AIG, Geithner And Backdoor Bailouts

I know Megan already commented earlier on the AIG bailout audit's findings regarding whether banks should have been forced to accept a discount on their contracts with the insurer. I generally agree that her that Treasury Secretary Timothy Geithner's hands were mostly tied in trying to get taxpayers a better deal as president of the New York Federal Reserve. But I want to note a few more observations, and then make a more general point about this business of worrying about supposed backdoor bailouts.

First, the argument is that Geithner tried to renegotiate these contracts. I think that's probably true. But I think it's probably false that he tried very hard. I think his "I do not recollect" moment proves this (via the NY Times):

The report said Mr. Geithner did not recall being told one bank was willing to take a haircut, but did not challenge the account of those on his staff.

How could you not remember that? These negotiations were likely one of the most intense moments of Geithner's life up to that point, and he doesn't remember how it went down? What I think is more likely is that a discount was never considered a legitimate possibly by Geithner, so he probably wouldn't have paid attention to UBS's willingness to take a haircut. Of course, that's fully rational, since he had no legal recourse to coerce them to agree to a discount anyway -- so why would they?

Second, this incident further demonstrates the need for a non-bank resolution authority. If such an authority were in place, then AIG could have gone into wind-down mode -- and it certainly would have. At that time, all contracts could have been renegotiated. But as it turns out, all the Fed could do was shrug when these banks demanded 100% payment. After all, the government committed to putting up whatever capital necessary to keep the AIG alive, rather than allow it to declare bankruptcy.

But I think there's a broader point to make here about this supposed backdoor bailout for banks. One of the clear intentions in bailing out AIG was to ensure financial stability. That implicitly meant that counterparties in its contracts would get what was owed to them.

Yet, this isn't different from any other firms benefitting when another they have a relationship with is bailed out. For example, if you bail out a computer maker, then the microchip companies it has contracts with will celebrate, because they will get paid. In the case of AIG, of course, banks were like the microchip companies in this example. If a company survives, so do its contracts.

And that's just part of the messy reality of bailouts. Like it or not, if you save a company, you get all of the baggage that comes along with it. The only reason people noticed in the case of AIG was because of the sheer magnitudes of dollars and the parties involved -- tens of billions went to investment banks instead of tens of thousands that might go to largely unknown suppliers if a manufacturing company had been saved.

At the end of the day, all you can really do is shake your head. But you should also change laws so that in the future firms won't need to be bailed out, but can be allowed to fail without bringing down the entire economy.