The Loophole that Became a Wormhole: Why the Fed Had to Bail out AIG
Many explanations have been offered for the “why” of the Fed found it necessary to bail-out AIG, mostly centering around uncertainty and risk. It’s not exactly that AIG was “too big to fail,” but rather that no one could say, with any certainty, that its failure wouldn’t lead to a real market crash of enormous scope. That is, AIG is a good example of the precautionary principle in action. Maybe so. But I still am a little unclear why AIG is so exceptional in that regard.
Back in the Spring, when Bear failed, I asked my colleague Jonathan Lipson to offer a set of observations about Bear’s bailout. (Check out also Ribstein’s response to Lipson here.) Based on a recent correspondence with him about AIG, I thought it would make sense to share with you his unique & very interesting perspective on the problem.
Why did the Fed bail out AIG but not Lehman?
The conventional answer—which is true but incomplete—is that AIG was too big to fail. But that begs two questions: Too big how? And why?
In part, AIG was too big to fail because it could owe an astronomical amount—allegedly about $300 BN—on credit default swaps issued to support mortgage-backed securities.
The problem, however, is not just the amount AIG owes, but the fact that these obligations are not like other obligations. They occupy a series of loopholes that make them unusually dangerous. Perhaps the greatest loophole of all came in the 2005 amendments to the Bankruptcy Code. Although designed ostensibly to “get tough” on profligate debtors, those amendments also made certain that CDS holders would get special treatment in bankruptcy—special treatment that may have made the Fed bailout inevitable.
Credit Default Swaps and AIG
Credit default swaps (CDS) function much like insurance on another party’s debt. So, for example, investors that purchased a mortgage-backed security issued by, say, Lehman Brothers may also have purchased a credit default swap issued by AIG that would pay if Lehman defaulted on its bonds (e.g., by going into bankruptcy).
Credit default swaps are essentially unregulated insurance contracts. Not technically securities, they do not have to be registered with the SEC. Not technically insurance, their issuance by AIG was not overseen by state regulators.
Among other things, this meant that AIG was apparently not required to disclose the full extent of its liability, or to hold reserves against these contingent liabilities, as they would for the life insurance policies their (currently) healthy subsidiaries write. So, when the rating agencies threatened to downgrade AIG, it is not surprising that the counterparties to these contracts would have required AIG to pony up more collateral.
This, AIG could not do.
Thus, a liquidity crisis.
Ordinarily, when an ostensibly healthy company (e.g., AIG) faces a liquidity crisis, it seeks protection under chapter 11 of the U.S. Bankruptcy Code. In chapter 11, the company benefits from, among other things, a temporary stay of collection actions, the exclusive opportunity to propose a reorganization plan, and the power to discharge debts.
So, if AIG merely had $300 BN in bonds that it could not pay because it found itself in a cash crunch, bankruptcy might be a sensible strategy. Bondholder collection actions would halt, and the company would be able to catch its breath and right the listing ship, or at least sell its parts for more than scrap value. Imagine Lehman Brothers, but to a higher order of magnitude.
Credit Default Swaps in Bankruptcy
That logic fails in the strange world of credit default swaps. Swaps are not like other debts. The 2005 amendments to the Bankruptcy Code were the culmination of a series of amendments which began in the 1980s, and which assure that CDS will essentially be untouched by the bankruptcy of any party to the swap.
Most important, the bankruptcy stay will not halt collection efforts by swap counterparties. Unlike other creditors, CDS counterparties may “net” their “positions”—claims—against the company. This simply means that if you were lucky enough to hold a swap issued by AIG, you would be able to enforce it even if AIG went into bankruptcy. If you were a bondholder, you wouldn’t.
For AIG, this presented a serious problem, because it meant bankruptcy could not realistically protect the company. Given the way the Bankruptcy Code treats CDS, an AIG bankruptcy would (likely) create a cascade of defaults, with all of AIG’s counterparties “running” the company to collect. Because the bankruptcy stay would not protect AIG, the CDS counterparties would simply be able to take their collateral and leave. With private lenders unwilling to lend, and bankruptcy off the table, this left only a Fed bailout as a viable alternative.
