The Fed offers banks an outrageous subsidy via AIG

Update 26 Mar 2009:  Paul Kedrosky has a good post out on how the collateral arrangement works in CDS contracts: Collateral 101: How It Works at AIG and Elsewhere

Don Kohn’s testimony before the Senate Banking committee was so outrageous that I feel compelled to re-post the first paragraphs of this article from Willem Buiter about the moral hazard it represents. Basically, the U.S. government settled a bunch of credit default swap contracts at sweetheart prices with the very financial institutions who got us into this mess. Shambolic, I say.

It is this unbelievable in-the-pocket-of-the-finance-industry mentality by regulators that is going to be the ruin of the U.S. banking industry. This type of thing must be condemned in the harshest of terms. The link is below as is an associated link on Jim Bunning giving Kohn a working over.

The reports on the evidence given by the Vice Chairman of the Federal Reserve Board, Don Kohn, to the Senate Banking Committee about the Fed’s role in the government’s rescue of AIG, have left me speechless and weak with rage.  AIG wrote CDS, that is, is sold credit default swaps that provided the buyer of the CDS (including some of the world’s largest banks) with insurance against default on bonds and other credit instruments they held.  Of course the insurance was only as good as the creditworthiness of the party writing the CDS.  When it was uncovered during the late summer of 2008, that AIG had nurtured a little rogue, unregulated investment banking unit in its bosom, and that the level of the credit risk it had insured was well beyond its means, the AIG counterparties, that is, the buyers of the CDS, were caught with their pants down.

Instead of saying, “how sad, too bad” to these counterparties, the Fed decided (in the words of the Wall Street Journal), to unwind “.. some AIG contracts that were weighing down the insurance giant by paying off the trading partners at the full value they expected to realize in the long term, even though short-term values had tumbled.”

An LSE colleague has shown me an earlier report in the Wall Street Journal (in December 2008), citing a confidential document and people familiar with the matter, which estimated that about $19 billion of the payouts went to two dozen counterparties between the government bailout of AIG in mid-September and early November 2008. According to this Wall Street Journal report, nearly three-quarters was reported to have gone to a group of banks, including Société Générale SA ($4.8 billion), Goldman Sachs Group ($2.9 billion), Deutsche Bank AG ($2.9 billion), Credit Agricole SA’s Calyon investment-banking unit ($1.8 billion), and Merrill Lynch & Co. ($1.3 billion).  With the US government (Fed, FDIC and Treasury) now at risk for about $160 bn in AIG, a mere $19 bn may seem like small beer.  But it is outrageous.  It is unfair, deeply distortionary and unnecessary for the maintenance of financial stability.

Don Kohn ackowledged that the aid contributed to “moral hazard” – incentives for future reckless lending by AIG’s counterparties – it “will reduce their incentive to be careful in the future.” But, here as in all instances were the weak-kneed guardians of the common wealth (or what’s left of it) cave in to the special pleadings of the captains of finance, this bail-out of the undeserving was painted as the unavoidable price of maintaining, defending or restoring financial stability.

The rest of this ridiculous story is available at the link below. But I would highlight how it closes:

The logic of collective action teaches us that a small group of interested parties, each with much at stake, will run rings around large numbers of interested parties each one of which has much less at stake individually, even though their aggregate stake may well be larger. The organised lobbying bulldozer of Wall Street sweeps the floor with the US tax payer anytime. The modalities of the bailout of the AIG counterparties of the Fed is a textbook example of the logic of collective action at work. It is scandalous: unfair, inefficient, expensive and unnecessary.

When principled individuals warn against nationalization, it is this type of activity that gives them the greatest concern, and with good reason.

Source
The Fed’s moral hazard maximising strategy – Willem Buiter

Related articles
Bunning to Fed: Skip the Press Release – Real Time Economics

4 Comments
  1. M.G. in Progress says

    There is a compelling case for the Euthanasia of the banking system at http://mgiannini.blogspot.com/2009/03/euthanasia-of-banking-system.html.
    I still contend that in the insurance business the first thing one should consider is to honor a contract. We can certainly say that AIG and its counterparts either European or Goldman Sachs had really bad assets and liabilities management (for instance by all concentrating their insurance contracts or CDS, at one insurer sic!), but can we say that AIG must not honour the financial commitments it has made through these insurance contracts, no matter the reason why they were taken out?
    It’s like saying that tomorrow the United States of America are simply defaulting on its Treasuries… Can you imagine that? The people who lose biggest out of the collapse of AIG are probably the European banks but from a certain perspective, it is very much in the interests of the U.S. to pay for the rescue of AIG.

  2. Edward Harrison says

    M.G.,

    It is not at all about honouring contracts. I too believe one must do so. In this case, it is a question of price. Clearly, the Federal government cancelled these contracts at prices which were very advantageous to AIG’s counterparties.

    {The Fed decided to unwind] some AIG contracts that were weighing down the insurance giant by paying off the trading partners at the full value they expected to realize in the long term, even though short-term values had tumbled.”

    It is essentially a subsidy to those firms.

  3. M.G. in Progress says

    To see an element of subsidy we have to see those contracts. If there was a compelling case and need to unwind them a premium over short term value could be justified if taking them to term or maturity could have had worst consequences on some balance sheets. It is for instance to be noted that Deutsche Bank reduced it’s leverage ratio considerably over the period in question. Have they claimed on some insurance contracts taken out with AIG? In any case one could still assume that unwinding those contracts “was very much in the interests of the U.S. to pay for the rescue of AIG”. If there is in the interest of the nation…you pay a premium as short term perspectives could be better than long term, particularly if you are trying to avoid bankruptcy in the long term.

  4. Edward Harrison says

    MG,
    Your argument has validity. However, I take a more cynical view given the lack of transparency. If a financial institution like AIG is nationalized, taxpayers deserve the right to know how their monies are being used. To the degree this does not happen, as it certainly has not with AIG, we should suspect nefarious reasons.

    I don’t buy it for one second that Don Kohn and company are withholding names to protect the collective interests of the banking system and its stability. What is happening is that the Federal Reserve is acting in concert with specific institutions in a way that calls the Fed’s independence from the industry into question. Were these machinations done in the full light of day, the uproar would have been immense.

    In my view, a more free market approach would have been an Austrian solution, whereby we allow a portion of the shadow banking system to disappear if they cannot fulfil their contractual agreements. As you say, a contract is a contract.

Comments are closed.

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