AIG Default Swap Repayments Criticized

NU Online News Service, may 27, 2:05 p.m. EDT

WASHINGTON–The Federal Reserve Bank of New York came under intense fire at a congressional hearing this week for its decision to allow 100 percent payback for counterparties to American International Group credit default swaps after it bailed out the firm in September 2008.

New York Fed officials, however, argued at the hearing that failure to make good on the CDS deals might have resulted in a bankruptcy filing with systemic implications for the economy.

They also suggested that failing to make the payments in full might have prompted rating agency downgrades that could have started a cascade effect, ultimately undermining the viability of AIG's insurance subsidiaries.

But both an outside lawyer experienced in dealing with insurance insolvencies as well as members of the Congressional Oversight Panel questioned various decisions made by federal regulators dealing with CDS payments to AIG counterparties in the fall of 2008.

The 100 percent payments to counterparties on swaps transactions, as well as to other creditors, were made by the New York Fed after AIG had been provided with an initial $85 billion in September 2008.

Other payments, directly and indirectly, by the New York Fed and other federal agencies at one point totaled $182 billion, according to various estimates by analysts.

Critical of the Fed's decisions at the hearing were Damon Silvers, a board member of the Troubled Asset Relief Program, and Martin Bienenstock, a member of Dewey LeBoeuf in New York and an expert in corporate reorganizations.

Mr. Silvers' criticism stemmed from the AIG decision not to disclose its payments or the names of the companies to which payments were made in AIG corporate filings.

"Why are the legal documents embodying the derivatives deals and securities lending deals that led to AIG's collapse still secret from the public that ultimately paid for those deals?" he asked.

In response, Thomas Baxter, executive vice president and general counsel at the New York Fed, defended the agency's actions, testifying that "a bankruptcy filing by AIG would have had disastrous consequences."

While defending the substance of the agency's action, he acknowledged to Mr. Silvers that the "perception" left the agency open for criticism. "We acknowledge in hindsight" that things could have been done differently, he said.

Meanwhile, Mr. Bienenstock challenged the Fed's thinking on paying 100 cents on the dollar to CDS creditors.

"My conclusion is that it was very plausible to have obtained material creditor discounts from some creditor groups as part of the [AIG reorganization] process without undermining its overarching goal of preventing systemic impairment of the financial system and without compromising the Federal Reserve's principles," Mr. Bienenstock said.

The New York Fed has been criticized for its decision by members of several congressional committees, including the Senate Banking Committee, the House Financial Services Committee, and the House Oversight and Government Reform Committee.

This involved paying at par, credit default swaps used by AIG to guarantee the value of mortgage-backed-securities purchased by Goldman Sachs and other banks and brokerages, including a number that were based in Europe, such as Societe Generale and Deutsche Bank.

The unwillingness of the Fed and AIG to disclose the names of counterparties for months also has been heavily criticized.

Unlike the positions taken by New York Fed officials to justify their decisions to pay off creditors completely, Mr. Bienenstock argued that the Fed and AIG were in a strong position to demand concessions and "haircuts" from creditors.

Mr. Bienenstock said the New York Fed and AIG could have argued that:

o State law recovery actions against AIG would be unlikely to yield any benefits due to the prior lien on AIG held by the New York Fed.

o AIG would not voluntarily file bankruptcy.

o Creditors would be unable to file involuntary positions in good faith because AIG was generally paying its debts as they became due, "even if AIG were not to post additional collateral or pay certain other debts of the entities that caused losses."

In their testimony before the panel, Mr. Baxter and Sarah Dahlgren, executive vice president of special investments management at the New York Fed, defended their decisions on the 100 percent CDS payments.

They said in written testimony that if AIG had failed to pay its contractual obligations, ratings agencies would have seen this as a selective default and downgraded the company, adding further fuel to the fire.

"As a result of a downgrade, many of AIG's insurance companies may have been unable to write new business, and state and foreign insurance regulators may have begun seizing AIG insurance company assets in their respective jurisdictions," they said in written testimony.

But Mr. Bienenstock argued otherwise. "Recent experiences with workouts of the monoline [bond] insurance companies help corroborate the likelihood of concessions," he told the panel. "I have had limited involvement in those negotiations, but my firm has been very involved on behalf of the insurance companies."

In restructurings similar to that of AIG, he added, "institutional lenders, including French institutions, were similarly owed additional collateral to secure credit default swaps and other derivatives. Consensual discounts were and are being granted in very material amounts."

He added, "there is litigation pending today over whether certain credit default swaps qualify for any priorities in payment afforded insured contracts under state law."

Accordingly, Mr. Bienenstock said, "there are many uncertainties causing counterparties to grant consensual discounts."

The Congressional Oversight Panel was created to act as a watchdog over government investments made through TARP, as well as by other Treasury Department and Federal Reserve Board programs launched to prevent a financial meltdown in September 2008.

At the hearing, two analysts raised red flags about AIG's long-term prospects despite assurances from President Robert Benmosche to the panel that AIG is on a "clear path" to repaying its debt to the government and "remaking itself into a more streamlined and focused company." (See http://www.property-casualty.com/News/2010/5/Pages/AIG-CEO-Analysts-Clash.aspx for the full story.)

FRANKENSTEIN?

In other testimony at the same hearing, AIG was characterized as a "corporate Frankenstein" by the head of Congressional Oversight Panel, Elizabeth Warren, who also charged that AIG's "regulators and regulations failed the American taxpayer."

Explaining her "Frankenstein" analogy, she said AIG was "a conglomeration of banking and insurance and investment interests that defied regulatory oversight and that would not have fit easily into the existing bankruptcy structure."

In her testimony, Ms. Warren lauded the decision of Congress in proposed financial services reform legislation to totally revamp the rules used to deal with large, complex financial firms teetering on financial collapse.

Thankfully, she said, "the House and Senate reform bills create a much better process for monitoring systemically important firms and winding them down if they falter–a process designed precisely as a response to the wildly expensive and unruly bailouts of companies like AIG."

She said AIG's corporate complexity, its systemic significance and the fragile state of the economy may all arguably have been reasons for unique treatment.

"But no matter the justification, the fact remains that AIG's rescue broke all the rules, and each rule that was broken poses a question that must be answered," she added.

Ms. Warren–currently a professor at Harvard Law School–said in her statement that she has taught bankruptcy law for 30 years. "I open today's hearing by listing the rules of bankruptcy because we are about to examine a bankruptcy that broke all the rules," she said.

In fact, she said, "the rescue of the American International Group was so extraordinary that it bypassed the entire legal process of bankruptcy."

She added that "in saving AIG, the government invented a new process out of whole cloth, a parallel set of rules devised and executed for the benefit of only one company."

Moreover, she said, by the time the federal government intervened in late 2008, "AIG was a poster child for the need for a well-functioning bankruptcy system."