The AIG Bailout Is Still A Mystery Shrouded In Lies

Will we ever know why AIG was bailed out and why its credit default swap counterparties were made whole?

When AIG first began to ask for a bridge loan from the Federal Reserve, the public was told that AIG wanted additional "liquidity" to avoid a ratings downgrade. This implied that AIG's problem was relatively modest, related only to a temporary gap between funding for liquidity and its obligations. As we now know, AIG needed far more than the $40 "bridge loan" it originally requested.

Initially, there was skepticism that the Fed would provide a loan to an insurance company. This was far outside the scope of the Fed's traditional role of lending to banks it regulated. Some thought it might not be legal for the Fed to lend to AIG--we only later learned that the Fed can do whatever it wants.

But why did the Fed bailout AIG? And why did they do it in a way that was so generous to the CDS counterparties? What overcame the initial resistance to bailout out AIG?

For the past year, the reigning theory has been that the New York Fed and the Treasury Department decided to bailout AIG to prevent collateral damage to the banks and other financial institutions that had purchased credit default swaps from AIG. The idea is that a bankruptcy of AIG would have forced, say, Goldman Sachs to mark-down the swap contracts to zero, which would then have triggered a need to mark down the insured securities. As those securities were marked down, they may have rendered some already thinly capitalized banks insolvent or at least pushed their reserve capital requirements below regulatory requirements.

This initially prompted many of those who saw the deal wonder why those creditors, many of whom might have received just pennies on the dollar in an AIG bankruptcy, were apparently made whole. Were they really so thinly capitalized that any haircut would have triggered system-wide failures? If so, AIG was just a covert bailout of the rest of the unhealthy financial firms.

We've known for a couple of weeks now that some of the counterparties believed they were healthy enough to accept at least some discount on the CDS payout. Others, especially a pair of giant French banks, apparently believed they were under legal obligations not to accept a haircut by a company that hadn't been declared insolvent by a bankruptcy court. Still others just seem to have played a game of chicken with the US government--refusing to accept any deal because they suspected eventually the government would be forced to pay them out whole.

But in his recent testimony to a Congressional panel, Tim Geithner said the CDS counterparty theory is wrong. AIG was really bailed out to save ordinary American individuals and businesses that had purchased insurance from the company. It wasn't the failure of derivative contracts or thinly capitalized financial firms but the failure of AIGs traditional insurance business that had the regulators worried.

"This is startling," the WSJ editorial page explains.

Yet, if there is one thing that all observers seemed to agree on last year, it was that AIG's money to pay policyholders was segregated and safe inside the regulated insurance subsidiaries. If the real systemic danger was the condition of these highly regulated subsidiaries—where there was no CDS trading—then the Beltway narrative implodes.

So what the hell was going on? Was it insurance contracts or derivatives? Both?

We suspect that answer is actually neither. All of these explanations assume that regulators knew what they were doing and provided a rational response to a perceived threat. But that doesn't match what we know about the regulators in the fall of 2008.

Hank Paulson only learned of the deep problems at AIG from a side conversation with private equity financier who was attempting to buy a piece of the company. Neither Paulson nor Geithner had understood that a private-sector rescue of Lehman Brothers would be impossible. The chaos in money market funds that followed Lehman's collapse caught them unaware. They were in a panic about the "unknown unknowns."

There is something annoying about having to speculate about the bailout. Under an allegedly republican form of government, major decisions by the US government should come with publicly articulated explanations that can be judged on their merits. What we're stuck with now is more like Kremlinology, trying to judge the secret rationales and beneficiaries of government policy. If that proverbial martian landed on earth and noticed the celebrations of 20th anniversary of fall of the Berlin Wall, we'd have to excuse some confusion on his part about whether the east or west had triumphed.