailout actions over the past 26 months have generated such extreme perverse incentives that one more dollop won’t make a difference.
We face an analogous situation in never having included rules governing exchange-rate manipulation in global trade agreements. Now, we must beg and bluster with China. But that is the subject of another column.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.