Public Policy Analysis & Opinion

Back from the abyss

How are we doing unwinding AIG’s not-so-excellent adventure?

By Kevin P. Hennosy

Neil Barofsky, Special Inspector General for the Troubled Asset Relief Program (SIGTARP), has again leveled heavy criticism upon Federal Reserve officials for their mishandling of the American International Group (AIG) collapse. This criticism extended to Obama administration Secretary of the Treasury Timothy Geithner, who was president of the New York Federal Reserve Bank (NY Fed) at the time of the AIG collapse.

On November 17, 2009, Barofsky issued an audit report that criticized how officials failed to negotiate the best deal for the public when committing public funds to the failed insurance holding company. In addition, Barofsky blasted the role of private rating agencies in the failure of AIG and by extension the Financial Collapse of 2008.

It is becoming clearer with every audit released by the SIGTARP that AIG’s operations were a prime cause behind the financial collapse. In addition, the government response to the collapse in the fall of 2008 was at best haphazard and possibly dishonest.

The report serves as a reminder to those who follow the insurance regulatory system that efficient and effective markets are not contingent upon state or federal regulatory frameworks, but upon regulators with the vertebral qualities to do the job.

Backdoor bailout

The SIGTARP report criticizes the deal cut with counterparties to AIG Credit Default Swap (CDS) products. The special inspector general expressed displeasure with how the NY Fed entered negotiations with a less-than-robust attitude.

Members of Congress asked the SIGTARP to investigate why the NY Fed underestimated the depth of AIG’s trouble and why the NY Fed did not drive a harder bargain when dealing with the counterparties.

With all the ferocity of your average house cat, the NY Fed agreed to use public funds to make all counterparties—the banking and financial institution that purchased CDS instruments from AIG—whole, rather than negotiating a settlement in the interest of taxpayers. In effect the NY Fed provided what the report terms a “backdoor bailout” for the counterparties.

The report focuses on the creation of a Special Purpose Vehicle (SPV) called Maiden Lane III, which the NY Fed created as a receptacle to hold the CDS instruments that the bank agreed to purchase from AIG when private sector financiers refused to extend liquidity to the insurance giant.

Auditors criticized the Fed officials’ inability to negotiate vigorously with individual counterparties. In addition, the auditors warned policymakers that a relatively small number of virtually unregulated credit rating organizations made this entire process more difficult and expensive.

Operating in a jurisdiction that can best be described as a dark regulatory orifice, AIG Financial Products sold what for all intents and purposes was an insurance policy on loans to sophisticated buyers. Furthermore, the company management engaged in regulatory arbitrage by shaping its operations in a way that made even casual regulatory review unlikely.

The AIG enterprise was an insurance company. And the CDS products transferred the risk of financial loss from non-performing loans through an instrument that can best be understood as an insurance policy. Nevertheless, the CDS products were not legally deemed to be insurance, so AIG was not bound by regulatory guidelines for underwriting, pricing, or reserving.

In 2007, when the housing bubble burst and defaults resulted in a rapidly increasing rate of “claims” against the CDS, AIG’s financial condition was undermined by the need to post more and more collateral in support of its CDS portfolio. Behaving like the Scarecrow in “The Wizard of Oz,” insurance and other financial regulators hung by and observed AIG in the hope that their presence would scare off predators.

As noted above, AIG made attempts to refinance and restructure its CDS portfolio through private funding arrangements in September 2008. These efforts proved fruitless and came to an end when private rating agencies downgraded the insurer’s creditworthiness on September 16.

Because a failure of AIG would have led to the collapse of numerous banks, insurance companies, investment houses and pension funds, as well as state and local governments, the NY Fed took emergency steps to extend liquidity to the company.

While the Fed officials acted with dispatch, as early as a few weeks after what amounted to a public takeover of the “world’s largest insurer,” controver­sial news came from the company. The NY Fed had underestimated the long-term liquidity needs of AIG. It is not clear at this time whether Fed officials were misled by the insurer, were overly optimistic, or in denial. Insurance regulators continue to deny culpability for their absence without leave.

