The Question Geithner Can’t Escape: Why Pay Off AIG’s Partners?

Image has not been found. URL: /wp-content/uploads/2010/01/geithner-hands-480x378.jpgTreasury Secretary Timothy Geithner (WDCpix)

The latest political clamor over AIG, poised to combust next Wednesday at a House hearing on backdoor payments to banks that made risky deals with the company, centers on the Federal Reserve’s effort to conceal details of those payments. But senior officials, including Treasury Secretary Timothy Geithner, have so far evaded a key question: Why were AIG’s trading partners fully paid with taxpayer money instead of being told to take a loss?

“They chose to pay some people off entirely,” Bill Black, an economics and law professor at the University of Missouri and a leading critic of the government’s bailout managers, said in an interview. “They have never given a coherent explanation of why those particular folks. Under their own logic, there was no reason to pay off these parties at 100 cents on the dollar.”

[Economy1] Geithner, who led the New York Fed when it orchestrated the $62.1 billion payout to 16 banks that held AIG’s credit default swaps, has been asked to explain that controversial decision numerous times over the past year. And his answers have varied, depending on the questioner, causing Black and other critics to wonder whether the nation’s financial regulators can be counted on to spot the next economic crisis.

In November, bailout inspector general Neil Barofsky quoted Geithner as stating that AIG’s bank counterparties — including Goldman Sachs, Merrill Lynch and 10 foreign firms — were not at direct risk if the troubled company defaulted on its debts. “The direct effects of that failure would not have been particularly significant,” Geithner reaffirmed last month during testimony on Capitol Hill.

In May, however, Geithner suggested that AIG could not have negotiated lower payments to its trading partners without endangering the health of the whole financial system.

“We have no option now to selectively diminish the value of those claims without taking risks that you would have a default,” he told Sen. Chris Dodd (D-Conn.). Rep. Jo Ann Emerson (R-Mo.) was told that “you can’t selectively allow the institutions to default on particular types of creditors without risk that the whole thing comes unwound.”

So which explanation is true: Were AIG’s creditors hedged against the risk of a default — as Goldman has argued — or not? And if the banks had already mitigated the risk of losing their deals with AIG, why didn’t that allow Geithner’s Fed to negotiate a cut in repayments?

“There’s no way to prove it and no way to know,” former New York governor Eliot Spitzer, who took on Wall Street as the state’s attorney general, told The Washington Independent. “It’s part and parcel of the willingness of the Fed and Treasury to obscure from public view transactions involving tens of billions of dollars.”

Spitzer, who co-wrote a New York Times op-ed with Black calling for the public release of all AIG emails, said the Fed’s inability to intelligibly explain its actions cast doubt on the central bank’s fitness to lead the monitoring of systemic risk — as envisioned in the House-passed financial reform bill.

“Maybe [that power] should go to the Treasury, maybe it should go to the New York State attorney general,” Spitzer quipped. “But certainly, the Fed hasn’t done very well.”

Under the House’s financial reform legislation, the Fed chief would take a senior role on an “oversight council” of regulators, including the Treasury Secretary, that would be asked to neatly dissolve failing companies. The bill also allows the Fed to declare a financial “emergency” that would allow it to extend up to $4 trillion in discounted loans to banks.

Jane D’Arista, who spent 20 years as a congressional economist and now leads the Political Economy Research Institute’s financial reform project, said the AIG saga shows Fed officials “didn’t have a real handle” on the collapsed insurance firm’s web of complex deals.

“I don’t feel the team in place in this administration … understands institutions that well, and that was shown in Geithner’s response to the crisis,” D’Arista said. “He thinks he did a good job.”

Geithner told CNBC last week that he believes that paying off AIG’s counterparties in full was “absolutely” the right thing to do, adding: “Personally, I feel like I have a good sense of what the principal failures were” that caused the nation’s lingering financial crisis.

Barry Ritholtz, chief of the financial research firm Fusion IQ and creator of the The Big Picture blog, connected the Fed’s failures to spot burgeoning bubbles and abuse of lending rules to its lack of staff with Wall Street experience.

“The Fed is filled with economists and academics, none of whom have been on a trading desk or managed assets for a living,” Ritholtz said. “They have nothing to do with what’s actually going on on Planet Earth.”

Federal Reserve Chairman Ben Bernanke and Geithner were neither traders nor financial regulators before they joined the central bank. Bernanke’s background lies in academia, while Geithner focused on international monetary policy for 15 years before ascending to the New York Fed.

“These guys were fighting a forest fire, and they did the equivalent of clear-cutting a region,” Rob Johnson, a Roosevelt Institute senior fellow and former chief economist at the Senate Banking Committee, said in an interview.

“The frontier they chose was to use AIG as a conduit … the result of using that logic is, they fortified stockholders and bondholders and management, and did so at the expense of taxpayers.”

Among the most fortified bondholders was Goldman, which played a role in an estimated $33 billion of AIG’s riskiest deals. The company has argued that AIG was a “sophisticated investor” which should not be given free rein to renege on its contracts with big banks, even in the case of an effective takeover by the government.

But Janet Tavakoli, founder of Tavakoli Structured Finance and an expert on the credit derivatives that swamped AIG, countered that the game changed when public money was used for a “backdoor bailout” of firms that took hazardous gambles.

“We, the taxpayers, are not sophisticated … I’m saying, now we should revisit it,” Tavakoli said, by clawing back some of the payments the Fed made to big banks. “Without trying to get inside peoples’ heads and trying to read particular motivations, I’d say it’s about the money. Goldman Sachs is saying they’re entitled to it all and get to keep it all.”

Two Republican members of the bailout’s congressional oversight panel made a similar suggestion last week as part of a broader report on government rescue efforts.

To tamp down furor over its role in the counterparty payments, the Federal Reserve on Tuesday endorsed a Government Accountability Office audit of the AIG rescue. A spokesman for the central bank’s New York branch referred The Washington Independent to a lengthy statement released that day, disputing that it sought to withhold public information about the choice to bail out the 16 banks in question.

For its part, the Treasury Department has said that Geithner recused himself from discussions about repaying AIG’s counterparties on November 24, 2008, when his nomination to lead the agency became public, and “began to insulate himself weeks earlier.”

Yet Geithner took at least nine meetings related to the AIG rescue in the month before his nomination, according to his official daily calendar, which was released by the New York Times last spring.

One of those meetings occurred on November 21, 2008, and another on October 30, the day before AIG’s senior vice president of financial services emailed a colleague that a New York Fed official “asked me to stand down on all discussions with counterparties on tearing up/unwinding” the trades that have sparked the current controversy.