The nonpartisan Congressional Budget Office has released new projections stating the Troubled Asset Relief Program will cost the federal government $23 billion in 2012, $20 billion more than originally anticipated. The announcement comes after Treasury claimed it earned $38 billion on its TARP “investments” in 2011 and more than $100 billion in 2010. That’s quite a reversal.
The cause of TARP’s deteriorating condition, nearly four years after it was put into place, is the declines in share prices at General Motors and insurer American International Group.
For AIG, in particular, this is truly a “chickens coming home to roost” moment. The series of profoundly bad decisions that followed the company’s initial $85 billion bailout in September 2008 (it later would grow to approximately $192 billion in loans, credit lines, and guarantees) are coming back to bite the bailout’s crafters, notably then-New York Fed Chairman and current Treasury Secretary Timothy Geithner.
Worst Possible Way
One can debate the merits of saving AIG, and there are reasonable positions on either side. But what’s been crystal clear since virtually day one is that if one were committed to government intervention at AIG as a means of avoiding a broader meltdown in the financial markets, Geithner and Co. picked absolutely the worst possible way to do it.
To start, there was the decision not to “resolve” AIG, as the FDIC would do with a failing bank, but instead to extend the company an enormous line of credit, which initially was supposed to expire within two years. (It is now nearly 40 months since the bailout.) The credit came from the New York Fed, while Treasury took equity collateral in the form of warrants equal to 79.9 percent of the company’s stock. Why not 80 percent? Because that was the threshold at which government accounting rules would dictate recognizing that AIG’s obligations must be counted as obligations of the federal government.
Preserving the fiction that AIG had neither failed nor been nationalized would come back to haunt the Fed when the first of many restructurings of the bailout was arranged less than two months later. AIG’s primary problems, the reason it needed the bailout in the first place, is that it faced enormous collateral calls in two areas of the company’s business: on credit default swaps the company’s AIG Financial Products division wrote on collateralized debt obligations, and on residential mortgage-backed securities the company purchased with cash collateral it received through its life insurance subsidiaries’ securities lending business.
The collateral calls were prompted by rating agency downgrades of the AIG corporate parent. Under its contracts, AIG’s counterparties were entitled to demand collateral on these transactions in the event of a deterioration in the value of the securities (both collateralized debt obligations and residential mortgage-backed securities were then in the toilet) or in the event of a credit downgrade. Indeed, some $52 billion already had been extended to CDO counterparties under these terms over the first nine months of 2008.
But the nature of a collateral call is also temporary; if, for instance, AIG was later upgraded, or the value of the CDOs it was insuring improved, or if the instruments performed as expected, the call could be reversed and the money returned to the company. Although AIG had business assets that were worth far more than what it owed, it didn’t have enough in liquid assets to keep making its collateral calls. Hence it turned to the federal government to give it the liquidity to survive the collateral call storm.
Had AIG been nationalized, the company’s credit rating would have been replaced with the then-AAA rating of the U.S. government. There have been no further credit-related collateral calls, and much of what the company had already ponied up could conceivably have been returned.
And should there have been interest in capping the company’s potential liabilities, the federal government certainly would have been in a great bargaining position to demand counterparties take haircuts on what they would have been owed. After all, if AIG had gone into bankruptcy, those holding AIG credit default swaps CDS would not necessarily have topped the list of creditors.
Additional Backdoor Bailouts
Instead, Geithner and Co. created two facilities—the $19.5 billion Maiden Lane II and $24.3 billion Maiden Lane III—that used loans from the Fed to buy out, at 100 cents on the dollar, both the RMBSs AIG was holding in its securities lending business and the CDOs it insured with credit default swaps. This was an unfathomably stupid decision.
Imagine a homeowners insurer that decides, instead of paying out the claims on roofs damaged in a hailstorm, it would just buy up the value of all the properties in the neighborhood at full listing price. That’s essentially what the Fed did.
The whys and wherefores of that decision have never been answered to almost anyone’s satisfaction, but i