As a result, the NY Fed had to increase its initial estimate of the cost of the AIG bailout several times, which reduced public confidence in the Federal officials’ ability to manage a rescue of the financial system. To make matters worse, the company did not cancel several incentive trips to resort locations, which received critical coverage in the general press. In addition, reporters learned that Fed officials did not, or could not, cancel bonus agreements, which, likewise, resulted in stories that did not play well with the general public.

Geithner response

A day after the SIGTARP published the report, now-Treasury Secretary Geithner, who as president of the NY Fed oversaw the AIG takeover, was grilled before a previously scheduled congressional hearing on financial re-regulation.

Geithner explained that the NY Fed was acting in the face of a crisis, and that some of the counterparties would not settle for anything less than having the CDS commitments completely honored. Absent statutory authority to unwind the agreements on a case-by-case basis, he had to pay the highest price demanded by the counterparties in order to forestall a complete collapse of AIG, which could have caused the failure of the counterparties and the insurance companies.

It is not clear whether Mr. Geithner is being completely truthful in this version of events. The Federal Reserve has a corporate culture that encourages employees and officers to think of themselves as bankers, not government officials. One of the few times Federal Reserve personnel present themselves as government officials is checking into hotels when there is a government rate available.

Some populist political commenta­tors from the left and the right have argued that AIG and the bankers should have been allowed to fail. While this kind of tough talk makes for entertaining political theatre, it is the kind of economic thinking that gave us The Great Depression.

In addition to the CDS situation, NY Fed officials worried about another particularly nasty bit of business lurking on AIG’s books. Through Synthetic Guaranteed Investment Contracts AIG insured “stable value funds,” which guarantee a minimum rate of return for retirement and pension funds. AIG wrote insurance on such funds for more than 200 companies; including, AT&T, Wal-Mart, Du Pont, Bank of America as well as the Vanguard and Fidelity mutual funds. If AIG had been allowed to fail, fund managers would have been forced to sell off assets at distressed prices, which would have accelerated the falling confidence in the world financial system.

Furthermore, AIG’s failure would have resulted in a catastrophic impact on the availability of commercial paper (short-term corporate loans), which were already difficult to secure after the failure of Lehman Brothers and several large banks. Tighter credit markets would have made economic recovery even more difficult while undermining the credibility of money market funds.

One economic threat that NY Fed and U.S. Treasury officials appear to have overlooked concerns the state-based insurance guaranty fund system. Had the AIG insurance holding company system failed, there is little reason outside marketing memos to believe that the insurance subsidiaries would have survived. The failure of those insurance companies would have overwhelmed the state guaranty fund system, which covers the claims of insolvent companies for a specific time period after a failure.

The state guaranty associations receive funding from assessments made against licensed insurers in a given jurisdiction, but the cost of insolvencies does not stay with insurers. Guaranty fund assessments are deductible from state premium tax liability. Property/casualty companies can deduct about 40% of assessments from their tax liability. In many states, guaranty fund assessments are 100% deductible for life and health insurers. Insurers finance guaranty fund coverage, but states ultimately pay for the cost of insurance failures. An AIG failure would have damaged state budgets for many years to come.

Causes ignored

The SIGTARP office is a federal entity charged with providing oversight to a federal program, so the report focuses on the failure of federal entities; however, AIG was a state-regulated insurance company and investigators should not ignore how the company management was allowed to destroy the company.

The SIGTARP audit report is a powerful document. On the other hand, it could have been even more powerful if auditors had investigated how the AIG failure came about rather than presenting a narrative that begins on September 15, 2008. To understand the rightness or wrongness of Fed officials’ actions in the face of AIG’s failure, one must understand how AIG failed.

