Was AIG Too Big to Fail or Not?

Includes: AFF, AIG, GS
by: Craig Pirrong

In an oped in today’s WSJ, Peter Wallison notes a fundamental inconsistency in the government’s defense of the AIG (NYSE:AIG) bailout:

Since last September, the government’s case for bailing out AIG has rested on the notion that the company was too big to fail. If AIG hadn’t been rescued, the argument goes, its credit default swap (CDS) obligations would have caused huge losses to its counterparties—and thus provoked a financial collapse.

Last week’s news that this was not in fact the motive for AIG’s rescue has implications that go well beyond the Obama administration’s efforts to regulate CDSs and other derivatives. It’s one more example that the administration may be using the financial crisis as a pretext to extend Washington’s control of the financial sector.

The truth about the credit default swaps came out last week in a report by TARP Special Inspector General Neil Barofsky. It says that Treasury Secretary Tim Geithner, then president of the New York Federal Reserve Bank, did not believe that the financial condition of AIG’s credit default swap counterparties was “a relevant factor” in the decision to bail out the company. This contradicts the conventional assumption, never denied by the Federal Reserve or the Treasury, that AIG’s failure would have had a devastating effect.

Wallison is exactly right: Geithner cannot run around Washington, using arguendo ad AIG to justify (a) the bailouts, and (b) the need for mandatory clearing, more draconian capital requirements, and restrictions on derivatives, while at the same time saying that the financial condition of counterparties was an irrelevancy in the decision to assume AIG’s obligations. These claims are impossible to reconcile logically. If one is true, the other is not. Period.

Wallison then traces out the implications of this inconsistency:

The broader question is whether the entire regulatory regime proposed by the administration, and now being pushed through Congress by Rep. Barney Frank and Sen. Chris Dodd, is based on a faulty premise. The administration has consistently used the term “large, complex and interconnected” to describe the nonbank financial institutions it wants to regulate. The prospect that the failure of one of these firms might pose a systemic risk is the foundation of the administration’s comprehensive regulatory regime for the financial industry.

Up to now, very few pundits or reporters have questioned this logic. They have apparently been satisfied with the explanation that the “interconnectedness” created by those mysterious credit default swaps was the culprit.

But the New York Fed is the regulatory body most familiar with the CDS market. If that agency did not believe AIG’s failure would have actually brought down its counterparties—and ultimately the financial system itself—it raises serious questions about the administration’s credibility, and about the need for its regulatory proposals. If “interconnections” among financial institutions are indeed the source of the financial crisis, the administration should be far more forthcoming than it has been about exactly what these interconnections are, and how exactly a broad new system of regulation and resolution would eliminate or reduce them.

Right again. If arguendo ad AIG is, as the old phrase goes, no longer operative, then what is the logical basis for this metastasizing regulatory framework?

And make no mistake about it, AIG has been the alpha and the omega of the case for mandatory clearing, exchange trading of derivatives, and more onerous capital requirements. It’s not just Geithner. If anything, CFTC head Gensler has been even been more of a repeat offender, subject to the three strikes rule multiple times, as evidenced by his recent testimony before the Senate Ag Committee. In that testimony, Gensler refers to AIG as “Exhibit A” for the case against OTC derivatives.

So . . . if even “Exhibit A” AIG’s financial condition posed no threat to its counterparties (as would be necessary to make this “not a relevant factor”), what’s the need for a draconian restructuring of the financial markets? And if the Fed and Treasury were truly concerned of the fallout from an AIG collapse, why insist to an official investigation that this was not the case? Is this an attempt to maintain the fiction that Goldman Sachs (NYSE:GS) and the other banks were totally safe and sound even during the maelstrom of the crisis, and didn’t need the money? If not, give me a better explanation.

Wallison is quite polite when he calls Geithner’s conflicting stories about AIG “a lack of candor about credit default swaps.” The Treasury Secretary has lied about AIG with probability one. The only question is which of his statements is a lie. I would wager that the “not a factor” statement is the dishonest one.

Hopefully Wallison is right in the second half of this judgment:

The administration seems to be using the specter of another financial crisis to bring more and more of the economy under Washington’s control.

With the help of large Democratic majorities in Congress, this train has had considerable momentum. But perhaps—with the disclosure about credit default swaps and the AIG crisis—the wheels are finally coming off.

Wallison’s call for a thoroughgoing explanation of “how exactly a broad new system of regulation and resolution would eliminate or reduce” interconnections is spot on. In particular, as I have been saying over and over, and over and over, and . . . just how does creating a central counterparty among major financial institutions eliminate interconnections? Indeed, by concentrating failure in a single institution connected to all other major financial institutions, and which arguably operates at an information and incentive deficit relative to the dealers in an OTC market, mandated clearing arguably increases systemic risk.

To put it bluntly. We can’t have such an epochal change in the structure and regulation of such immense financial markets based on lies plus superficial and specious analysis. But it is abundantly clear that that is the case, as Wallison’s piece succinctly demonstrates.