Where AIG Bailout Money Went

[girl gone mad]

nice infographic via http://www.ritholtz.com/blog/2009/03/where-aig-bailout-money-went/">The Big Picture

[depakid]

1. I'm less concerned with where it went than what it went for, and why

Dean Baker poses the questions:

There are at least three obvious issues that arise with these payouts:

1. Did the banks hold the underlying assets, or just the CDS?
2. Did the government have to buy back the underlying assets from the banks, or could it have waited to see what happened?
3. Could the support for the banks have been done directly, including some quid pro quo, without having AIG as an intermediary?

These three issues are outlined below.

CDS: Insurance or Gambling?

In 2007 the outstanding nominal value of all credit default swaps was close to $75 trillion. This was approximately five times as large as the outstanding value of insurable bonds. This meant that there was an average of five CDSs issued for every insurable bond, which implies that at least 80 percent of CDSs were not owned by institutions that actually owned the bond being insured.

The Treasury and Fed have not released the rules they applied in dealing with AIG's CDS. They may have only honored CDS where the institution held the bond being insured or they may have honored all of AIG's CDSs, regardless of whether or not the bank held the bond being insured.

This makes a big difference in terms of the purpose of the bailout. If a bank had bought a CDS to protect itself against losses on a mortgage backed security, and the CDS was not honored, then it would be an unexpected blow to its balance sheet. On the other hand, if the bank was just gambling that a bond that it did not hold would go bad by buying a CDS issued against it, it is difficult to see how a failure to honor the CDS would impose a serious hardship.

There may be legal issues that would prevent a non-bankrupt AIG from choosing which CDSs it chooses to honor, but that fact may have implications for the wisdom of rescuing AIG, as opposed to just directly supporting the counterparties, where it is considered appropriate.

Did the Government Pay Off the Bets Before the Race Was Over?

The government, through AIG, paid an additional $30 billion to counterparties because it paid off CDSs at their notional value rather than their market value. In principle, AIG would have owed the notional value of the CDSs if the underlying bond had defaulted. In these cases, the bond had not defaulted. In effect, the government acted as though AIG had already lost its bet, at a time when it was still possible that the underlying bonds would not go bad.

It is important to keep in mind that CDSs are typically relatively short-lived assets. Many provide insurance for only three years and most insure bonds for five years or less. Most of AIG's CDSs were issued before 2007. This means that by late 2008, they would have already been two years old or older. In this context, it might have been reasonable to take a chance to see whether the CDS would actually have to be paid. In any case, there was no obvious reason to pay above the market value for the CDS. This seems like a straight gift to the banks.

Should the Government Have Gotten Something in Return for Giving Tens of Billions to the Banks?

When the government lent hundreds of billions of dollars to the banks through TARP, it got preferred shares of stock in return, in addition to placing conditions on the banks' conduct. By contrast, the government received absolutely nothing for the tens of billions of dollars that it passed on to the banks through AIG. It may have been desirable to ensure that AIG's defaults did not lead to the collapse of the major banks that were its counterparties, but this could have been accomplished by directly giving these banks capital through TARP or some equivalent mechanism. There is no obvious reason why it was necessary to give the money through AIG without getting anything in return.

It is worth noting that if the government had instead lent the AIG money to the banks through TARP, and under similar conditions, it would own an even larger share of these banks. Obviously the banks prefer that the money instead pass through AIG without conditions, but there is no reason that the taxpayers should prefer this route.

It is also worth noting that several of the recipients of AIG money were foreign banks. While the public has an interest in the stability of the world economy, which means preventing major foreign banks from going bankrupt, there is no obvious reason that American taxpayers should be forced to bail out foreign banks of wealthy countries. It is possible that there is some quid pro quo under which foreign governments are bailing out U.S. banks on losses suffered in their countries, but there has been no public acknowledgement of such an arrangement.

There is a possible alternative explanation. The government may have made these payments in order to preserve the international reputation of the U.S. financial industry. If that is the case, then this is a rather expensive subsidy to the financial industry. To date there has been no explanation as to the reason for making these payments.

More: http://www.commondreams.org/view/2009/03/20-12