Very Abbreviated Takedown on SIGTARP Report on AIG CDS Payouts

Dear sports fans, your humble blogger, along with a ton of others, got the not-very-embargoed copy of the SIGTARP report on the New York Fed’s conduct with respect to its full payout on AIG’s credit default swaps to its counterparties.

The press is treating the report as if it was tough. I was sputtering with anger when reading it on how soft it was on the Fed. The positioning and framing of the issues was almost without exception far too forgiving. It read as if the findings had been negotiated with the Fed (and SIGTARP lost the negotiations as the “shape of the table” stage), but I am assured not, not by SIGTARP, but by those, as they like to say, in a position to know. That says SIGTARP is almost as badly cognitively captured as the Fed is.

Remember, the GAO covered this ground in a report in September. The SIGTARP did come up with some details, and did weigh in on where it thought the Fed went awry, but there is less new here than today’s headlines suggest.

Look, let’s get real here. The Fed paid out 100% on these contracts. AIG was trying to negotiate them down. Who knows how far they would have gotten, AIG went into crisis mode pretty quickly. There was absolutely no reason to pay 100%. Companies that get into trouble renegotiate their obligations as a matter of course. You cannot get blood from a turnip. And the fact that the Feds stepped in to prevent the financial system from collapsing is NOT THE SAME as an open-ended commitment to honor the obligations of a dead company. To quote the Epicurean Dealmaker:

Tim Geithner and the Federal Reserve got royally played. And you and I, my friends, paid dearly for the privilege.

Sure, the Fed was worried that AIG’s uncontrolled collapse could lead to a complete and utter meltdown of the global financial system. Even now, with the worst of the crisis behind us and plenty of time to reflect, it is hard to criticize this worry as hysterical. It is also true that things were moving way too quickly to sit down and think them through logically, so we should not superimpose unreasonable expectations of measured, rational thought on the Fed’s negotiators. It is also even remotely possible that some of AIG’s counterparties were so inept and unprepared for the insurance company’s troubles that they truly might have blown up themselves if it went down. (Although AIG’s train wreck was so long coming and so well telegraphed that any bank so blind to the obvious and unprepared for the inevitable probably should have been shut down purely on principle.)

But Christ, people, think about it.

What moronic financial entity—fully hedged or not—would really risk global financial catastrophe by throwing AIG into bankruptcy, even if it had the contractual and legal right to do so? Because it insisted on receiving 100% of the proceeds due to it by contract? Even though parties to financial contracts renegotiate existing terms under normal market conditions all the time? What good, for example, would those extra five billion clams—not collected, by the way, until the bankruptcy judge wound the company down, if ever—have done Goldman Sachs if it, Morgan Stanley, and every other major investment and commercial bank were in liquidation too?

Furthermore, what foreign or domestic bank CEO in his right mind has the balls to threaten the government of the United States of America with financial meltdown if it doesn’t cough up another couple billion dollars out of the public purse? Are you fucking kidding me?

AIG’s counterparties had no leverage whatsoever. None.

Of course, Geithner and Bernanke were over a barrel, too, because they didn’t want to do anything stupid to trigger Armageddon either. Among other things, I believe it is in their brief to prevent just such annoyances. I do not claim they should have been able to get all 40% of the target discount from the banks. But nothing? Not even from the guys who claimed not to care?

Give me a break.

That Turbo Timmy and the Fed were “played” is the most charitable interpretation possible of this sorry turn of events. This was criminal. It may merely have been criminally incompetent, but this needs to be treated as a very serious lapse. Yes, I’m sure a very high percent of the CDS contracts needed to be paid out to prevent Very Bad Stuff from happening, but that should have been bifurcated, with the percentage that reflected fair payout as the CDS compensation, the balance as an equity infusion.

Who was the Fed representing? Here we get into the usual debate of was the Fed operating as a government entity (as it likes to pretend when convenient, which is most of the time) or a private bank favoring entity? It most certainly appears to have behaved like the latter. It acted only from the vantage of what was best for the financiers, and gave nary a thought as to whether that might conflict with the interests of other constituencies.

And we get the cute revelation that UBS (which by the way, had very very serious CDO losses, they were certainly not a strong institution) offered to take a haircut, but that was vetoed by the Fed as opposed to

Now I hope to return to this topic later, but let me illustrate how Fed-flattering the framing of the report was. Start with the title: “Factors Affecting Efforts to Limit Payments to AIG Counterparties and Future Exposures.”

Huh? Even before we start, we have about two levels of Newspeak. First, the framing presupposes efforts were made to limit payments. No such efforts took place. And given the utter absence of said efforts, “Factors Affecting” is therefore an apology.

