Was the AIG Bailout a Conspiracy?

Eliot Spitzer wants to know if the bailout of AIG was an inside deal among Goldman Sachs, the Treasury, and the Fed. Edward Jay Epstein, who has been unraveling conspiracy theories since the Warren Commission, examines the evidence.

04.02.09 6:01 AM ET

The colossal bailout of AIG is now so mired in the muck of conspiracy theories that even Eliot Spitzer, who had to resign as governor of New York after laundering secret payments to a call-girl service through an offshore account, is back on his moral high horse denouncing the rescue of the firm as “nothing more than a conduit for huge capital flows to the same old suspects, with no reason or explanation.” Suggesting it was an “inside deal” with Goldman Sachs, he demands to know, “the precise conversation” that took place among Federal Reserve Chairman Ben Bernanke, New York Fed President Timothy Geithner, Treasury Secretary Henry Paulson, and Goldman Sachs’ CEO Lloyd Blankfein that preceded the initial loan to AIG in mid-September 2008. Failure to answer, Spitzer warns, “will feed the populist rage that is metastasizing.”

The question Spitzer does not ask is: What would have happened if the Fed and Treasury had not acted decisively to bail out AIG after it informed them it was unable to meet its obligations?

The question Spitzer does not ask, and which goes to the heart of the issue is: What would have happened if the Fed and Treasury had not acted decisively to bail out AIG after it informed them it was unable to meet its obligations?

AIG at that time was the world’s largest insurance company. It had more than $1 trillion in assets. With operations in 130 countries, it insured most international commercial transactions (including much of China’s exports to the United States). Its triple-A credit rating backstopped its portfolio of $2.7 trillion in derivatives contracts that, for better or worse, had spread throughout the globalized financial system. Here is what would have happened if AIG moved into bankruptcy proceedings:

For starters, it would have left the major banks of Europe short of their government-mandated capital requirements. AIG, through a French subsidiary called Banque AIG, had been providing these banks with what it innocuously called “regulatory capital.” These arcane derivatives contracts allowed banks to report to authorities high capital-to-debt ratios, so an AIG default that invalidated them would force the banks to call in hundreds of billions of dollars in loans. In addition to these dominos, AIG had sold hundreds of billions of dollars of credit-default swaps, assuming in the process the default risk on everything from securitized credit, such as subprime mortgages and credit-card debt, to the sovereign debt of countries from Eastern Europe to Latin America. Without the guarantees, these securities would lose their ratings and banks, pension funds, trusts, and sovereign investment funds would be forced to unload their holdings at any price, causing untold havoc.

The municipal-bond market would have also been thrown into turmoil. Not only was AIG the second-largest holder of municipal bonds, but also much of the money from the sales of municipal bonds—some $12.1 billion—had been temporarily invested in AIG vehicles called Guaranteed Investment Agreements, through which states and municipalities earned extra interest until they needed the money for construction and other purposes. If this money was unavailable, a large number of municipal bonds would be downgraded or, if they could not make up the shortfall, default.

Far more disastrous would have been the impact of a default on AIG’s insurers and the enterprises it had insured, which would have faced seizure by regulatory authorities around the world.The immediate problem was that AIG had loaned out much of the stock in its insurance companies’ portfolio to banks as part of an interest-rate play through its “securities-lending program.” As collateral for the stock, the banks had deposited on a short-term basis $43.7 billion in AIG accounts on which they earned the money-market rate of interest. AIG, to make a higher rate of interest, put the money in residential mortgages. But after the collapse of Lehman Brothers in September 2008, the banks demanded their $43.7 billion back, as they were entitled to do as the contracts expired weekly, but, with residential mortgages now almost unsalable, AIG could not repay them or retrieve the shares backing its insurance policies.

So what Bernanke, Geithner, and Paulson were looking at on September 15 was financial armageddon with AIG as the Death Star. We do not need a transcript of their “precise conversations,” or even to know who else they consulted in or out of government that day, to figure out why they decided to intervene. It was what Geithner meekly called “systemic risk.” In other words, preventing the AIG Death Star from destroying world financial markets.

Their actions were no secret. They provided AIG with an initial $85 billion emergency loan that allowed it to meet its pending obligations. This loan was not a grant. It was collateralized by first call on AIG’s $1 trillion in assets, and carried a high interest rate—3 percent above the London interbank rate. For making this loan, the U.S. government got 77 percent-ownership in AIG. Nor is there much mystery to what happened to the money. It is detailed on AIG’s Web site.

The largest part went to repaying 18 banks the $43.7 billion owed to them in AIG’s security-lending program, which allowed AIG to get its insurance companies out of harm’s way by recovering their shares. And $19.2 billion of this money came from AIG selling its distressed mortgages to the New York Fed’s entity, Maiden Lane II. An additional $12.1 billion went to pay off its obligations to states from its Guaranteed Investment Agreements. Finally, $22.5 billion was initially used to post the collateral at 24 banks holding its credit-default swaps and then, in November, used as part of the purchase price of the toxic securities insured by these swaps by another New York Fed entity, Maiden Lane III. By buying these securities at a heavily discounted price, the Fed relieved AIG of posting any further collateral. As a result, international and American banks wound up with money due them from AIG, the government, via Maiden Lane II and III, took part of the toxic assets off their books, and the world’s largest insurance company was saved from bankruptcy.

While no conspiracy theory is needed to explain why Bernanke, Geithner, and Paulson pushed the $85 billion panic button in mid-September, one may be necessary to unravel how a world-class insurance company turned into a near Death Star. Certainly, AIG needed enablers to so permeate the globalized financial system.

Edward Jay Epstein studied government at Cornell and Harvard, and received a PhD from Harvard in 1973. The Big Picture: The New Logic of Money and Power in Hollywood is his 13th book. The sequel, The Hollywood Economist will be published in January 2010.