How Fed let AIG banks off easy

Federal regulators, in rushing to rescue AIG last year, failed to use their clout to negotiate concessions from business partners of the troubled insurer, a bailout overseer said on Monday.

As a result, $62.1 billion of taxpayer and AIG funds were essentially funneled to 16 banks, which were counterparties to AIG insurance contracts, according to a report by Neil Barofsky, special inspector general for the $700 billion bailout.

The amount paid to the 16 banks represented the full-dollar amount of the underlying assets that the counterparties had insured through AIG. The news that the Fed paid 100 cents on the dollar for the assets caused a big stir among lawmakers and taxpayers.

In his report, Barofsky said the Fed had given up significant leverage to force AIG's counterparties to accept less than the full amount for the assets. Barofsky does not suggest that the Fed acted improperly, he argued that, as a regulator, the Fed still had power to get AIG's counterparties to fall in line.

"Once they bailed AIG out, the Fed said it lost a lot of leverage, because it couldn't threaten to put AIG into bankruptcy anymore," Barofsky told CNNMoney in an interview. "But with GM and Chrysler, the government still played hardball with their creditors."

Though the situation was slightly different, Barofsky noted that Treasury was able to negotiate substantial concessions from GM and Chrysler's creditors after the government bailed them out last year.
How the banks got full-dollar

After the housing bubble burst in summer 2007, the value of subprime home mortgages began to tumble. AIG insured against losses on assets backed by subprime mortgages with insurance contracts called credit-default swaps.

When the underlying home loans began to plummet in value, AIG's counterparties asked the insurer to post billions of dollars of collateral to make up for the tumbling value of the swaps.

AIG started hemorrhaging dollars by the tens of billions in 2008, leading up to a mid-September taxpayer-funded bailout of the insurer. But the collateral calls from AIG's counterparties kept coming, and AIG (AIG, Fortune 500) was quickly running out of bailout funds.

By November, it became clear that the government had to do something to stop the collateral calls.

In an attempt to save taxpayers from paying 100 cents on the dollar for the credit-default swaps, which had clearly lost their initial market value, the New York Federal Reserve asked 16 counterparties to take a voluntary "haircut" on the value of the insured assets. Only UBS volunteered, but the Swiss bank said it would take the haircut only if all of the other banks also agreed to take a cut.

The Fed, chaired at the time by current Treasury Secretary Tim Geithner, said in response to Barofsky's report that it has a policy to treat all counterparties equally. It also believed it had no leverage with the banks, because it had already bailed out AIG. In addition, the Fed believed it did not have the right to force banks to break their contracts.

Believing it had no other option, the Fed opted to send $27 billion of government funds and $35 billion of collateral already posted by AIG to 16 banks, including Goldman Sachs (GS, Fortune 500), Merrill Lynch, UBS (UBS), Bank of America (BAC, Fortune 500), Wachovia (WB) two French banks and several others.
Not the only solution

The news caused an uproar in Congress. Some called into question the Bush administration's ties with Goldman Sachs, since Goldman held $14 billion in mortgage assets insured by AIG's credit-default swaps.

In his report, Barofsky said that the Fed did not act purposefully to bail out Goldman or the other 15 banks, even though that was the result of their actions.

But the report said the Fed limited itself in its negotiations with AIG's counterparties. For instance, Barofsky said that the Fed failed to use as leverage the fact that its bailout of AIG helped to save the 16 banks from losing substantial capital, since an AIG bankruptcy could have led to a systemic failure of the financial industry.

The Fed also could have used its power as regulator to force the banks to take less than full-dollar on the underlying assets. He said that regulators used "overtly coercive" language to convince financial institutions to take TARP money and creditors take concessions on the amount owed to them by GM and Chrysler.

"In many ways, the New York Fed took all the limitations they had from being a regulator but none of the benefits," said Barofsky.