Fed criticized for not negotiating harder with AIG creditors

By Brady Dennis
Washington Post Staff Writer
Tuesday, November 17, 2009

Federal Reserve officials made only a passing attempt to negotiate discounts from the creditors of American International Group last fall before directing the company to fully pay what it owed on its troubled derivatives contracts, according to a report from the special inspector general overseeing the government's financial rescue program.

Treasury Secretary Timothy F. Geithner, who was then the president of the New York Fed, concurred with advisers that it would be impractical to impose losses on AIG's counterparties and that they essentially should be paid at 100 cents on the dollar, the report by special inspector general Neil Barofsky states.

Barofsky said he undertook the report after 27 members of Congress asked him to review the basis for the payments and whether they were made in the best interest of taxpayers. The issue has caused consternation among lawmakers, who have repeatedly questioned why such vast amounts of money flowed with little transparency and without condition to AIG's creditors, which included some of the world's largest financial firms.

Barofsky said the Fed's decisions in bailing out AIG "came with a cost -- they led directly to a negotiating strategy with the counterparties that even then-New York Fed President Geithner acknowledged had little likelihood of success."

The government extended an $85 billion loan to AIG in September 2008 as the company struggled to pay obligations related to derivatives contracts at its Financial Products unit. According to Barofsky, that initial loan came with a high interest rate, which "inadequately addressed AIG's long term liquidity concerns, thus requiring further government support."

Later, New York Fed officials agreed to buy tens of billions of dollars worth of complex securities that would allow Financial Products to cancel its most troublesome contracts, and staff members developed talking points that stressed to AIG's trading partners that they were benefiting from the bailouts and asked them to agree to concessions, according to Barofsky.

On Nov. 6 and 7, 2008, a host of top New York Fed officials called eight of Financial Products' largest trading partners, including Goldman Sachs, Merrill Lynch, Deutsche Bank, UBS, Barclays and Bank of America, to ask if they would be willing to accept less than they were owed. Only UBS agreed to accept a 2 percent "haircut," and only if the others accepted similar concessions, Barofsky said. The other firms balked.

In addition, the officials were told by a French regulator that Société Générale and Calyon, two firms that AIG owed large sums, could not voluntarily agree to accept less than full payment absent an AIG bankruptcy.

The report states that Geithner thought it wise to try to win concessions "but had little hope that the efforts would be successful." In large part, that was because the federal bailout itself had removed the threat of bankruptcy and weakened any leverage the company might have had.

"In its negotiations with its counterparties, AIG just didn't have the same bargaining power that it did with the Federal Reserve standing in the background, Thomas C. Baxter, the New York Fed's general counsel, said in a recent interview with The Washington Post. "The only sensible outcome was to give them what they were legally entitled to."

Ultimately, AIG's trading partners received more than $62 billion, which many critics have branded as "backdoor bailouts."

In a letter commenting on Barofsky's report, Fed officials called the original AIG loan "appropriate in light of the circumstances at the time." In addition, they argued that the Fed had done what it could in trying to negotiate with AIG's trading partners.

"We believe that the Federal Reserve acted appropriately in conducting these negotiations, and that our negotiating strategy, including the decision to treat all counterparties equally, was not flawed or unreasonably limited," the letter said. It said the Fed actively sought concessions from AIG's counterparties, "but was unable to obtain any such agreements." The officials added that they were wary of using their supervisory authority on behalf of AIG to impose losses on other companies.

Herbert M. Allison, Jr., assistant Treasury secretary for financial stability, also wrote a response highlighting the dilemma that officials faced.

"What must be remembered is that the decision by the government not to let AIG go bankrupt meant that AIG had to meet its contractual obligations," Allison wrote. "The government could not unilaterally impose haircuts on creditors, and it would not have been appropriate for the government to pressure counterparties to accept haircuts by threatening to retaliate in some way through its regulator power."

He said the central lesson from the AIG episode is that the federal government needs power to wind down such complex, failing institutions in an orderly way in the future. The House and Senate are considering legislation to accomplish that goal.

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