Insider's Game

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, were fatally 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 hold 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 becausethose 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

 

It wasn’t simply the banks who dug in their heels, it was also the French government. The Commission Bancaire, acting on behalf of Societe Generale and Calyon, said that French banks could not legally be compelled to reduce their claims against AIG outside of a formal bankruptcy. Again, bank regulators can act swiftly and decisively on insolvent banks like Washington Mutual, but Geithner lacked any comparable authority to impose his will on the creditors of an insurance company.

 

That’s why Spitzer’s insinuation, that Geithner deserves some blame for creating the predicament faced by AIG, doesn’t hold water. Spitzer writes that Geithner and others “grievously damaged the nation and capitulated to the very banks they should have been supervising.” But Geithner’s job was to regulate New York banks, not the shadow banking system, which is the multitude of non-bank entities – including AIG, hedge funds, brokerage firms, and mortgage lenders – that relied on short-term credit to fund their long-term investments. It was the shadow banking system that had collapsed in the fall of 2008. Prior to September 2008, Geithner’s regulators could only know that the banks had credit derivatives with a big insurance company rated AA-; they did not have access to AIG’s books. Everyone knew that the unregulated shadow banking system dominated the traditional banking system. But everyone also knew that any attempt to expand regulatory oversight while Bush was in office was a fool’s errand.

 

“For Geithner to say it would have been ‘unethical’ to negotiate for concessions is sheer silliness,” writes Spitzer. Actually, Geithner said that it was unethical to threaten actions that he couldn’t possibly enforce. But at the end of the day it wasn’t a matter of being ethical or unethical. Everyone knew what the endgame was, and Geithner knew he couldn’t fool the banks into thinking otherwise.

 

LTCM was Different

Krugman frames the situation somewhat differently, suggesting that Geithner could have strong-armed the banks, who are all members of the same Wall Street club, to do the right thing. But he cites the bailout of a hedge fund, Long Term Capital Management, as a controlling precedent. The comparison is off base. The deal proposed by the New York Fed in 1998 was that all the major U.S. banks could contribute funds to acquire equity in LTCM. The offer was not compulsory, and Bear Stearns refused to participate. To bank executives, it’s one thing to say that you should provide emergency financing to invest in a hedge fund with some upside potential, and quite another to say that you should write off your legal claim to several billion dollars. In October 2008 Wall Street executives knew that when the dust settled, a lot of finger pointing would ensue and a lot of people were going to get fired, so no one was willing to stick his neck out. (If you think that foreboding was unwarranted, ask Ken Lewis or John Thain.) Whether or not you find that attitude morally repellant, you should not be shocked. Look at how politicians respond to the crises in health care and climate change.  “Major financial firms are a small club, with a shared interest in sustaining the system,” wrote Krugman.  That’s what they used to say about the U.S. Senate.

 

Of course, there’s still the most obvious question: Isn’t this the government? Can’t the government that bailed out these banks demand something in return? Yes it could have, at one time.

 

Hank Paulson’s Preemptive Policy: Throw Money, Don’t Ask Questions, Don’t Negotiate

Every negotiation is a game of chicken. Geithner’s ability to say to the banks, “You’d better make some concessions on behalf of the taxpayer, or else!” was undercut by the actions of Hank Paulson. Two weeks before Geithner tried to resolve the problems of AIG’s credit default swaps, Hank Paulson announced that he was throwing money at the banks indiscriminately. On October 13, 2008 he told the nine largest U.S. banks that they must take $125 billion in government funds, with no strings attached, whether they wanted to or not. Paulson’s modus operandi was consistent throughout the crisis and afterwards. He pushed everyone into a corner to preempt any good faith negotiation or problem solving, he used threats to emasculate normal standards of government accountability and corporate governance, and he lied about his actions afterwards.

 

After October 13, 2008, Geithner and the banks knew that the Paulson’s Treasury did not care about protecting the taxpayers’ money, only about making problems go away. He could not withhold government aid, because the money was already out the door.

 

As with any complex financial transaction, if you overlook an important detail, you don’t understand what’s really going on. That’s why the conventional wisdom about Geithner’s role in the AIG bailout is wrong.

 

Finally, none of the foregoing is a slam on anything else written by Spitzer and Krugman, whose writings are almost always perceptive and illuminating.