Scandal

It's hard to say whether a story like this has any legs. On the one hand, those legs have the potential to kick the Obama Treasury and the remaining credulity of the Federal Reserve system square in the groin. On the other hand, it's more complicated than a story about a boy getting carried away by balloon, so it could go either way. But regardless of whether this makes it off the pages of Bloomberg and a few financial blogs, this is a legitimate scandal. And by that, I do not mean the flashing-coochy-in-the-back-of-a-limousine kind of scandal or the kind that puts the offender on the cover of National Inquirer, but instead, one can hope, in a prison cell.

One of the more transparent miscarriages of fair economic policy from the trans-presidential assortment of seemingly ad hoc policies called the Bail-Out is the way in which A.I.G.'s credit default swap contracts were re-negotiated--or rather, how they were not renegotiated:

Beginning late in the week of Nov. 3, the New York Fed, led by President Timothy Geithner, took over negotiations with the banks from AIG, together with the Treasury Department and Chairman Ben S. Bernanke’s Federal Reserve. Geithner’s team circulated a draft term sheet outlining how the New York Fed wanted to deal with the [credit default] swaps -- insurance-like contracts that backed soured collateralized-debt obligations.
[...]
Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public. (Bloomberg)

Which is to say that as the New York Fed helped to restructure the bankrupted insurance company, rather than renegotiating the terms of its various obligations as would be the case in any typical Chapter 11 proceeding, the Fed decided to pay off this particularly deleterious section of the company's liabilities in full.

This fact seems particularly offensive in light of the following discovery by Bloomberg:

In the months leading up to the September 2008 collapse of giant insurer American International Group Inc., Elias Habayeb and his colleagues worked nights and weekends negotiating with banks that had bought $62 billion of credit-default swaps from AIG, according to a person who has worked with Habayeb.

Habayeb, 37, was chief financial officer for the AIG division that oversaw AIG Financial Products, the unit that had sold the swaps to the banks. One of his goals was to persuade the banks to accept discounts of as much as 40 cents on the dollar, according to people familiar with the matter.

It's impossible to know how close to the 40-cent mark the end result of any negotiations with the various counter-parties (most notably, Goldman Sachs and Deutsche Bank) would have come, but it's fair to say that any real bout of bargaining would have produced something slightly more favorable to the taxpayer than the full dollar-for-dollar value coughed up by the Fed. Which is to say that the Fed never planned to force the counter-parties into a haircut.

This may sound outrageous, but it also kind of flows the the entire perverted logic of bailing out so-called too-big-to-fail institutions. An institution is considered TBTF if its failure would trigger the failure of its business partners and contribute to a veritable Rube Goldberg machine of financial apocalypse. Making sure A.I.G.'s counterparties were insulated from that company's collapse--insulated with a cushy padding of public funding--was in many ways what the bail-out was all about. Evidently, during its secret negotiations between the New York Fed and the various A.I.G. counterparties, the bankers were able to convince the then N.Y. Fed President Timothy Geithner that every last cent of those settlement payments and collateral posts were absolutely necessary for the solvency of their firms. So maybe those payments were necessary after all.

Or maybe not.

Vickrey says that one reason the New York Fed should have insisted on discounted payments for AIG’s CDSs is that the banks likely had hedges against their insured CDOs or had already written down their value. On March 20, Goldman Sachs CFO David Viniar said in a conference call with investors that Goldman was protected.

“We limited our overall credit exposure to AIG through a combination of collateral and market hedges,” Viniar said. “There would have been no credit losses if AIG had failed.”

And maybe, as CFO of Goldman, it is Viniar's job to push the "everything is fine/everything has always been fine" line.* And maybe Goldman was unique amongst its fellow swap-buyers. But if a recent deal negotiated by Citi provides an example of the industry norm, the taxpayers got hosed. And they got hosed for no good reason.

Citigroup Inc. agreed last year to accept about 60 cents on the dollar from New York-based bond insurer Ambac Financial Group Inc. to retire protection on a $1.4 billion CDO.

