Sunshine on a Cold Winter Day

“Sunlight is said to be the best of disinfectants: electric light the most efficient policeman.” Justice Louis D. Brandeis, Other People’s Money

Neil Barofsky, special inspector general overseeing the trouble asset relief program has raised questions regarding the role of the Federal Reserve Bank of New York in American International Group, Inc.’s (AIG) efforts to conceal the identities of counterparties who received full payment for credit default swap agreements after AIG’s near collapse. The Federal Reserve has been chided for paying the full value of the agreements rather than negotiating discounted payments and accused of assisting AIG in concealing the payments in filings delivered to the SEC. Today, Secretary of the Treasury and former President of the New York Federal Reserve, Timothy Geithner will respond to Congressional inquiries regarding evidence that the Federal Reserve assisted in efforts to conceal counterparty payment details.

Last year in mid-March, AIG reported that during the period from September through December 2008, the company suffered severe valuation losses on its senior multi-sector credit default swap (CDS) portfolio. In response, the Federal Reserve provided AIG with an emergency loan of $85 billion; government aid has since grown to $182.5 billion. With the aid received from the Federal Reserve, AIG made two significant sets of payments. AIG paid its counterparties and bonuses to its executives and employees.

According to the Federal Reserve, the “special” nature and role of AIG and its counterparties in the financial system justified urgent intervention and full payment to counterparties. The funding included collateral of $22.4 billion paid to private counterparties to CDS agreements (a $2.5 billion payment to Goldman Sachs and over $6.0 billion to foreign banks, Société Generale and Deutsche Bank). In all, AIG paid over $52.0 billion to terminate outstanding CDS agreements and related arrangements.

Putting aside for another day the veracity of the allegations of conspiracy, the payments to counterparties and bonuses last March illuminate two significant issues that reform of the credit derivatives industry must address – the intricate web of financial institutions engaged in the credit derivatives market and the factors allowed to influence the enterprise and systemic risks undertaken by these types of institutions. I’ll plan to take up the latter issue in a future posting.

The systemic risk concerns that prompted the Federal Reserve’s bailout of AIG beg the question of whether financial institutions are the types of entities that ought to be allowed to engage in the origination and trading of credit derivative instruments. The Federal Reserve has argued that its decision to lend AIG discounted funds prevented its counterparties from suffering losses and a broader systemic disruption of the financial system. Few disagree that emergent intervention was necessary to prevent a domino-effect across the market if AIG failed to make payments on credit default swap agreements and secured lending arrangements. Looking back, even if we were required to act once the arrangements were in place, we must ask about the values assigned to those agreements in light of AIG’s pending collapse and perhaps more importantly, why institutions of such unique significance were permitted to engage in such risky activities.

How did banks and insurance companies become involved in trading credit derivatives like credit default swap agreements? Many point to the Gramm-Leach-Bliley Act’s deregulatory era repeal of the Glass-Steagall Act, eliminating the forced separation of banking and insurance and securities underwriting activities, as the first step in the wrong direction. Others nod toward decisions by the Office of the Comptroller of the Currency (OCC) adopting increasingly permissive standards for determining the appropriateness of banks and bank holding companies’ participation in the derivatives market. Despite the uncertain nature of the risks related to derivatives trading and the systemic risks of the opaque derivatives market, the OCC concluded that the risks related to activities undertaken in the derivatives markets were similar to the credit risks posed by banks’ traditional lending activities.  As Professor Saule Omarova notes, the OCC’s conclusions reflect either a lack of understanding of the risks and complexities associated with derivatives trading or a willfulness to ignore such concerns.

Lots of questions remain unanswered. We eagerly await testimony in today’s hearings to see if there will be bursts of sunlight on this cold winter day.

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