It was mid-2008 and a little-noticed wrangle was taking place that will be of particular interest to the US congressional committee that is on Wednesday due to grill Tim Geithner , US Treasury secretary, over the rescue two months later of AIG, America’s biggest insurer.
On one side of the earlier negotiations stood a group of banks that included Merrill Lynch of the US and France’s Société Générale. On the other: Security Capital Assurance (SCA), a Bermuda-based bond insurer that had run into difficulties as the US subprime mortgage market imploded. At stake was how much money the banks should receive on insurance contracts that SCA provided for complex pools of mortgage securities known as collateralised debt obligations, or CDOs.
Among other reasons, the banks had bought the insurance – called credit default swaps, or CDSs – to protect themselves against a panic just like the one sweeping the markets at that time. But SCA lacked sufficient capital to pay the claims in full and the banks feared that if the insurer went under, they would receive nothing.
Something had to give. After heated talks, Merrill agreed that July to cancel its CDS contracts for a pay-out of 14 cents on the dollar – a severe “haircut”, in market parlance. The other banks also reduced their original claims. At the conclusion of talks that dragged on until May 2009, not a single lender was paid in full.
That is potentially awkward for Mr Geithner, who before joining the administration of President Barack Obama was president of the Federal Reserve Bank of New York, the most important regional component of the US central banking system. What Congress, and perhaps historians, will have to decide is: did the government, through collusion or mistakes, take billions of dollars from the taxpayers’ purse and put them into the coffers of some of the world’s largest banks without forcing them to accept much lower payments? Why, in other words, did the counterparties of AIG wind up with so better a deal than those of SCA did – some of which were the same banks?
His inquisitors on the House of Representatives oversight committee will want to take him back to the apocalyptic month when the world’s financial system came close to meltdown. September 2008 brought not only the collapse of Lehman Brothers on Wall Street but a flurry of rescues that included staving off bankruptcy at AIG. It is the terms of the AIG bail-out that members of the congressional committee will want to examine, amid growing concern that not only might the taxpayer have been made to foot a higher bill than necessary but that details of a deal done in secret are to be kept under wraps for a decade.
The hearing comes as Mr Obama, after a fraught first year, prepares to deliver his first State of the Union address to a joint session of Congress tonight. It follows a week when not only did the Democrats lose their Senate super-majority, making it more difficult to pass legislation, but Mr Geithner’s own position appeared to grow less secure. It was not to him but to Paul Volcker, a former Federal Reserve Board chairman, that the president turned for a blueprint on how to curb future banking industry excesses.
Crucial, therefore, will be the Treasury secretary’s account of the most turbulent few days during his time at the stern stone edifice between Liberty Street and Maiden Lane, from which the New York Fed keeps watch over the financial district of downtown Manhattan.
“By not granting the transparency they are basically conspiring to not inform either Congress or the public so that they could, in fact, go about their business in secrecy and the public would not be wise until 2018 when these counterparties are due to become public,” says Darrell Issa, a Republican representative who has pushed Congress to investigate the AIG payments. The question is whether the efforts amounted “to nothing less than a backdoor bail-out of AIG’s creditors, including Goldman Sachs, Merrill Lynch, Société Générale and Deutsche Bank”.
Mr Geithner’s supporters say he was part of a team that responded pragmatically to prevent the collapse of the global financial system. But criticism of payments made to AIG – seen variously as a deliberate attempt to funnel public money to creaking banks or a negligent failure to safeguard the public interest – has been fuelled by e-mails showing New York Fed officials attempting to keep details of the transaction from the public.
It emerged this week that the New York Fed is under investigation by Neil Barofsky, the inspector-general overseeing the administration’s Troubled Asset Relief Programme, over its disclosure of documents relating to the bail-out of AIG and its counterparties. Mr Barofsky is deciding whether it failed to disclose information about the episode to the Securities and Exchange Commission and his own office.
The issue is emblematic of the controversies that have followed the unprecedented federal response to a crisis in which complex financial products that were nearly impossible to value threatened to drag down the world’s biggest banks – and with them the global economy.
Like SCA, AIG had provided credit insurance on CDOs that were falling in value and it, too, found itself facing a group of banks looking for compensation. Under agreements with its counterparties, AIG had to post collateral as the value of the CDOs it insured fell. AIG had pledged some $35bn but was still struggling.
As was the case with SCA, something had to give – only this time around, neither the banks nor the insurer would end up doing the giving. Instead, the New York Fed arrived bearing an early Christmas present for the banks. Fearing that the collateral calls on the CDSs were quickly sapping the $85bn (€60bn, £53bn) it had agreed to lend AIG to nurse it through the crisis, Mr Geithner’s operation opened secret negotiations with the banks and agreed to buy underlying CDOs with a face value of $62bn from them.
No haircut was required. Instead, the Fed provided most of the $27bn in financing needed to make up the difference between the face value of the CDOs and the collateral AIG had posted, which the banks were allowed to keep.
