AN OVER- GENEROUS DEAL FOR AIG CLIENTS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

An over-generous deal for AIG clients

By Robert Pozen

Published: December 2 2009 14:28

When an insolvent American International Group distributed $165m in executive bonuses last winter, the public was outraged. But this was small change compared with what we have learnt recently from a federal auditor’s report on the US insurance group, almost 80 per cent owned by the US government. At the direction of the Federal Reserve Bank of New York, AIG quietly gave $62bn to pay in full the claims of Goldman Sachs, Barclays and other large investors.

Why did US taxpayers pay so much to the sophisticated clients of AIG when we could have spent much less to settle these claims? The federal auditor has finally explained to us exactly what happened in this episode, but we still do not know why. At best, we have three inconclusive explanations.

The financial products subsidiary of AIG sold these investors a large volume of credit default swaps, which obliged AIG to pay the full face value of designated bonds if they were to default. When these bonds deteriorated during the summer of 2008, AIG executives tried to persuade these investors to settle their CDS contracts at a 40 per cent discount to the face value of these bonds. On September 16 2008, the federal government recapitalised AIG and in November took over these negotiations. After less than a week, the FRBNY instructed AIG to capitulate by paying the full face value of the bonds – $62bn, compared with their $30bn market value.

Why? While Fed officials recognised that these settlement payments were “offensive”, they were defended as necessary to prevent the collapse of the financial system. But we have no way to evaluate the factual basis of this defence. Similarly, Fed officials initially refused to name the recipients of AIG’s payments on the grounds that disclosure would undermine the stability of AIG and the financial markets. However, the sky did not fall when these names were finally disclosed in response to pressures from the Senate Banking Committee.

A second unsatisfactory theory revolves around Stephen Friedman, who was FRBNY chairman and a director of Goldman Sachs in November when that firm quietly received almost $13bn in payments from AIG. In December of 2008, he also bought 37,300 more shares of Goldman Sachs. He was subsequently granted a waiver from the Fed’s requirement that the board chairman of a regional Fed be a public director who is not a director or shareholder of any member bank. Goldman Sachs has repeatedly asserted that it did not benefit from these payments because it was fully hedged against AIG’s potential failure, although the federal auditor has questioned these assertions. In May, Mr Friedman resigned as chairman of the FRBNY board despite the Fed’s waiver. In a letter to William Dudley, president and chief executive of the FRBNY, he wrote: “Although I have been in compliance with the rules, my public service-motivated continuation on the Reserve Bank board is being mischaracterised as improper. The Federal Reserve system has important work to do and does not need this distraction.”

A third explanation is that the US government wanted to prevent foreign banks from becoming insolvent as a result of the American credit crisis – what has been called the exportation of the American disease. These foreign banks received roughly $40bn of the $62bn in settlement payouts from the AIG. Perhaps this was an indirect method to achieve the Treasury’s goal since Congress would not have authorised a direct bailout of foreign banks.

In my view, the FRBNY should have threatened to put AIG’s financial products subsidiary into bankruptcy unless the large US and foreign investors accepted a settlement of their CDS contracts at a reasonable discount. In bankruptcy, the AIG subsidiary would have been allowed to repudiate all its CDS contracts subject to a court-approved reorganisation plan. Most investors would have accepted a reasonable discount to settle CDS contracts immediately with an insolvent counterparty, rather than take the risk of much lower payouts after a lengthy legal proceeding. As the federal auditor’s report stated: “By providing AIG with the capital to make these payments, Federal Reserve officials provided AIG’s counterparties with tens of billions of dollars they likely would not have otherwise received had AIG gone into bankruptcy.”

A bankruptcy filing by AIG’s financial products subsidiary would not have meant the insolvency of the insurance companies owned by the parent AIG; these insurance companies were separate legal entities with their own capital and reserves. Holders of insurance policies issued by these companies were protected by a broad array of state laws.

In short, this AIG episode drives home an important lesson for the next financial crisis. In these situations, it is easy to predict the worse and assume that the only choices are full protection or no protection of investors. In fact, as the federal auditor’s report recognised, the FRBNY “refused to use its considerable leverage” to negotiate an intermediate settlement. If the FRBNY had insisted on payments of 80 cents on a dollar, that would have saved US taxpayers billions of dollars without bankrupting AIG’s large counterparties.

The writer is senior lecturer at Harvard Business School and author of ‘Too Big to Save? How to Fix the US Financial System’

Copyright The Financial Times Limited 2009.