Had the U.S. government not taken action to bail out American International Group, it would have proven to be an economic catastrophe for the nation, Treasury Secretary Timothy Geithner and his predecessor, Henry Paulson, both insisted before a skeptical congressional committee last week.
Their comments came at a hearing before the House Oversight and Government Reform Committee, which has questioned all elements of Federal Reserve and U.S. Treasury actions to supply billions of dollars to bail out the insurance conglomerate and pay its bank trading partners in full for claims against depreciated assets.
Mr. Geithner was scrutinized about his role as Federal Reserve Bank of New York president before he became Treasury secretary, and the New York Fed's steps to squash disclosure of how much the banks were getting on credit default swaps purchased from AIG's Financial Products unit covering collateralized debt obligations consisting of subprime mortgages.
Two lawmakers on the committee who challenged his denials about knowledge of any such effort to withhold information asked for his resignation.
Mr. Geithner said the Federal Reserve Board acted to bail out AIG because the Fed was "the only fire station in town."
Republicans on the panel have said in a report they released that the Fed's New York branch, which Mr. Geithner headed in 2008, pushed through the bailout by the Federal Reserve, providing a bonanza to banks that were AIG's trading partners.
They attacked the decision to pay off AIG's bank counterparties to complex and highly speculative collateralized debt obligations in full, instead of pressing them to take "a haircut" and accept only a percentage of what was owed.
At the conclusion of the testimony from Mr. Geithner--who denied he was part of the New York Fed's demands that AIG withhold information about the 100 percent payout to bank counterparties--Rep. Darrell Issa, R-Calif., the committee's ranking Republican member, said he had "no confidence" in the secretary and called for his resignation. He said to Mr. Geithner, "you are either incompetent," or tried to cover up the details of what was going on through payoffs of the credit default swaps.
Rep. John Mica, R-Fla., said Mr. Geithner had given "lame excuses" and asked, "Why shouldn't we ask for your resignation?" Mr. Geithner said that was Rep. Mica's right, but added that he still takes pride in decisions made by federal banking officials on AIG.
Committee Chair Edolphus Towns, D-N.Y., complained in his opening remarks that "in the case of AIG, nobody got a haircut. Instead, everybody got a piggy bank full of taxpayers' money." However, after questioning Mr. Geithner, he added: "I don't know what else you could have done."
Mr. Geithner testified it was "important to remember that the Federal Reserve, under the law, had no role in supervising or regulating AIG [or] investment banks," but that Congress had given the Federal Reserve authority to provide liquidity to the financial system in times of severe stress.
"Given that responsibility, the Federal Reserve had to act," he said, because the Fed was "the only fire station in town."
Mr. Geithner said that "imprudent risk-taking in better times" at AIG "meant that, when the financial cycle turned, AIG had hundreds of billions of dollars in commitments without the capital and liquid assets to back them up." He said such "excessive risk-taking should not have been allowed, but it was."
"Despite regulators in 20 different states being responsible for the primary regulation and supervision of AIG's U.S. insurance subsidiaries, despite AIG's foreign insurance activities being regulated by more than 130 foreign governments, and despite AIG's holding company being subject to supervision by the Office of Thrift Supervision, no one was adequately aware of what was really going on at AIG," he testified.
He defended the decisions of the Federal Reserve Bank of New York, the Board of Governors of the Federal Reserve and the U.S. Treasury by saying that the steps the government took to rescue AIG "were motivated solely by what we believed to be in the best interests of the American people."
"We did not act because AIG asked for assistance," he said. "We did not act to protect the financial interests of individual institutions. We did not act to help foreign banks. We acted because the consequences of AIG failing at that time, in those circumstances, would have been catastrophic for our economy and for American families and businesses."
Mr. Paulson called AIG "an unregulated holding company" and a "mismanaged and misguided enterprise."
The former Treasury secretary said that "although the road to complete recovery is slow and unemployment is still high, had AIG failed I believe we would have seen a complete collapse of our financial system, and unemployment easily could have risen to the 25 percent level reached in the Great Depression."
The committee, as part of its inquiry, is probing whether the Federal Reserve Bank of New York acted inappropriately in limiting disclosures that as part of the bailout arrangements AIG would be paying off the bank credit default swaps in full.
"The rescue of AIG was necessary, and I believe that we in government who acted to rescue it--including [Treasury] Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke and me--acted properly and in the best interests of our country," Mr. Paulson said.
He asserted that AIG needed a federal rescue because it was "incredibly large and interconnected," it was "seriously underregulated," and because "it could not have been effectively wound down." Specifically, he said AIG had:
o A $1 trillion balance sheet.
o A massive derivatives business that connected it to hundreds of financial institutions, businesses and governments.
o Tens of millions of life insurance customers.
o Tens of billions of dollars of contracts guaranteeing the retirement savings of individuals.
"If AIG collapsed, it would have buckled our financial system and wrought economic havoc on the lives of millions of our citizens," according to Mr. Paulson.
He concurred that AIG was not effectively regulated. "Although many of AIG's subsidiaries--including its insurance companies--were subject to varying levels of regulation, the parent entity was, for all practical purposes, an unregulated holding company," he said.
Consequently, there was no one regulator with a complete picture of AIG or a comprehensive understanding of how it was run, he explained.
"It was not until AIG started to fail that regulators began to understand how badly managed it had been and how much the toxic aspects of parts of its business had infected otherwise healthy parts," Mr. Paulson said.
AIG could not be effectively "wound down," he said. "Unlike failed depository institutions which can be taken over by the FDIC with little or no harm to depositors...there was--and is--no resolution authority available to wind down a failing institution like AIG. The only option is bankruptcy--a process that is simply not capable of protecting the millions of Americans whose finances are intertwined with AIG."
"I do not mean to say that I am happy that we needed to intervene," said Mr. Paulson, noting that taxpayer money should not have to be spent to save a "mismanaged and misguided enterprise."
However, he added, "the fundamental problem lies not in how we intervened, but in why we needed to intervene."
He said the U.S. must modernize its regulatory structure by creating a systemic risk regulator and resolution authority, so any large firm that fails can be liquidated without de-stabilizing the entire system.
Federal Reserve Board Chair Ben Bernanke said stabilizing AIG, not the financial health of the trading partners, was the reason the Fed decided to pay off the AIG credit default swaps at par.
His statement came in a written response to Rep. Issa, who oversaw the minority report suggesting AIG bank counterparties were paid too much, and asserting that the Federal Reserve Bank of New York and the Federal Reserve attempted a cover up of bailout details.
"The overriding motivating factor in structuring the payments to the counterparties was to relieve AIG of the destabilizing drains on its liquidity caused by the requirement to continue to post collateral as required by the [credit default swaps] contracts," he said.
"All counterparties were treated the same for payment purposes," he added. "Whether the individual counterparties were in relatively sound financial condition or not was not a factor in the decision regarding the amount paid to the counterparties or whether concessions should be sought from them."
Mr. Geithner, in response to a question, said the Fed had no legal or other authority to take any other action than it did in paying off the credit default swaps in full. He said there was no way to put AIG in bankruptcy.
"To stand back and let it burn," he said, would be irresponsible, adding that the Fed acted to protect the innocent through the bailouts, and made an effort to reduce the cost to the American taxpayer to the lowest amount possible.