Report: Bush Officials Knew AIG Would Use Bailout Funds to Pay Counterparties

Government officials were aware that billions of dollars used to bail out American International Group (AIG) last year were used by the insurance giant to pay off its creditors, according to a newly released government watchdog report.

The 43-page report prepared by Neil Barofsky, the special inspector general for the Troubled Asset Relief Program (SIGTARP), who probed the circumstances surrounding AIG’s bailout, stated, “The Federal Reserve Board of New York’s (FRBNY) negotiating strategy to pursue concessions from counterparties offered little opportunity for success” and that “the structure and effect of FRBNY’s assistance to AIG … effectively transferred tens of billions of dollars of cash from the government to AIG’s counterparties.”

The report concluded that it’s difficult to ascertain the true costs of the Federal Reserve’s actions “until there is more clarity as to AIG’s ability to repay all of its assistance from the government.”

Senior officials at the Federal Reserve and the Treasury determined that an AIG bankruptcy would have had far greater systemic impact on the global financial system than Lehman’s bankruptcy and decided to step in to prevent that result: “FRBNY officials believed that an AIG failure would pose considerable risk to the entire financial system and would have significantly intensified an already severe financial crisis.”

When first confronted with the crisis at AIG, the Federal Reserve Board and the FRBNY, which were then contending with the demise of Lehman Brothers, turned to the private sector to provide funding to prevent AIG’s collapse. Confident that a private sector solution would be forthcoming, FRBNY did not develop a contingency plan. When private financing soured, FRBNY felt it was left with little time to decide whether to rescue AIG and, if so, on what terms, the report stated.

“Not preparing an alternative to private financing, however, left FRBNY with little opportunity to fashion appropriate terms for the support, and believing it had no time to do otherwise, it essentially adopted the term sheet that had been the subject of the aborted private financing discussions (an effective interest rate in excess of 11 percent and an approximate 80 percent ownership interest in AIG), albeit in return for $85 billion in FRBNY financing rather than the $75 billion that had been contemplated for the private deal.”

The report concluded that the government’s providing AIG loans offers a couple of lessons: “AIG stands as a stark example of the tremendous influence of credit rating agencies upon financial institutions and upon government decision making in response to financial crises,” the report read.

Also, the report stated that government officials’ argument about dire consequences of basic transparency “once again simply does not withstand scrutiny,” and whenever the government is using funds to help out during a crisis, the public generally is entitled to know what the government is doing with funds.

“Notwithstanding the Federal Reserve’s warnings, the sky did not fall,” the report concluded. “There is no indication that AIG’s disclosure undermined the stability of AIG or the market or damaged legitimate interests of the counterparties. The lesson that should be learned – one that has been made apparent time after time in the government’s response to the financial crisis – is that the default position, whenever government funds are deployed in a crisis to support markets or institutions, should be that the public is entitled to know what is being done with government funds.”

Although SIGTARP acknowledges that there might be circumstances in which the public’s right to know what its government is doing should be circumscribed, the report stated, “those instances should be very few and very far between.”

Not much thought was given to the government’s bailing out AIG from its troubles and its impact, the report stated. “The decision to acquire a controlling interest in one of the world’s most complex and most troubled corporations was done with almost no independent consideration of the terms of the transaction or the impact that those terms might have on the future of AIG.”

The impact of those terms, however, soon became apparent to FRBNY; FRBNY officials recognized that, although the $85 billion credit line allowed AIG to avoid an immediate bankruptcy, the interest rate imposed upon AIG was so onerous that, if unaddressed, the burden of servicing the FRBNY financing greatly increased the likelihood that there would be further credit rating downgrades for AIG, a result that FRBNY officials believed would have “devastating” implications for AIG.

According to the report, FRBNY made several policy decisions that severely limited its ability to obtain concessions from counterparties. For instance, it determined that it would not treat the counterparties differently, and, in particular, would not treat domestic banks differently from foreign banks. Also, it felt “ethically restrained” from threatening an AIG bankruptcy because it had no actual plans to carry out such a threat. And it was concerned about the reaction of the credit rating agencies should FRBNY be viewed as backing away from fully supporting AIG.

“Although these were certainly valid concerns, these policy decisions came with a cost – they led directly to a negotiating strategy with the counterparties that even then-FRBNY President [Timothy] Geithner acknowledged had little likelihood of success,” the report stated.

The refusal of FRBNY and the Federal Reserve to use their considerable leverage as the primary regulators for several of the counterparties, including the emphasis that their participation in the negotiations was purely “voluntary,” made the possibility of obtaining concessions from those counterparties extremely remote, according to the report: “While there can be no doubt that a regulators’ inherent leverage over a regulated entity must be used appropriately, and could in certain circumstances be abused, in other instances in this financial crisis regulators (including the Federal Reserve) have used overtly coercive language to convince financial institutions to take or forego certain actions.”

The report stated that questions have been raised as to whether the Federal Reserve intentionally structured the AIG counterparty payments to benefit AIG’s counterparties. Then-FRBNY President Geithner and FRBNY’s general counsel deny that this was a relevant consideration for the AIG transactions. However, the report stated that there is no question that the effect of FRBNY’s decisions – indeed, the very design of the federal assistance to AIG – was that tens of billions of dollars of government money was funneled directly to AIG’s counterparties.

“Although the primary intent of the initial $85 billion loan to AIG may well have been to prevent the adverse systemic consequences of an AIG failure on the financial system and the economy as a whole, in carrying out that intent, it was fully contemplated that such funding would be used by AIG to make tens of billions of dollars of collateral payments to the AIG counterparties,” the report read.

In a letter to the Special Inspector General Herbert M. Allison Jr., assistant secretary for the Treasury, wrote, “We believe the central lesson to be learned from the AIG experience is that the federal government needs better tools to deal with the impending failure of a large institution in extraordinary circumstances like those facing us last fall.

“It is for these reasons that the Obama administration has proposed a regulatory reform agenda that includes giving the government the emergency authority to resolve a significant, interconnected financial institution. This authority would allow the government to dissolve or break up failing firms in an orderly way, with the costs borne by the firm’s shareholders and creditors (not by the taxpayers) and without disrupting the broader financial system.”

Some economists argue that the Fed effectively had all the power it needed to drive a better bargain, but chose not to use it and is also unlikely to use such power in the future.