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.

But what if the government had publicly stated (as bankruptcy was imminent): "Okay, AIG: you fail. But in the course of bankruptcy, after handing out whatever assets you've got left as the court dictates, we will help to make some of your customers, creditors and counterparties, whole. Specifically, we'll guarantee all of your consumer insurance products (think life and health) in full. Your creditors will get, say, 50-cents-on-the-dollar for the debt you owe. Your counterparties will get, say, 80-cents-on-the-dollar for the obligations you have with them. Etc. And by the way, any current TARP recipient that we ultimately provided a net cash infusion to based on this guarantee will have to pay us back just like it must with the other bailout money it borrowed from Uncle Sam."

I just made up some numbers here to give an example, but the point is that this wouldn't have been a bailout for AIG. It would have been a situation where the government let AIG fail, but assured anyone the firm did business with that they wouldn't lose everything owed. Instead, it would give them a concrete floor for their losses and that cash infusion they needed. After all, if AIG's assets turned out to be sufficient to cover more than the minimum the government guaranteed, then its customers, creditors and counterparties could ultimately do even better.

I think something like this would have been completely legal and still would have eliminated most of the uncertainty that a regular bankruptcy would have caused. Now Goldman Sachs, for example, would know it was getting 80-cents-on-the-dollar for its swaps with AIG. Would this scenario have still cost taxpayers money? Possibly. But they wouldn't have owed 100-cents on the dollar for all of AIG's obligations, with little hope of recovery, as they essentially did.

Of course, hindsight is 20-20. But it's a little disturbing that policymakers weren't creative enough to try to think up some alternatives to forcing taxpayers to foot the bill for all of what AIG owed, and still ultimately keep the company afloat. In the future, I hope there's a resolution authority in place that has tailored wind-down plans for big firms like AIG so such creativity isn't necessary. And that wind-down should also be prepaid by firms as a sort of failure-cost insurance fee, so that taxpayers won't be on the hook for any of the associated costs. But even without such an authority in place, I find it hard to believe that those who engineered the AIG bailout couldn't have done better.