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.
So why did government officials accept par? According to Bloomberg (who quotes financial researcher Donn Vickrey):
One reason par was paid was because some counterparties insisted on being paid in full and the New York Fed did not want to negotiate separate deals, says a person close to the transaction. "Some of those banks needed 100 cents on the dollar or they risked failure," Vickrey says.
Banks' Gain Is Taxpayers' Loss
Clearly, those banks were thrilled to get 100 cents on the dollar. But taxpayers obviously got a raw deal. Retiring these derivatives should only have cost AIG somewhere in the ballpark of 50 to 70 cents on the dollar, according to Bloomberg sources. That represents a 30% to 50% loss to taxpayers, assuming AIG doesn't pay the government back in full.
It also makes for a backdoor bailout. If these institutions needed par value to survive, then they should have sought a direct bailout from the government. After all if AIG didn't need a bailout, these institutions would have gotten market value for the CDS, and consequently, been forced into a direct bailout anyway. By collecting payments in this manner, they skirted the official process. And what's more: they don't need to pay the government back for the premium they got.
It's AIG's Loss Too
Of course, there is one party who this deal was worse for than taxpayers -- AIG. In theory, AIG is supposed to pay the government back all of the bailout money it got. Many people, including myself, doubt that will ever happen. But AIG does owe the government for this "at least $13 billion" overpayment. That will make it even harder for AIG to dig itself out of the hole it's in.
The Cherry On Top
One last juicy tidbit, via Bloomberg:
The deal contributed to the more than $14 billion that over 18 months was handed to Goldman Sachs, whose former chairman, Stephen Friedman, was chairman of the board of directors of the New York Fed when the decision was made. Friedman, 71, resigned in May, days after it was disclosed by the Wall Street Journal that he had bought more than 50,000 shares of Goldman Sachs stock following the takeover of AIG. He declined to comment for this article.
I certainly hope that those shares were purchased after it had already been made public that Goldman was to receive full par value for what it was owed on its CDS with AIG. If it was between the time of the AIG takeover and that information being publicly released, then, well, you can draw your own conclusions of whether Friedman's stock purchase was ethical.