Is AIG a Disguised Lehman Bailout After All?
Last March, I put up some paranoid posts about the Fed’s bailout of Bear Stearns. I argued that chapter 11 of the Bankruptcy Code could solve problems like those presented by Bear’s failure.
I was suspicious of the motives to keep Bear out of bankruptcy. Who was being protected? The executives? The hedge fund managers? The folks on Wall Street and the Fed, however, believed that a Bear bankruptcy would have catastrophic results. It, too, was too big to fail.
The Fed’s resistance to a Lehman bailout was thus curious. Wouldn’t a Lehman bankruptcy be even more catastrophic than a Bear bankruptcy?
So far, the answer would seem to be: No. The stock market rose the day after Lehman’s bankruptcy. If the reaction to Lehman is any indication (and of course it may not be), in hindsight, a Bear bankruptcy may not have been so bad either.
Not so for AIG. After the AIG bailout was announced, the market plunged.
Why? One possibility is that the AIG bailout really isa disguised Lehman bailout. If Lehman’s bondholders purchased, say, $85 BN of AIG-issued CDS insuring against a Lehman bankruptcy, perhaps they are the ultimate beneficiaries of the Fed’s largesse. Perhaps no one cared when Lehman itself filed because insiders knew (or hoped) that the real money was coming from AIG. Then the only question was: Where would AIG get it?
This is rank speculation, of course. We may never know the relationship between the AIG bailout and the Lehman bankruptcy because—being unregulated—the general public has no idea who issues or holds CDS, in what amounts, or against whom.
The Real Problems—Selective Socialism and Deregulation
Ultimately, there are two problems here, one of regulation, the other of policy.
The regulatory problem is that once the Fed bailed out Bear, it created a new grade (tranche?) of moral hazard. Why wouldn’t every anxious Wall Street executive plead for a meeting with the Fed? If they did it for Bear, they might do it for Merrill, or Lehman, or Wachovia, or WaMu, or AIG.
But this was the worst of all possible regulatory strategies (and I use that word generously), because it is opaque, unpredictable and unfair. It’s selective socialism. It gave Wall Street nothing but an incentive to keep begging rather than doing the hard work of deleveraging.
If Bear had gone into bankruptcy, it may have caused some pain. But perhaps that pain would have prevented the much larger pain we see today. Bailing out Bear may simply have forestalled the day of reckoning.
Which, by the way, may still have yet to come.
The policy problem involves the choice in the 1970s to embark on a massive program to deregulate many industries. It is difficult to point to many success stories here. With the possible exception of certain telecom sectors (i.e., cell phones), few of the promised benefits of deregulation materialized. Electricity is more expensive, cable television is (generally) pretty lame, and transportation hasn’t exactly improved. And, while lightened regulation has been good for executives and hedge fund managers, average investors aren’t doing nearly so well. And they’re likely to do a lot worse in the near term.
The CDS Loophole: The Wormhole Cometh
The story of the CDS exemption under the Bankruptcy Code is part of this deregulatory story, which has seen Bankruptcy Code loopholes for all sorts of special interests. Swaps are not the only specialized financial contracts that are immune from bankruptcy. Among others, repurchase agreements and commodity contracts also get special treatment.
The difference is that those are generally regulated in other ways, whether by federal securities laws, by the Commodities Futures Trading Commission, under Federal Reserve Bank regulation, or state securities or insurance law. The decision to exempt those contracts from bankruptcy may not be ideal policy, but may also not be so harmful because those contracts get some regulatory reality check at some point. Not so for credit default swaps.
No one stops to think about the role that obscure and technical amendments to the Bankruptcy Code play in larger debates about regulatory policy. But here, the decision to exempt swaps from the ordinary operation of the Bankruptcy Code may have been the greatest deregulatory mistake of all. It may have helped AIG to become too big to fail in any way short of a massive Fed bailout. It may be the loophole that became a wormhole, sucking all value out of the financial space-time continuum.