After following insurance regulation for more than 20 years, I have formed the opinion that AIG was an ethically bankrupt institution long before it fell into financial bankruptcy. A culture of corruption hung to the company fostered by the company’s disgraced former CEO, Maurice Raymond “Hank” Greenberg. The company bullied its way through the public policy process with an arrogance that is difficult to describe.

For 38 years, Greenberg ran the company as his own fiefdom and concentrated economic and political power. Under Greenberg, AIG built a reputation for writing its own rules and bending those rules any way that served Greenberg’s purposes. The sheer size of AIG made it impossible for regulators, and particularly individual state insurance regulators, to apply oversight to Greenberg’s whims. AIG was too big to regulate, which allowed it to grow too big to fail.

Two federal laws made Greenberg and AIG even more domineering as compared to state insurance regulators.

First, the Gramm-Leach-Bliley Act (GLBA) of 1999 repealed the Glass-Steagall Act of 1933. GLBA allowed the consolidation of banking, securities, and insurance while compartmentalizing regulatory oversight through “functional regulation.” This approach made sure that no single regulator was capable of getting a complete view of a financial conglomerate’s activities.

Second, Congress passed the Commodities Futures Modernization Act of 2000, which forbade both securities and insurance regulators from regulating traffic in debt insurance contracts known as Credit Default Swaps (CDS). President Bill Clinton signed both bills into law.

The implementation of GLBA resulted in a wave of insurance deregulation activities in the states and at the National Association of Insurance Commissioners (NAIC). The NAIC adopted a series of policy recommendations that invited trouble. The “prudent person” version of the NAIC Model Investment Law was based on the hope that people like AIG management would act in a prudent manner. When the NAIC codified insurance accounting, the framework was riddled with loopholes that allowed companies to overstate their actual financial condition. The NAIC amended its system of risk-based capital require­ments to make it less restrictive. The NAIC took action to cede its anemic ability to review the value of insurers’ investments by agreeing to accept whatever value private rating agencies assigned to investment holdings. And the NAIC adopted weak rules govern­ing Synthetic Guaranteed Investment Contracts by succumbing to the argument that sophisticated buyers and sellers should not be bothered with government regulation.

In the early years of the 21st century, the NAIC membership simply ceded its responsibility to protect the public interest in an attempt to curry favor with people like Hank Greenberg. The fear was palpable at NAIC meetings. Insurance commissioners were willing to give away the store in order to retain jurisdiction over an industry sector that produces billions of dollars in premium taxes for state treasuries and millions of dollars in campaign contributions.

In October 2004, Greenberg’s imperial rule was shaken by then-New York Attorney General Eliot Spitzer who alleged fraudulent and anticompetitive behavior involving sham reinsurance at AIG. The investigation linked anticompeti­tive behavior at AIG and the insurance brokerage firm Marsh and McLennan, which at the time was run by one of Greenberg’s sons.

Looking back, it appears that Spitzer’s competing interests in the New York governorship and prostitutes took his attention away from prosecuting AIG to the fullest extent of the law. In addition, the Bush administration’s Securities and Exchange Commission went easy on Greenberg and allowed him to settle charges against him for an insignificant sum.

Even after the elder Greenberg was forced out as CEO of AIG, he controlled investment entities that hold significant amounts of AIG stock, which appears to have allowed Greenberg to continue to exert his will upon company operations long after he agreed to leave the company in March 2005. He was highly critical of the government takeover of the scuttled hulk of AIG in the fall of 2008.

In early 2009 when Congress held hearings on the AIG failure, state regulators again sought refuge behind the functional regulation ruse. Pennsylvania Insurance Commissioner Joel Areo testified on behalf of the NAIC that AIG was not an insurance company because the AIG Financial Products subsidiary that marketed the CDS instruments was functionally regulated by the Office for Thrift Supervision. The NAIC testimony ignores the states’ responsibility for the insurance holding company, and the financial stability of the insurance subsidiaries.

State and federal officials ignore this reality at our peril.