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Can US let AIG fail?

Public outrage could force the Treasury Department to reconsider which financial giants pose a ‘systemic risk’ to the economy.

By Staff writer / March 22, 2009

PUBLIC ANGER: Protesters assembled outside Goldman Sachs in New York Thursday.

Eric Thayer/Reuters

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Outrage about employee bonuses at AIG has put new focus on a larger question: whether saving the economy also means saving all the largest financial firms.

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Economically, the financial crisis may have moved into a phase where the risk of a total meltdown, should a major financial corporation go through something like a government-managed bankruptcy, is not as great as it was last fall.

Yet it remains a sensitive moment. Treasury Secretary Timothy Geithner is expected to announce this week a strategy to deploy more dollars to purchase bad loans from banks. It’s part of a plan to keep troubled firms afloat without taking them under federal control. But anger at AIG has begun to ripple outward into a wider reluctance to rescue tottering financial giants.

“The political reality has changed,” says Simon Johnson, a former chief economist at the International Monetary Fund who is now at the Massachusetts Institute of Technology.

The new bailout climate is troubling, Mr. Johnson says. It could make it difficult for the Obama team to sell its plan. Moreover, it could also thwart a key fallback option: putting troubled firms into government receivership and spending money to clean them up so that they can be privatized again.

Without significant new public spending on banks, he says, the recession could go on longer and a recovery will be slower.

Governing out of anger?

President Obama is scrambling to keep his options open. He’s been aligning himself with public opinion – declaring his own outrage at the AIG bonuses – while also trying to redirect it. He warns that it would not be responsible to “govern out of anger.”

Last week, anger was rising, not waning. In an AIG-related hearing on Capitol Hill, lawmakers voiced the frustration of their constituents, and not just about some $165 million or more in employee bonuses. It was also about the full cost of rescuing AIG, with more than $170 billion in public funds now on the line there.

“There remains a possibility that AIG will come back for additional [federal] funds associated with the $1.6 trillion in your derivatives portfolio,” Rep. William Lacy Clay (D) of Missouri told AIG chief Edward Liddy. “Can you convincingly illustrate to us why this is not an exercise in staving off the obvious collapse or prolonging the agony?”

Another Democrat, Joe Donnelly (D) of Indiana, said it was “incredibly distasteful” that the bailout so far used public funds so that AIG can pay off customers on products that Donnelly likened to casino bets.

The products, credit-default swaps, are so-called derivative products that are part investment, part insurance contract. Buyers can use the products to protect against the default of a bond they own, or as a bet on the possible default of bonds they don’t own.

Republican lawmakers, meanwhile, are calling for an exit strategy from corporate bailouts.

So far, large chunks of the AIG money – about $20 billion – have passed through AIG to pay off on those derivatives to financial firms including Goldman Sachs, and a host of European banks.

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