[...]

Far more money was wasted in paying the banks for their swaps [relative to AIG bonus payments], says Donn Vickrey of financial research firm Gradient Analytics Inc. “In cases like this, the outcome is always along the lines of 50, 60 or 70 cents on the dollar,” Vickrey says.

So essentially what we have is, at the very least, some seriously excessive cautiousness on the part of the New York Fed. If we give them the absolute benefit of the doubt, the folks at the Fed were so concerned that AIG would become another, bigger Lehman, that they threw more cash at the problem than was strictly necessary. Just to make sure.

But as the Bloomberg article makes very clear--and here we get to the heart of the scandal--we should not give these people the benefit of the doubt.

The deal contributed to the more than $14 billion that over 18 months was handed to Goldman Sachs, whose former chairman, Stephen Friedman, was chairman of the board of directors of the New York Fed when the decision was made. Friedman, 71, resigned in May, days after it was disclosed by the Wall Street Journal that he had bought more than 50,000 shares of Goldman Sachs stock following the takeover of AIG. He declined to comment for this article.

[...]

Friedman’s role remains controversial. In December 2008, weeks after the payments to the banks were authorized in November, Friedman bought 37,300 shares of Goldman stock at $80.78 a share, according to SEC filings. On Jan. 22, he bought 15,300 more at $66.61.

Both purchases took place before the payments to Goldman Sachs were publicly disclosed under pressure from Senator Dodd in March. On Oct. 26, Goldman Sachs stock closed at $179.37 a share, meaning Friedman had paper profits of $5.4 million.

Jerry Jordan, former president of the Federal Reserve Bank of Cleveland, says Friedman should have resigned from the New York Fed as soon as it became clear that Goldman stood to benefit from its actions.

“It’s an outrage,” Jordan says. “He needed to either resign from the Fed board or from Goldman and proceed to sell his stock.”

There is of course a third option, the one where Friedman go directly to prison. I am not a securities lawyer. I am not an expert on financial regulation. But someone tell me how this is not the most idiotically blatant form of insider trading. How does this differ in any way from what Raj Rajaratnam was just arrested for at Galleon?

Did the prospect of private gain provide the primary incentive of the various members of the N.Y. Fed to pay in full AIGs CDS obligations? I seriously doubt it. I doubt it partially because the claim just sounds conspiratorial. But I also doubt it because in order to believe that such obvious corruption exists at the top of the financial regulatory structure, I would have resign myself to the fact that the U.S. government will probably never be able to adequately regulate the financial sector and that financial, fiscal, and monetary policy of the United States will always be dictated by the interests of investment banking.

In the meantime:

Bloomberg News has filed a Freedom of Information Act request seeking copies of the term sheets related to AIG’s counterparty payments, along with e-mails and the logs of phone calls and meetings among Geithner, Friedman and other New York Fed and AIG officials. The request is pending.

*There is also the possibility, as suggested at ZeroHedge, the Bedlam of frothy-mouthed but often convincing financial blogs, that not only was Goldman fulled hedged against AIG's failure, but that the value of those "hedge" positions--largely CDS contracts on AIG debt itself--far exceeded Goldman's potential return given AIG's success. Which is to say that Goldman was actually betting on an AIG bankruptcy. Therefore the reimbursement of Goldman on its CDS contracts with (as opposed to on) AIG only padded a hefty return on the entire deal.

Purchasing $10 billion in CDS (roughly in line with what Viniar claims happened) at a hypothetical average price of 25 bps (and realistically much less than that) and rolling that would imply that at today's AIG 5 yr CDS price of 1,942 bps, the company made roughly $4.7 billion in profit from shorting AIG alone! This would more than make up for the $2.5 billion collateral shortfall (out of $4.4 billion total) GS claims AIG had with Goldman Sachs. (ZH)

I have absolutely no idea how realistic those "hypothetical" figures are, but the claim isn't one that I would dismiss on its face alone.