Last week I was out sick and took the day off on Wednesday, so I ended up listening to Tim Geithner give his testimony at the House Oversight and Government Reform Committee‘s hearing on AIG. I’ve never been a fan of Geithner, and I probably never will be.
But for a second, let’s assume that something should’ve been done to aid AIG for systemic reasons. What should’ve the response been? What would’ve it have looked like?
So I started trying to look for the loan agreement information that’s out there. First, there’s the news stories that were flying around:
The Federal Reserve will provide a two-year loan, take 79.9 percent of the New York-based company’s stock and replace its management because “a disorderly failure of AIG could add to already significant levels of financial market fragility,” according to a statement by the central bank late yesterday.
And over here at the Federal Reserve’s website:
The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.
The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.
via FRB: Press Release–Federal Reserve Board, with full support of the Treasury Department, authorizes the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG)–September 16, 2008.
So at first blush, it sounds like a pretty stout loan agreement. All of AIG’s assets are being held as collateral, including the stock. They could’ve put a compensation covenant in the loan agreement (it’s been done before) as well as mandating some asset sales (which are going to be needed anyway).
To get an idea of what this all amounted to, I started looking at the balance sheet. Below is the financial supplement from 3Q ’08. Page 9 has the company’s balance sheet:
There’s a trillion dollars in assets on that balance sheet. If you were going to lend $100bn or even $200bn against all the assets on the balance sheet, you’d be overcollateralized by a wide margin. Even if you marked everything down by half to two-thirds, you still had a margin for error to the deal.
But the discussion always makes its way back to the New York Fed’s commitment to purchase the CDOs and the CDS contracts at par.
100 cents on the dollar. For assets that are so obviously not worth 100 cents on the dollar.
Looking at the loan structure and the CDO/CDS settlement decisions, you can see the issue isn’t the loan structure. The issue then is, the administration/monitoring of the loan. And the November ’08 restructuring letter proves it. Look at page 2:
That’s what I call “letting them off the hook.” A loan agreement like the one that was originally negotiated (with a couple of tweaks) probably would’ve sent a strong message to the market that if you’re asking Uncle Sam for a loan, he’ll give it to you. But he’ll have a lead pipe in his hand when you sign the loan agreement. And that’s the way it should be.
So when I started reading this article from Reuters, I couldn’t help to think about what happened with AIG:
The main challenge facing central banks is how to keep economic growth going without inflating the next bubble. Put starkly, that means jacking up interest rates from their current nonexistent levels, as Australia, Israel and Norway have now done.
It also means halting the spread of cheap money, which has turned out to be the financial equivalent of crack cocaine.
Weaning the world off the liquidity drug won’t be easy. The two most important economies, America and China, are moving at different paces, perfectly exemplifying the two-speed recovery that seems to be taking hold.
I think they’re on the right track, but I also think they miss the mark. There’s a fetish among central bankers to tinker and meddle with interest rates. Like they have some special ability to predict what rates should be or something. Funny thing is, I don’t remember there being a class in rate forecasting on offer at Hogwarts or at the Jedi Academy. So it’s not like central bankers really know any better than you or I what interest rates should be, but the media and many others believe they do. Even though, some of their thoughts and behaviors are just bizarre.
The truth is, there’s another way to conduct monetary policy, which is to control the money supply and let interest rates take care of themselves. Volcker did it and was immensely successful.
Which brings me back to who/what we need as a central banker. Maybe it’s someone less professorial. Less Papa Smurf.
And more like Dog the Bounty Hunter. Hey, would you want to take a loan from this guy?