The Bailouts Revisited

Who got bailed out and why? Is there any alternative to “Too Big to Fail”?

By Marty Wolfson

Bank of America got bailed out, but Lehman Brothers was allowed to fail. The insurance company American International Group (AIG) was rescued, but in July federal authorities refused to bail out a significant lender to small and medium-sized businesses, the CIT Group (not to be confused with Citigroup, which did get bailed out).

What is the logic behind these decisions? Who is being bailed out—and who should be? The AIG story offers an instructive case study, one that sheds light on these and other questions.

Last September, the Federal Reserve Board announced that it was lending AIG up to $85 billion to prevent the firm’s collapse. Unless it bailed out AIG, the Fed warned, financial markets could panic, loans could become more difficult to get, and many more businesses, jobs, and homes could be lost. To counter public anger over the bailout, the Fed argued that the ultimate beneficiaries would be the American people.

Citing proprietary information, AIG initially released few details about how it paid out the money it received. But this March, AIG’s plan to pay $165 million in bonuses to employees at its Financial Products unit hit the headlines. An angry firestorm erupted: why should public bailout money be used to pay excessive bonuses to the very people who had caused the problem? U.S. officials and AIG CEO Edward Liddy denounced the payments as outrageous, but claimed they could not rescind the bonuses because they were bound by legal contracts. As it turned out, many AIG employees returned the bonuses voluntarily. And in a rare display of bipartisanship, the House of Representatives voted 328 to 93 to enact a 90% tax on bonuses paid to executives at companies that had received at least $5 billion in bailout money.

But the AIG bailout involved billions of dollars. The Financial Products employees only got millions. Who got the rest of the money? Under mounting public pressure, and after consulting with the Federal Reserve, AIG finally revealed who the beneficiaries were.

It’s the Banks!

Yes, the money went primarily to large banks, those same banks that took their own large risks in the mortgage and derivatives markets and that are already receiving billions of dollars in federal bailout money. The banks are using AIG’s bailout money to avoid taking losses on their contracts with the company.

Why did AIG, an insurance company, have such extensive dealings with the large banks, and why did those transactions cause so much trouble for AIG?

The story begins with AIG’s London-based Financial Products unit, which issued a large volume of derivatives contracts known as credit default swaps (CDSs). These were essentially insurance contracts that provided for payments to their purchasers (known as “counterparties”) in the event of losses on collateralized debt obligations (CDOs), another kind of derivative. Many of the CDOs were based in complicated ways on payments on home mortgages. When the speculative housing bubble popped, mortgages could not be repaid, the CDOs lost value, and AIG was liable for payment on its CDSs.

By September 2008, AIG’s situation had deteriorated to the point where its credit ratings were downgraded; this meant the company was required to post collateral on its CDS contracts, i.e., to make billions of dollars in cash payments to its counterparties to provide some protection for them against possible future losses. Despite its more than $1 trillion in assets, AIG did not have the cash. Without assistance it would have had to declare bankruptcy. After attempts to get the funding from private parties, including Goldman Sachs and JPMorgan Chase, failed, the Federal Reserve stepped in. The initial $85 billion credit line was followed by an additional $52.5 billion in credit two months later. By March 2009 the Treasury had invested $70 billion directly in the company, after which the Fed cut back its initial credit line to $25 billion.

AIG paid out those billions in several categories. Between September and December of 2008, $22.4 billion went to holders of CDSs as cash collateral. This cash was paid not only to those who sought insurance for CDOs they actually held, but also to speculators who purchased CDSs without owning the underlying securities. (Data to evaluate the extent of speculation involved have not been published.)

The largest beneficiaries of these payments were Société Générale, Deutsche Bank, Goldman Sachs, and Merrill Lynch.

Second, in an effort to stop the collateral calls on these CDSs, AIG spent $27.1 billion to purchase insured CDOs from its counterparties in return for their agreement to terminate the CDSs. Again, the largest beneficiaries of this program were Société Générale, Goldman Sachs, Merrill Lynch, and Deutsche Bank.

Third, it turned out that a significant cash drain on AIG was its securities lending program. Counterparties borrowed securities from AIG and in turn posted cash collateral with AIG. When AIG got into trouble, though, the counterparties decided that they wanted their cash back and sought to return the securities they had borrowed. However, AIG had used the cash to buy mortgage-backed securities, the same securities that were falling in value as the housing market crashed. So $43.7 billion of AIG’s bailout money went to those counterparties—chiefly Barclays, Deutsche Bank, BNP Paribas, Goldman Sachs, and Bank of America, with Citigroup and Merrill Lynch not too far behind.

