Can US let AIG fail?

The rationale for such moves from the get-go has been what economists call “systemic risk.” This is the notion that some firms are so large in themselves, and so intertwined with other important firms, that their failure would put the whole financial system at risk.

When the AIG rescue began in mid-September, the firm was facing the prospect of collapse. Credit markets were in a state of high uncertainty because Lehman Brothers had gone into bankruptcy just months after a similar investment bank, Bear Stearns, had received government help to avoid that outcome.

Many economists say that, in that environment, letting AIG fail without a federal lifeline of some sort would have been catastrophic. As it was, with the firm’s rescue and an ensuing program to begin propping up US banks, the economy has deteriorated sharply since then.

Managing systemic risk

But some experts question the way the bailout has been managed – or argue that concerns about systemic risk no longer justify a pay-all-customers approach to the risky contracts that AIG made, outside its traditional regulated insurance business.

Since September, governments have put new protections into place for bank depositors and financial counterparties. And strains in credit markets have eased.

The government could put AIG into bankruptcy without sparking a broad meltdown, argues Lucian Bebchuk, a Harvard University law professor who focuses on corporate issues. That would allow traditional insurance customers to be protected. This way, taxpayers would not be on the hook for paying off AIG’s derivatives customers at 100 percent, although the government could arrange a middle ground, shielding against some of those losses if it chose.

This is similar to the choice the Obama administration faces on bank rescues. So far, the government has avoided an outright nationalization or bankruptcy for AIG, just as it has for large troubled banks such as Citigroup.

Mr. Bebchuk argues that the government can save taxpayers a lot of money by shifting gears and no longer trying to protect shareholders and bondholders in the large banks from losses.

“As long as depositors are fully protected, a system meltdown is not to be feared,” he says in an e-mail interview.

Geithner’s approach to rescuing banks faces pressure not just because taxpayers are growing weary of bailouts. The next part of his plan, to be announced soon, involves trying to incentivize private firms to partner with the government in buying so-called toxic assets from banks.

Congress’s recent moves – from tar-and-feathers hearings to consideration of a retroactive tax to seize the AIG bonuses – have made financial firms believe that partnering with the government comes with unknown risks.

In the Geithner plan, buying toxic assets helps the banks clean up their books, while another part of the plan involves injecting new capital into banks that need it, through government investments.

Critics say that the plan to rid banks of bad loans comes with risk to taxpayers. The government would loan money to private firms to buy those assets. If they go up in value after that, the government gets paid back. If they go down in value, preliminary news reports about the plan suggest that the investors would have the option of defaulting on the loans and handing the dud assets to the government.

Taking over troubled banks is not without its own problems. It could take several years, potentially, before a large bank were ready to be reprivatized.

And under any of the scenarios, the bad loans need to be written off, probably at some cost to taxpayers.

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