The central bank wound up with a portfolio of CDOs of uncertain value – now residing in Maiden Lane III, a special purpose vehicle named after the New York Fed’s location – and a political headache with few parallels in the history of US finance. The $62bn transfer has become a cause célèbre for politicians, bankers and conspiracy theorists clamouring to know what really happened in those fraught few days when the financial system was on the brink.
People familiar with the matter maintain that the officials were confronting a classic “run on the bank”. The difference was that instead of depositors lining up outside bank branches to get back their savings, banks were lining up at an insurer demanding collateral to cover the payments owed to them.
Had AIG failed to meet collateral calls, these people argue, the rating agencies would have downgraded it, sparking a cascade of claims for more collateral from parties that had bought credit insurance on AIG itself.
Bill Dudley, Mr Geithner’s successor at the New York Fed, said last month: “From the moment the US government made it clear that its goal was to prevent AIG’s bankruptcy in order to stem a broader collapse of the financial system, this undercut the ability to obtain concessions from AIG’s counterparties [over those derivatives deals].”
The rules of the rating agencies were crucial to the decision to pay out 100 cents on the dollar, say people familiar with the process. Under these rules, a company loses its investment grade rating if it does not pay out 100 cents on the dollar on such contracts. “No matter at what level in the market debt trades, if you don’t pay par, the rating agencies say it is coercive and you get downgraded,” says one.
Regulators also say they were worried that they might be accused of “bullying” the banks to accept less than the full value of the insurance contracts. “We had to accept the sanctity of the contracts,” says another person familiar with the matter.
In the wake of the decision to let Lehman go only days before, regulators were uncertain about whether Wall Street could withstand the shock of losing money on the $62bn of credit protection – even though the banks had already received some collateral from AIG and had sold some of these CDOs to customers. Critics of the Fed, and of Mr Geithner, argue that the regulators did not try hard enough to extract concessions from the banks.
According to a government investigation into the affair, when the Fed telephoned the banks, Goldman and Merrill refused to accept any discount. The French banks also ruled that out, backed by their regulator, the Commission Bancaire, which “forcefully asserted that, under French law, absent an AIG bankruptcy, the banks could not agree to less than par value”, the report notes. The only bank to volunteer a deal was UBS – which said it might accept a discount of just 2 per cent.
Another question requiring resolution is exactly who benefited from the $62bn. Some of the banks who bought insurance from AIG – such as UBS – appear to have done so to protect CDOs they held on their own books. However, others – such as Goldman and SocGen – also bought it as a type of reinsurance for clients. In particular, back in 2005 and 2006, banks such as Goldman sometimes wrote credit default swaps for other clients holding CDOs – and then Goldman bought insurance, via CDSs from AIG, to cover that risk – while collecting a fee for the service from customers.
That created a complex web of deals – even more so because banks such as Goldman sometimes underwrote the same CDOs that they then insured for their clients and reinsured with AIG.
The authorities have refused to reveal the identity of the banks’ ultimate clients or precise details of the Maiden Lane III portfolio. On the contrary, the government recently stipulated that this information should stay hidden until 2018. Federal officials argue that such secrecy is essential to ensure they will be able to sell the CDOs in the future.
Still, the Maiden Lane saga has laid bare one of the main reasons why the credit crunch of 2007 turned the following year into virulent turmoil, knocking the global economy off course. By paying AIG’s counterparties in full, the Fed sidestepped one of the thorniest issues facing financial markets: how to value securities that were so complicated that no one – not the credit agencies, not the bankers, not the issuers themselves – knew how to price them.
The disputes struck, too, at the heart of a growing conceit in the financial world that nearly any asset could be priced and traded. This development was interpreted as a sign that markets were growing more “free” since the pool of tradeable assets appeared to be growing.
Indeed, this reverence for free market ideals was so deeply ingrained in the psyche of Washington and Wall Street that banks have been increasingly encouraged to mark the value of their assets to “market” prices. Groups such as Goldman, which received some $14bn in collateral from AIG and payments from the Fed for its AIG CDOs, were especially evangelical about the merits of “mark-to-market” accounting.
What the AIG drama exposes is that much of the recent innovation on Wall Street was dedicated to creating assets that barely traded and whose values were determined almost exclusively by computer models used by the banks and rating agencies.
In this 21st-century hall of mirrors, it has been possible for tens of billions of dollars of value to vanish or reappear at the click of a computer button – or at the behest of the rating agencies or through a change in accounting rules. That in turn makes it hard for the US government to explain whether the taxpayer really got “value for money” by bailing out AIG – or whether Americans will ever get back all the billions already spent.
The longer the finger of suspicion continues to swirl around AIG, the harder it could be for the Obama administration to lance the boil of voter anger – or, in a world where values could appear illusory, to prove that it spent taxpayers’ money wisely.
Little wonder, then, that Mr Barofsky, the Tarp overseer, warned late last year that “the lesson that should be learnt [from AIG] is that whenever government funds are deployed in a crisis to support markets or institutions the public is entitled to know what is being done with government funds”. Mr Geithner now has his work cut out for him.
Additional reporting by Aline van Duyn and Tom Braithwaite
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