Opinion

Felix Salmon

Why the government should have nationalized AIG

By Felix Salmon
February 7, 2010

This weekend’s big NYT story on Goldman Sachs and AIG does not, I think, say anything much we didn’t already know. But it does suggest, I think, that the US government made a big mistake in bailing out AIG rather than nationalizing it outright:

The government would soon settle the yearlong dispute between Goldman and A.I.G., with Goldman receiving full value for its bets. The federal bailout locked in the paper losses of those deals for A.I.G. The prices on many of those securities have since rebounded.

The dispute between Goldman and AIG was one over collateral. Goldman wanted AIG to put up ever-increasing amounts of collateral against the CDS which it had written — demands for cash which AIG was unable to meet. So the government stepped in and unwound the contracts near the bottom of the market, paying out Goldman Sachs and other AIG counterparties in full, and locking in massive losses for the insurer.

The alternative would have been to nationalize AIG outright, and imbue it with the government’s own triple-A credit rating. Since many of the largest collateral calls were a function of AIG’s own deteriorating credit rating, that alone would have helped to minimize the amount of cash needed to be put up as collateral. AIG, rather than unwinding all those CDSs, could then simply have held onto them, putting up as much collateral as it needed to, and paying out on them as and when the underlying bonds defaulted. The end result would, with hindsight, have been significantly cheaper for both AIG and US taxpayers.

Now it is true that as part of the AIG bailout, the New York Fed took possession of a lot of CDOs, putting them in portfolios with names like Maiden Lane III, and hiring Blackrock to manage them. As the value of those CDOs has risen, the US government has seen mark-to-market gains on its portfolio. But that doesn’t change the fact that Goldman Sachs bought credit insurance very cheap from AIG, and then sold it back at a very high price to the US government, locking in billions of dollars in trading gains. AIG took equal and opposite losses on those transactions, and ended up passing those losses on to the US taxpayer.

It will be many years before it becomes clear whether or not Goldman pulled off a great trade here, cashing in on its insurance assets at the height of the panic. It’s still possible that the bank would have been better off holding all that insurance to maturity, and collecting a steady income stream over the years as various instruments went into default. But Goldman will tell you until it’s blue in the face that it always marks all its positions to market, and that it doesn’t really believe in holding financial assets for very long time periods.

So at the very least, AIG and the New York Fed should have threatened to call Goldman’s bluff, and said OK, we’ll continue to put up collateral. Goldman would then have had to hand that collateral back over the course of 2009 as the credit markets rebounded, and AIG wouldn’t have locked in any losses at all. But no one did that, because AIG was only 80% owned by the government, and the government didn’t want to provide essentially unlimited liquidity support to a company which still had a relatively large number of private shareholders. Outright nationalization, then, might have been a much simpler — and cheaper, in the long run — way of addressing the situation.

Comments
15 comments so far | RSS Comments RSS

I predominantly agree with your point here; however, where I disagree is with regard to Goldman possibly having been better off holding the insurance to maturity. In the midst of a liquidity crisis, the value of access to short-term liquidity far outweighs any greater value that may have come through payments overtime. That liquidity alone may have been the difference between survival and failure. Additionally, the ability to redeploy that newfound liquidity in the throes of the crisis opened up countless profit opportunities for the bank. Those with liquidity in a time of crisis can profit off of the lack of liquidity in other areas.

All in all though, it is clear that nationalization would have been a far better choice than simply bailing out AIG.

Posted by offpeak34 | Report as abusive
 

Hi Felix:

Haven’t read your blog since you left Portfolio.com and I must say, you’ve sure kicked it up a notch here.

Good work!

Posted by Teresa_Lo | Report as abusive
 

Agreed that this is the direction the story should have taken. A small directional position (and many conspiracy theories) aside, Goldman appears to have had its AIG counterparty risk thoroughly `hedged’, in the sense that only a total collapse of the financial system would have left them exposed. Goldman was diligent when it came to collateral calls because in many cases it was facing them itself on the other side of a corresponding trade, as the article points out. (Of course, in most cases, it was likely more diligent than that other party, or had secured more favorable terms — that’s what it means to be Goldman, after all.) So the question should have been, what is the cheapest way to stop AIG from failing?

An interesting question is whether nationalizing AIG would have triggered anything in Goldman’s contracts, whether with AIG or further down the line. It’s possible they could have profited massively from that — first if it triggered CDSs that Goldman took out on AIG from diverse parties, and second when Goldman benefited from its counterparty being upgraded to a `risk-free’ arm of the US.

Even though most of these deals were just being passed down the line, it’s clear that besides taking its cut along the way, Goldman was able to bargain for slightly better provisions in the structure of the deals, of precisely the sort that benefited it in the crisis.

Posted by absinthe | Report as abusive
 

Closing out deals at the bottom also means you’re putting pressure on the market away from its normal-liquidity equilibrium. I wonder how much simply buying back mortgage default swaps at a high price pushed them higher, let alone any risk-aversion effects that AIG’s implosion was having.