Yes, the criticism is in there, with the report firmly stating that the Fed didn’t exploit “its considerable leverage” and the press dutifully rooted those remarks out, but there was tons of bubble wrap around it. For instance, the report uncritically repeats (page 14) the excuse that the Fed was worried about the impact of an AIG BK on stable value funds. AIGFP had written $38 billion of them. First, did you see any Federal official run to the rescue when the $200 billion auction rate securities market collapsed? That was a retail market, and the users mistakenly regarded it as a near money market equivalent. Loss of access to these funds was far more catastrophic to many investors than taking a haircut on an investment provided by a dud company (those stable value fund investors should have been delighted to get even 60 cents on the dollar. They were so lucky as to have Goldman as a fellow creditor. Does anyone think for one nanosecond that the Fed would have rescued AIGFP if its only creditors were stable value fund investors? Please.

The uncritical reportage of defenses by the officialdom is annoying. While these remarks may be narrowly true (as in someone in the thick of things no doubt did go over who was on the other side of AIG’s trades and what the impact of letting them flounder might be), they are not the operative truths (as in these were at most tertiary issues that did not drive the decision). And including them again deflects attention from the question of what the true motives behind the actions taken and again makes the process look more orderly and deliberate than it really was.

The most useful bit is that SIGTARP actually made a bit of a detour to shred the bogus Goldman claim that it was due a full payout because it has hedged its exposures (in other words, the rescue kept it from being paid out on CDS in the event of an AIG bankruptcy). The report dryly notes those hedges were non-performing airbags.

I would love to go further, but you get the drift of the gist. It is worrisome that an overseer feels the need to play ball nicely.

Update 5:45 PM. Some readers took objection of my failure to mention the half-hearted Fed efforts to negotiate, and I agree I should had addressed this above. But these were not even handled like a negotiation. Fed staffers called the counterparties, individually, with “proposals”. Huh? Having anything less than very top Fed officials someone contact counterparties individually by phone assured nothing would happen. In fact, this was so badly thought out and executed I question whether this was serious, or simply an exercise in CYA.

The way to do this was to haul DECISION MAKERS (CEOs, not minions who can say they are not authorized to commit, and for foreign firms, the most senior guy in the US) to the Fed in person (probably as a group)and tell what the deal is, and tell them the consequences if they mess with the Fed and try forcing their hand. What the Fed did was NOT handle this as a negotiation, it was a lame-low level plea.

Another argument is the French regulators said their banks could not “voluntarily agree” to take less than full value. Fine, this isn’t an agreement. The Fed could simply have said, “this is the deal that the others are being made to accept, take it or leave it.” Trust me, the French regulators would have figured out a way to make this work. Their banks needed the dough. There had to have been to have been cases in other pre-BK negotiations where some French institution accepted a cramdown when the majority of bondholders accepted it (in fact I suspect there are plenty of examples, just in instances less material to the institution than this, just on settling transaction errors and valuation disputes). They could find a precedent if they looked hard enough.

In the bigger picture, the Fed could have simply pretended it was willing to retrade the deal, or do preferential payouts. Remember, it famously DID with Bear, first saying it was lending Bear money for 28 days, which Bear thought was enough of a lifeline to rescue itself. The Fed could have said, “We are paying only X%, the rest is equity (or warrants or a loan). You can take it or leave it.” The onus would have been on the banks to reject this and put AIG into BK. No one would have done that.

Update 7:00 PM: I should have realized that doing this short form would lead to my issues being misconstrued. Hoisted from my remarks in comments:

This is NOT a matter of tone, it is a matter of framing of information and proportion. You can take a neutral tone and still reach very devastating conclusions.

Let me give you a very simple example of how easily perceptions are influenced. A poll that asks, “What do you think of the job Obama is doing” will receive markedly lower ratings than “What do you think of the job Obama is doing as President?” The “as President” confers greater dignity on him and reminds listeners of the difficulty of his job.

First, Barkofsky had to issue a critical report. The GAO had set the stage; there was no defending the outcome. So we are merely talking degrees within a pre-set parameter.

Second, as an example of a “free” and very important win delivered to the Fed is that the report ENDORSES the Fed retrading the original financing of AIG at 11%! The Fed stepped in and provided money on the same terms AIG had sought from private parties, and then REGURGITATES WITHOUT ANY CRITICAL EXAMINATION the Fed’s logic for its conduct. And this is framed in a faux-critical wrapper, “oh, see, another example of the Fed moving too fast, acting before it thought.” Huh? The 11.5% rate WAS an appropriate risk (in fact, too low given the failure of any private sector buyer to step forward). The report is not written clearly enough to be certain, but it looks as if the professed concern was that the interest payouts would lead to further downgrades. If the issue was the cash drain, you could simply have modified the terms so interest was payable from the proceeds of asset sales rather than on a current basis. There was no justification for lowering the rate. Or if that might not suffice, in an extreme version why didn’t the Fed intervene with the rating agencies (you do this counsel to counsel first to make this privileged communication)? AIG is backstopped by the bloody central bank with unlimited check writing authority; why are they subject to downgrades?