The Government Could Have Handled AIG's Bailout Better

I listened to the AIG bailout hearing yesterday. The testimony of those involved, including current and former Treasury Secretaries Tim Geithner and Hank Paulson, mostly focused on the same message. Yes, we hated having to do the AIG bailout, but it was utterly necessary to save the U.S. economy. I actually agree. Unfortunately AIG was too interconnected to simply fail. But that doesn't mean that the situation couldn't have been handled better.

First, a brief background, for those who aren't up to speed on the situation. When the U.S. government decided to bailout AIG, it agreed to pay its obligations. Some of those obligations included swap derivatives. Because of those swaps, lots of big banks, including Goldman Sachs and a few foreign banks, got billions of dollars of bailout cash.

Many people complained about this for a number of reasons. First, it looked a lot like a sort of back-door bailout for banks. If they were the ultimate recipient of billions of dollars, then the government could have just wiped out those obligations and given the banks that money directly with the usual strings attached. Second, some complain that the government should have forced the banks to accept less than par for those swaps. For example, if AIG had gone into bankruptcy instead, it's very unlikely that the banks would have gotten 100 cents on the dollar, but would have been forced to take a haircut.

As for that second complaint, the banks, particularly Goldman, claim that they were hedged anyway -- so it wouldn't have matted if the government didn't pay them. As for why the government paid the obligation in full, it claims that it had no choice. There was no authority by which the government could have demanded banks accept less through a bailout.

This problem would have been more easily solved had there been a resolution authority in place to wind down AIG with the authority to distribute the firm's assets quickly and cleanly. Unfortunately, there wasn't one, but with any luck Washington's regulatory effort will correct that.

But I was struck when Rep. Darrell E. Issa (R-CA) asked Special TARP Inspector General Neil Barofsky:

Had we used other means to underwrite AIG, such as we'll buy assets at a discount, or we won't buy them. We will guarantee or buy at a discount -- you decide whether you want our triple-A rating -- versus actually getting the transfer at a time when these banks wanted a transfer. If any of these other techniques that you are now aware of could have that logically been used, would we be in as bad a situation of not getting paid back as we are?

Okay, so I don't really understand much of what Issa is talking about in his specific suggestions, as they aren't particularly comprehensible. But the inquiry he's making here -- could we have done things better -- is a good one. I think they could have.

In a purely logistic sense, AIG could have failed. The problem would have been the fallout. Its failure would have created incredible economic uncertainty. The firm would have to undergo bankruptcy proceedings. How much will swap counterparties get? What about creditors? And how will that affect those who AIG's clients do business with? What about the consumer insurance products? Disaster. It could take months or years to get answers to all of that, while the market collapses under the weight of the unknown.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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