Posted by dWj | Report as abusive
 

Nationalization doesn’t trigger anything if the entity maintain the same or gets a better credit rating than pre-nationalization. In addition, if AIG had got back its AAA rating, then the banks would have had to return all collateral to AIG as it was not required to post collateral as long as it was AAA.

Posted by alea | Report as abusive
 

How exactly were the paper losses locked in? The Fed and AIG via ML3 are still long the same CDO’s that AIG wrote protection on, and if they do bounce back in value, they will make money.

Posted by niveditas | Report as abusive
 

alea, what you say sounds reasonable, but we have no idea what the terms of the contracts were.

Also, the AAA rating wouldn’t result in the return of all collateral. Some (much? all?) collateral was triggered by a decline in the underlying asset, which would not have been fixed by a better rating. But collateral is not the main issue here — even if none had been posted, the contracts would have paid out during the unwind. I’m not sure the unwind was merely due to margin calls; it could also have been an attempt to stop the marked value of these from going lower, since AIG could no longer stomach an indeterminate downside risk on a massive portfolio. The only way to avoid paying out was to hang on to the contracts until the panic was over, which Felix suggests would have happened had it been nationalized.

Posted by absinthe | Report as abusive
 

Yes, the AAA rating would result in the return of all the collateral. Basically the credit support agreement that rules collateral postings is triggered only when the AAA rating is lost and for all practical purposes doesn’t apply otherwise (i.e when AIG is AAA) regardless of the performance of the underlying assets.

Posted by alea | Report as abusive
 

Yes, the government should have absolutely called Goldman’s bluff. They should have offered them fifty cents, and said take it or leave it. And if Goldman would have said that they would default and bring down their customers, risking a complete collapse, the government could have said “That’s ok, we’ll bail some of them out. But not you. You’ll be done, just like Lehman and Bear Stearns”.

Had they done that, Goldman would not have taken the scorched earth route, and there would be no debate about their bonuses this year, because there wouldn’t be all those profits that the government subsidized or enabled.

But Geithner and Bernanke didn’t want to do this. They were afraid of Goldman and the other AIG counterparties. They caved in, demonstrating why they were working for the government and not for the banks – the banks never would have hired them at a high level job.

Posted by OnTheTimes | Report as abusive
 

The previous commentator mixed up the time-line. I believe the AIG bailout was engineered in 2008, when Paulson was still Treasury Secretary; Paulson himself was CEO of GS before going to Treasury, was he not?

I would think, all technical details aside, the mentality of government officials at Treasury, Fed, SEC, etc., has been a major problem. They’ve all drunk the cool-aid and believed their mission is to offer whatever sacrifices demanded by ‘the market’ so that it wouldn’t go down. I would challenge that mentality first, before discussing anything else.

It’s also breathtaking that it’s not even a scandal, when we look at the obvious revolving door between major investment banks (GS in particular) and government overseeing agencies. It’s hard for Paulson or anyone with his history to not treat GS differently in the financial crisis; similarly, it’s hard for Geithner or anyone in his position to not treat investment banks with kid gloves, when he might very well hope to go work for them at a senior position after the government stint.

The blatant conflict of interests speaks for themselves. I’m not by any means questioning any particular player’s personal integrity. I’m saying this system of the revolving door is corrupting and wrong and harms all of us. It should be changed, more buffer should be put in.

Posted by jian1312 | Report as abusive
 

Geithner was head of the NY Fed and Bernanke was chairman of the Federal Reserve, and both were involved in the negotiations with AIG and Goldman. Paulson no doubt liked the solution, but it was the Fed that put the deal together. Geithner “negotiated” with Goldman and the other AIG betting partners, and Bernanke had to approve it. They were both rightly frightened by the domino effect-like consequences of an AIG collapse, but giving Goldman whatever they asked for was not the only solution. They deserve, at best, a D- grade – just barely passing. We deserve better (ok, maybe we don’t deserve better, but we need better management of the financial system).

Posted by OnTheTimes | Report as abusive
 

Obama’s idea of expecting large banks to make the taxpayers whole should include money the taxpayers lost in bailing out AIG… which is currently does not.

GS is not taking any losses on its AIG dealings. That means that someone else must take those massive losses instead. That someone else is the taxpayers.

It must be nice to have such powerful friends in high places. It’s too bad that the US taxpayers don’t have many people in DC who are interested in representing their interests.

Posted by breezinthru | Report as abusive
 

Could the US Treasury or the Chancellor of the Exchequer nationalised just the trading arm of AIG?

Posted by Boabdil | Report as abusive
 

Felix,
All well and good if you could just explain the mechanics. Who could do this, and under what authority?

To Boabdil’s comment, I doubt the UK would want to nationalize the FP subsidiary, and it would probably be pretty interesting if the US sought to nationalize a UK-incorporated firm!

Posted by Carter | Report as abusive
 

You make some very interesting and prudent points. However, we need to understand this in the context of the whole of the financial crisis. AIG was just one (and a big one at that) of the financial dominoes falling in the global economy and US Govt Capital could (and was) needed elsewhere. Also, the CDO’s (and losses) by their nature were hard to quantify and if you cannot accurately measure the risk then why put a govt’s capital and financial rating potentially at risk?

Posted by CSC | Report as abusive
 

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