Can US let AIG fail?

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

Eric Thayer/Reuters
PUBLIC ANGER: Protesters assembled outside Goldman Sachs in New York Thursday.

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.

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.

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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