Warren, Head of TARP Oversight Panel, Criticizes Bailout of ‘Frankenstein’ AIG

Today, the Congressional Oversight Panel for the Treasury’s Troubled Asset Relief Program, headed by Elizabeth Warren, is holding a set of hearings on failed insurer AIG. Warren takes AIG to task for its blatant disregard for sound practices. “The company was a corporate Frankenstein, a conglomeration of banking and insurance and investment interests that defied regulatory oversight,” she says in her prepared remarks.

But she hits even harder at AIG’s regulators and the government’s extraordinary intervention. “[AIG's] complexity, its systemic significance, and the fragile state of the economy may all arguably have been reasons for unique treatment. But no matter the justification, the fact remains that AIG’s rescue broke all the rules, and each rule that was broken poses a question that must be answered,” she argues.

AIG’s regulators and regulations failed the American taxpayer, Warren says. And thankfully, the House and Senate reform bills create a much better process for monitoring systemically important firms and winding them down if they falter — a process designed precisely as a response to the wildly expensive and unruly bailouts of companies like AIG.

Now, firms like AIG need to author their own “funeral plans,” telling the government how to unwind them. Additionally, the reforms clarify the government’s process for deciding a firm needs to be shut down and then doing it, wiping out shareholders, firing management and giving counterparties haircuts. (There are differences between the House and Senate bills on the resolution authority front, differences that will be worked out in conference committee. The biggest difference is that the House bill has a $150 billion liquidation pool, funded by big financial firms. The Senate bill instructs the government to recoup its costs after the fact.)

Here is a fuller clip of the remarks from Warren, a bankruptcy professor at Harvard Law School:

When a company digs itself so deeply into debt that it cannot escape, our legal system provides a set of strict and simple rules to force the business to bear as much of the cost of its mistakes as possible and to minimize the impact on others. Of these rules, two are paramount. First, the business’s owners — its shareholders — lose everything. Second, the business’s creditors — including its bondholders and counterparties — lose money, and depending on how deep the hole, they could lose a great deal.

The rules may seem harsh, but they are fundamental to the functioning of a free market. After all, the parties that gain the most when a business succeeds should also lose the most when a business fails.

I open today’s hearing by listing the rules of bankruptcy because we are about to examine a bankruptcy that broke all the rules. In fact, the rescue of the American International Group was so extraordinary that it bypassed the entire legal process of bankruptcy. In saving AIG, the government invented a new process out of whole cloth, a parallel set of rules devised and executed for the benefit of only one company.

By the time the federal government intervened in late 2008, AIG was a poster child for the need for a well-functioning bankruptcy system. Its stock price had plummeted 79 percent in only two weeks. The sharp decline in mortgage-linked asset prices and the failure of Lehman Brothers had led to staggering collateral calls from AIG’s counterparties, and AIG simply did not have enough cash on hand to keep its doors open.

The next steps would ordinarily have been straightforward. Under the rules that applied to everyone else in America, AIG’s shareholders should have lost everything, and its creditors should have taken substantial losses. Yet even today AIG continues to trade on the New York Stock Exchange, and no creditor has lost a penny on its dealings with the company.

Put another way, under the rules that applied to everyone else in America, the costs of AIG’s mistakes should have been borne by AIG and its partners. But under this new, ad hoc set of rules, the costs of AIG’s mistakes were borne by the rest of us – the American taxpayers.