Necessary Bailouts?

Without all that bailout money going to the banks via AIG, wouldn’t the financial system have crashed, the banks have stopped lending, and the recession have gotten worse? Well, no.

At least, the banks did not need to receive all the money they did. If a regulatory agency such as the Federal Reserve or the Federal Deposit Insurance Corporation had taken over AIG, it could have used the appropriate tools to, as Fed chair Ben Bernanke told a House committee this March, “put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now.” (A haircut in this context is a reduction in the amount a claimant will receive.) A sudden and disruptive bankruptcy of AIG could indeed have caused a crash of the financial system, especially as it would have come just one day after the sudden fall of Lehman Brothers on September 15. It is the element of surprise and uncertainty that leads to panic in financial markets. On the other hand, an orderly takeover of AIG such as Bernanke described, with clear information on how much counterparties would be paid, likely could have avoided such a panic.

So why didn’t the Federal Reserve take over AIG? It said it did not have the legal authority to take over a nonbank financial institution like AIG. Indeed, to his credit, Bernanke frequently asks for such authority when he testifies to Congress. So why didn’t the Fed demand it last September? Wasn’t such authority important enough to make it a condition of the bailout? And couldn’t Congress have passed the necessary legislation as quickly as it passed the bank bailout bill last fall and the tax on AIG bonuses? Even if that took a few weeks, the Fed could have lent money to AIG to keep it from failing until it had the authority to take the company over.

Of course, the Fed already has the authority to take over large troubled banks—but refuses to use it. Now, Fed and Treasury officials claim that since all the major banks passed the recently administered “stress test,” such takeovers are unnecessary. However, even some of the banks that passed the test were judged to be in need of more capital. If they can’t get it from private markets then, according to Treasury Secretary Timothy Geithner, the government is prepared to supply them with the capital they need.

In other words, the federal government’s strategy of transferring extraordinary amounts of public money to large banks that lose money on risky deals will continue. In fact, the same strategy is evident in the Treasury’s proposed Public Private Investment Program, which uses public money to subsidize hedge funds and other private investors to buy toxic assets from the banks. The subsidy allows the private investors to pay a higher price to the banks for their toxic assets than the banks could have received otherwise.

Bail Out the People

The consistent principle behind this strategy is that no large bank can fail. This is why the relatively small CIT Group wasn’t rescued from potential bankruptcy but Bank of America was. The decision not to bail out Lehman Brothers, which led to panic in financial markets, is now considered a mistake. However, policymakers drew the wrong lesson from the Lehman episode: that all large bank failures must be prevented. They failed to recognize the important distinction between disruptive and controlled failures.

Yes, there are banks that are too big to fail suddenly and disruptively. However, any insolvent bank, no matter what its size, should be taken over in a careful and deliberative way. If this means nationalization, then so be it. Continental Illinois National Bank, at the time the 11th largest bank in the United States, was essentially nationalized in 1984, ending the turmoil in financial markets that Continental’s difficulties had created.

This “too big to fail” strategy equates stabilizing the financial system and promoting the people’s welfare with saving the corporate existence of individual large banks. Likewise the auto companies: while GM and Chrysler have been treated much more harshly than the banks, the auto bailout was similarly designed to keep these two corporate entities alive above all else, even at the expense of thousands of autoworker jobs.

The federal government’s current bank bailout strategy may be well-meaning, but there are four problems with it. It uses public money unnecessarily and is unfair to taxpayers. It may not work: it risks keeping alive “zombie banks” that are really insolvent and unwilling to lend, a recipe for repeating Japan’s “lost decade” experience. It makes financial reform going forward much more difficult. Protecting the markets for derivative products like CDOs and CDSs allows for a repeat of the risky practices that got us into the current crisis. And finally, by guaranteeing the corporate existence of large banks, we are maintaining their power and priorities and thus are not likely to see gains on predatory lending, foreclosure abuse, and other areas where reform is sorely needed.

If we want to help the people who are suffering in this crisis and recession, then we should make financial policies with them directly in mind. Just throwing money at the banks will not get the job done.

Marty Wolfson teaches economics at the University of Notre Dame. Previously, he was an economist with the Federal Reserve Board in Washington, D.C. He is the author of Financial Crises: Understanding the Postwar U.S. Experience, 2nd ed., M.E. Sharpe, 1994.