The Loophole that Became a Wormhole: Why the Fed Had to Bail out AIG

lipson.JPGMany 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.

Chapter 11

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.

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3 Responses

  1. Gordon Smith says:

    Excellent post, Jonathan. Very insightful. Thanks for sharing, Dave.

  2. Mark says:

    Proclamation on the Federal Reserve System of the United States of America

    March 2008

    WHEREAS, Article I, Section 8 of the Constitution of the United States of America authorizes Congress “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures”;

    WHEREAS, on December 13th, 1913 the US Congress enacted the Federal Reserve System;

    WHEREAS, the Federal Reserve System is considered an independent agency within the federal government, with oversight of Congress and containing appointed public officials on its board of directors;

    WHEREAS, the Federal Reserve System Controls the Federal Reserve Note, the official currency of the great nation of the United States of America;

    WHEREAS, there may be controversies regarding the legality and constitutionality of the Federal Reserve System, it is recognized that the said system has operated continuously as the central banking system of the United States since the inception of the Federal Reserve Act of 1913;

    WHEREAS, the Constitution of the United States of America granted Congress the authority to create the current Federal Reserve System, it also does grant Congress the authority to modify or revoke the Federal Reserve System;

    WHEREAS, the actions of the Fedreral Reserve System represent the credit and currency of the United Stated of America to the citizens of this great nation and to the world;

    WHEREAS, the Federal Reserve System, acting independently within the federal government allowed, supported, and even promoted parasitical and non-productive uses of the money and credit of the United States of America;

    WHEREAS, the United States and likely the entire world’s financial system is undergoing massive de-leveraging of the said parasitical and non-productive uses of the credit and money of the United States of America (as well as other nations’ currencies);

    WHEREAS, the US dollar, the “Federal Reserve Note” is declining in value due to these parasitical activites, as well as potentially other causes;

    WHEREAS, it is recognized that the citizens of the United States and other nations did willingly participate at some level in the creation and propogation of said parasitical activities;

    WHEREAS, it is also recognized that the United States of America, a sovereign nation, has the legal, moral, and God given authority to take actions to benefit its citizens and to protect its good name, credit and money in times of difficulty;

    WHEREAS, it is recognized that the current time is such a time of great difficulty;

    WHEREAS, it is recognized the parasitical financial institutions and their activities are at odds with citizens of the United States of America and the good credit and money thereof;

    WHEREAS, the current indications are that the Federal Reserve System is acting to preserve the financial system currently flooded with the parasitical activities;

    WHEREAS, the current indications are that the neither the Federal Reserve System, nor the Congress of the United States, nor the people of the United States have access to the books of the institutions being preserved by the Federal Reserve, and therefor the degree of inter-connectivity and risk associated with the institutions and other entities cannot be determined;

    WHEREAS, the Federal Reserve System is accepting non-performing assets as collateral for credit with ultimate taxpayer responibility to entities not under its constitutional mandate;

    IT MUST BE CONCLUDED, that the Federal Reserve System is not acting to the benefit of the people of the United States of America, its credit, money, and good name;

    WHEREAS, it is recognized that the political will and capability of the government of the United States of America may not be up to the task of prosecuting this proclamation ; It is also recognized that this may be the only hope for the continued survival of the United States of America as the great nation as it has historically existed.

    NOW THEREFORE, it is PROCLAIMED by those supporting this Proclamation that the Congress of the United States of America FULLY NATIONALIZE the Federal Reserve System, and take full control of the credit and money of our great nation; The Congress must take whatever action necassary to seperate out, sequester, disown, or otherwise neutralize the effect of the parasitical financial activities which led to the current crisis; The Congress of the United States of America must reorganize, replace, or terminate the Federal Reserve System as appropriate; or otherwise devise a system for creation of the national currency.

    IT IS FURTHER PROCLAIMED, that the Congress of the United States of America in cooperation with the Executive of the United States of America contact allied nations and any other nation willing to participate in the overhaul of the failing and parastical financial sytem currently in operation and create new treaties and alliances as necassary to create a sane and productive system of finance with the express goal of supporting a productive national, and by extension and through voluntary cooperation, world economy;

    FURTHERMORE, it is PROCLAIMED that it should be the goal of such an international effort to maintain fair international trading practices allowing for protection in national interest of labor, resources, and productive capabilities;

    WHEREAS, it is recognized that such a move on the part of the United States of America may result in the necessity of an isolationist policy IF the other developed nations do not follow our lead; If such occurs, so be it.


  3. A.J. Sutter says:

    Thanks for the clear and informative analysis, Jonathan.