Posted on Tue, Apr. 07, 2009
last updated: March 15, 2013 11:58:40 AM
WASHINGTON — The Federal Reserve Bank of New York in November chose not to pursue tough negotiations with large foreign and domestic banks and instead allowed them to receive 100 cents on the dollar in government funds to settle tens of billions of dollars of exotic financial bets guaranteed by American International Group.
At the time, Timothy Geithner, now Treasury Secretary, headed the powerful New York Fed. On his watch, the decision was made to forgo a reduced payout — called a "haircut" in industry parlance — to creditors of AIG to prevent financial chaos around the world, the officials told McClatchy.
Had the Fed negotiated a reduction of just 10 cents to 15 cents on the dollar, it could've saved between $2 billion and $3 billion.
The revelation sheds new light on last month's disclosure by AIG that it used loans from the New York Fed to pay more than $17 billion to foreign creditors such as France's Societe Generale and Credit Agricole, and Germany's Deutsche Bank. U.S. investment banks, including Goldman Sachs and Merrill Lynch, also were paid $10 billion in what amounted to a back-door bailout of the troubled institutions that had financed the insurer's risky investments.
The real reasons behind these decisions weren't revealed at the time. And like the Obama administration's decision last month to allow more than $165 million in controversial bonuses to AIG executives, their disclosure is fueling new criticism.
Geithner's office declined requests to comment.
At issue is the Fed's handling of nearly $30 billion that AIG owed on complex insurance-like financial instruments known as credit-default swaps, which are unregulated products that the company issued to guarantee often risky investments.
AIG had at least $440 billion in credit-default swaps outstanding when the New York Fed and the Treasury Department rode to the rescue of its creditors in September with an unprecedented $85 billion cash infusion — a bailout that has since been revamped and grown to some $180 billion.
The rescue, which gave the Fed control of almost 80 percent of AIG, was designed to prevent what Fed Chairman Ben Bernanke has since said could've been a collapse of the global financial system.
The decision to extinguish some of AIG's credit-default swaps, however, was made in mid-November, after the waters had calmed.
Gerald Pasciucco, the new chief executive of AIG's Financial Products division, which sparked the company's meltdown, recently told McClatchy that Fed officials made the decision to pay full value, but he declined to elaborate when pressed. Pasciucco is negotiating the sale of the remaining $1.4 trillion in the division's business.
The decision to pay full contract value is the latest example of the Fed appearing to be "very much out of sync with the attitude of the public and the taxpayers," said John Coffee, a Columbia University law professor who testifies frequently before Congress on matters of corporate finance.
The Fed could have offered 85 cents on the dollar — saving billions of dollars — and claimants would've had little recourse but to sue, he said.
Once the Fed decided against bankruptcy for AIG, it was logical to presume that the company would fully honor its swaps contracts, a senior Fed official said.
By then, AIG had been downgraded by credit-rating agencies. The downgrade meant that AIG had to post $35 billion in collateral with various swapholders _and the company faced catastrophe, another Fed official said. Both officials requested anonymity to speak freely.
After the Fed intervened in September, it made attempts to convince some of AIG's foreign counterparties to accept a reduced payout. They declined. New York Fed officials worried that U.S. defaults on the swaps would lead to "a cascade of other defaults" by firms around the world that had counted on full payouts, one of the officials said.
The idea of a discount was met with "a very hostile reaction" and warnings that such a stance would be viewed as a default, officials said. They pointed to the global financial chaos after the 1991 collapse of the Bank of Credit and Commerce International. Authorities in England and Luxembourg seized Pakistan-based BCCI, and its creditors scrambled for assets across the globe.
Once the decision was made to fully pay AIG's foreign counterparties, including $2.8 billion to Deutsche Bank and $6.9 billion to Societe Generale, the officials concluded that it would be discriminatory to pay less than 100 cents on the dollar to U.S. banks holding the same contracts.
"I was concerned that people would say the Fed used its power to exploit some domestic financial institutions," said Thomas C. Baxter, the general counsel of the New York Fed, in a telephone interview.
At that time, he said, it was easy to explain "why an entity you kept out of bankruptcy was paying its legitimate and lawfully incurred debts. That didn't seem hard."
That, however, was before public anger mounted over Wall Street rescue efforts.
Columbia's Coffee countered that "you could have asked everybody to scale down their expectations at least 10 or 15 percent, and that wouldn't have been discriminatory. And if you asked Congress, I think they would have been much more in favor of being discriminatory towards foreign banks, because this is funded with U.S.-taxpayer-funded dollars."
In bankruptcy, he said, the swaps might've been settled at 20 cents on the dollar. In other words, the government had leverage and chose not to use it.
"So I think that there has been an absence of hard bargaining here, and it is because the Fed puts its highest priority on its loyalty to the banking system and tends to subordinate economizing with taxpayer dollars."
The payouts also have fueled allegations of unnecessary back-channel bailouts on top of the publicly disclosed taxpayer-funded efforts.
New York Insurance Commissioner Eric Dinallo, the most vocal advocate for regulating credit-default swaps, told Congress on Oct. 18 that regulators were working in a vacuum.
"Because the credit default swap market is not regulated, we do not have valid data on the number of swaps outstanding," he said.
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