Watchdog: Fed Used Flawed Strategy in AIG Bailout

WASHINGTON, Nov. 16, 2009— -- The Federal Reserve last year "severely limited" the chance to save taxpayer money by using a flawed negotiating strategy in discussions with AIG's business partners, a government watchdog said in a report released today.

Ultimately, 16 of AIG's counterparties -- financial institutions in the United States and abroad that had deals with the insurance giant -- received $62.1 billion in taxpayer money after the Fed paid them full value for their credit-default swaps.

In his new audit, Neil Barofsky, the special inspector general for the $700 billion financial bailout, said the Federal Reserve Bank of New York "made several policy decisions that severely limited its ability to obtain concessions from the counterparties."

The Fed's initial rush last fall to save AIG -- and thereby avoid a widespread market meltdown -- "was done with almost no independent consideration of the terms of the transaction or the impact that those terms might have on the future of AIG," Barofsky said.

Without the threat of a possible AIG bankruptcy, the Fed, led at the time by current Treasury Secretary Tim Geithner, then had less leverage in negotiations with banks and other institutions that had credit-default swaps through AIG.

But still, Barofsky found, the Fed did not use what leverage it did have. For instance, the watchdog said, the Fed did not use its "considerable leverage" as the regulator for some of these banks, nor did it treat AIG's counterparties differently, even though some banks were based in the United States and some overseas.

"These policy decisions came at a cost," Barofsky stated in the report. "They led directly to a negotiating strategy with the counterparties that even then-FRBNY President Geithner acknowledged had little likelihood of success."

At one point in the discussions last November, one of the counterparties, UBS, conditionally accepted a 2 percent cut in what it was owed -- a "haircut" -- but since negotiations with the other counterparties proved fruitless, the Fed paid all of them in full. Societe Generale received $16.5 billion in payments, Goldman Sachs $14 billion, Deutsche Bank $8.5 billion, and Merrill Lynch received $6.2 billion. Another 12 institutions received a total of $16.9 billion.

Although the Fed has denied that the AIG assistance was in essence "a backdoor bailout" of the insurance giant's counterparties, Barofsky argued that "there is no question that the effect of FRBNY's decisions -- indeed the very design of the federal assistance to AIG -- was that tens of billions of dollars of government money was funneled inexorably and directly to AIG's counterparties."

In response to Barofsky's report, the New York Fed said it acted "appropriately in attempting to obtain concessions from AIG counterparties," while Treasury's bailout chief Herb Allison noted that "the government could not unilaterally impose haircuts on creditors and it would have been inappropriate for the government to pressure counterparties to accept haircuts by threatening to retaliate in some way through its regulatory power."

In a statement Monday evening, Treasury spokesman Andrew Williams also criticized the watchdog's report, before using the AIG situation to push for financial regulatory reform measures currently making their way through Congress.

"This report overlooks the central lesson learned from the unprecedented steps taken to support AIG," Williams said. "The lesson is that the federal government needs better tools to deal with the impending failure of a large institution in extraordinary circumstances like those facing us last fall.

"It is for these reasons that the Obama administration has proposed a regulatory reform agenda that includes giving the government the emergency authority to resolve a significant, interconnected financial institution," he said. "We cannot afford to face such a crisis again without the tools needed to protect taxpayers and prevent disruption to the financial system."

In his report Barofsky also took issue with the Fed's initial reluctance to disclose the identities of the counterparties, with Fed officials claiming that it would undermine the privacy and business interests of the counterparties and the stability of AIG and the market.

But when the counterparties' identities were revealed, Barofsky recalled, "The sky did not fall."

"There is no indication that AIG's disclosure undermined the stability of AIG or the market or damaged legitimate interests of the counterparties," he said. "The lesson should be learned ... whenever government funds are deployed in a crisis to support markets or institutions ... the public is entitled to know what is being done with government funds."

Since last fall AIG has now received government approval for a record $182 billion in taxpayer aid, but policy-makers with the Fed and Treasury have said repeatedly that its collapse would have been devastating for a financial system already battered by the Lehman Brothers meltdown.