AIG and Foreign Banks

A quick update on the supposed ‘bailout’ of foreign banks via AIG.

The problem with using the word ‘bailout’ here is that it is not fully accurate, even though it loosely describes what went on. I would prefer we reserve the word for situations where taxpayer money is used to prevent an organization from filing for unassisted bankruptcy. By this definition AIG has clearly been bailed out. Without the loan from the Federal Reserve Board and the subsequent cash injection from the Treasury department AIG would not have been able to meet its contractual obligations back last Fall and thus would have been forced into bankruptcy. That is a ‘bailout’.

Note what happened to AIG:

Last Fall AIG’s credit rating was reduced by the various rating agencies because of mounting fears over its Credit Default Swap [‘CDS’] book of business held by its Financial Products division [‘AIGFP’]. This credit rating change triggered key clauses in the ‘master agreement’ which is a legally binding document covering the terms and conditions of its swap portfolio. Specifically the master agreement allowed companies who had contracts for CDS’s to require AIG to increase the amount of collateral it placed against each contract. When AIG tried to comply by raising collateral, via selling off other assets, it found itself unable to meet the full requirements on some contracts. This pushed it into what is called a ‘cross default’. Essentially all counter-parties could now, under the terms of the master agreement, call on AIG to pay up on its contracts. This it could not do. And so it fell towards bankruptcy. The threat of AIG winding down its swaps business on an emergency basis, and particularly the threat that it would default totally on scores of contracts is what led the Federal Reserve Board to intervene. The Fed wanted to avert chaos in the financial markets.

So the primary reason AIG was ‘bailed out’ was so it could meet its contractual obligations on its swap book. The purpose of the money flowing to AIG from the Fed was to allow AIG to pay up. That meant inevitably that taxpayer cash went into AIG and then straight out to its counter-parties. This is why we have been calling the bailout of AIG a bailout of the counter-parties. The money never stayed within AIG, or at least not all of it did.

Now. Many of the counter-parties are foreign banks. So it appears that US taxpayers have been ‘bailing out’ foreign banks. Naturally enough in this age of crisis and panic that doesn’t sit too well with the public. Who wants to use our taxes to save French, German, and British banks? That’s why I want us to focus on what actually happened: those banks had contracts with AIG. When AIG could not fulfill its obligations as described in those contracts it fell into technical default. The Fed pumped money in the stave off the financial crisis that would inevitably have followed had the default not been averted. That some of that money flowed abroad is simply a function of AIG being a huge global company. It does business worldwide. Not to mention that the financial markets are global anyway. For America to refuse to allow AIG to pay on its foreign contracts, while allowing it to pay on its domestic contracts, would have caused a bigger financial crisis than the one the Fed was working to avoid. World markets would have collapsed immediately. The integrity of the US as a world financial center would have been destroyed instantly. And retaliation would have been severe. Remember that the US is the world’s largest debtor: it needs inflows of capital to fund its deficits and maintain its standard of living. It cannot renege simply based on geography.

All of this is a separate argument from that concerning the payments in total. It could be argued that AIG should only have paid part of its liability and thus force its counter-parties to share in the loss. This is what would have happened had it gone into formal bankruptcy: it is normal in bankruptcy for part payments to be used to pay off contracts. Creditors are regularly being forced to accept less than full repayments. That’s what bankruptcy is for.

It is this second argument that I think has more substance. We should have forced Deutsche Bank, Societe Generale, Goldman Sachs, Barclays, et al, to swallow at least some of the consequences of AIG’s incapacity to repay. After all they were negligent in their due diligence: it was clear that AIG was sailing close to the wind all along because it had extraordinarily slim reserves against a massive book of business. It was horribly over-leveraged. AIGFP eventually tried to disguise this by being less than transparent in its financial reporting. In fact it may well be accused of fraud for this. The irony of a fraud charge is that it weakens the notion that the US should not allow cash to flow abroad: those foreign counter-parties could plausibly argue that slack US accounting and reporting allowed AIGFP to commit its fraud. They could then sue for restitution. Who would they sue? The shareholders of AIG, i.e. the US taxpayers.

A slightly different take on this is that were the US to force AIG to renege on foreign payments other countries could retaliate by simply seizing any AIG assets within their territories. Unfortunately for the US some of AIG’s remaining profits, in its traditional insurance business, come from abroad. So the seizure of those assets would completely destroy any chance of AIG ever repaying the loans from the Fed or the Treasury. AIG’s basic game plan is to sell off those assets and use the cash as a source of repayment. It has insurance subsidiaries in dozens of countries. They are generating profits that reduce the amount of aid taxpayers here have to pump in for the bailout. Take those assets away and the cost of the bailout sky rockets.

One overall lesson to be learned from the AIG mess is that there must be tighter international supervision of these behemoth global financial companies. Not only must they not be allowed to grow so big that we are forced to bail them out, but there must also be a more coordinated approach to any future bail outs. Perhaps under an international regulatory system we could have raised bailout money from foreign sources. But that has to be specified up front. Right now we are stuck with AIG being an American company. One that is our responsibility to fix.