At this point, I don't think that many doubt that taxpayers are generally not on the better end of the deal when it comes to government bailouts. Still, an article today on Bloomberg accentuates this belief. It explains how the New York Federal Reserve gave banks that had credit default swaps (CDS) with AIG 100% par value to retire the derivatives, essentially ignoring the market value. This is disturbing for a few reasons.
First, a let me provide a little background for anyone who is unfamiliar with the situation I'm referring to. During the height of the financial crisis, the U.S. government bailed out AIG to the tune of $85 billion (eventually, that number would grow to around $182 billion). A portion of that bailout money ended up going to large banks including Goldman Sachs, Merrill Lynch and others. Some were even foreign banks.
These banks got some of AIG's fresh capital because they had CDS with the insurer. Those derivatives served as hedges on collateralized debt obligations (CDOs) that ended up losing a great deal of value when the mortgage market collapsed. As a result, AIG owed the banks a lot of money based on those CDO losses. Goldman, for example, was provided around $14 billion by AIG.
That's somewhat understandable. The reason AIG needed so much money was because it had to pay obligations like this. After all, it's an insurance company. So the idea that its customers would want what they're owed based on insurance agreements is obvious. CDS are essentially a kind of insurance. That such distributions were paid is just part of what had to be expected when the government decided to bail out the insurer.
The Government's Deal
But the government decided to do something odd. It decided to pay the banks the par value for what it would have cost to retire those derivatives instead of the market value -- what AIG would have paid without government involvement.
The New York Federal Reserve Bank stepped in and told AIG to do this. It should be noted that current Treasury Secretary Timothy Geithner was the president of the New York Fed at that time. Bloomberg says he took over negotiations, which led to this result:
Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.
The New York Fed's decision to pay the banks in full cost AIG -- and thus American taxpayers -- at least $13 billion. That's 40 percent of the $32.5 billion AIG paid to retire the swaps. Under the agreement, the government and its taxpayers became owners of the dubious CDOs, whose face value was $62 billion and for which AIG paid the market price of $29.6 billion. The CDOs were shunted into a Fed-run entity called Maiden Lane III.