Tuesday, November 17, 2009

Fed Lousy Negotiator During AIG Crisis

So why did the Fed pay off AIG's couterparties at 100 cents on the dollar during AIG's meltdown late last year? Many of us critical of the Fed's drastic and opaque actions with respect to AIG, which it didn't even regulate or have authority to lend to, lie awake at night pondering this question. According to a government audit by the special inspector general for the TARP, the answer is that the folks at the Fed are terrible negotiators. Apparently the Fed called up AIG's counterparties late last year, asked them to cancel the swaps and take a haircut on the securities, the counterparties refused and demanded they be paid 100 cents on the dollar. The Fed said "Ok. Fine." That's your government working hard for you, as it shoveled multiple billions of dollars to Goldman Sachs, Merrill Lynch, Soc Gen, Calyon and others. Just keep that in mind next time you ever wonder who the Fed is really working for. Clearly, its allegiances lie with the big banks.

I've never actually taken a negotiations class, but common sense tells me that when you have even the tinniest bit of leverage, you use it to get a better deal. When you hold all the cards, you squeeze the living daylights out of the counterparties. Of course, when you have none, you cave. A fine example of someone who did a terrible job of negotiating was former CEO of Lehman Brothers, Dick Fuld. Mr. Fuld kept pretending that he had leverage, insisting on a ridiculous price for Lehman during its final days. Yet everyone knew he had no leverage, but Mr. Fuld refused to cave, costing him his firm. That's lousy negotiating taken to the opposite extreme. In the Fed's case with AIG's counterparties, the Fed held all the cards. Or rather, all the money. At the time, the Fed was the only game in town. Had it let AIG collapse, AIG's counterparties would've lost multiple billions of dollars. Why the Fed didn't use its leverage remains a complete mystery to me, despite its lame explanations in the inspector general's report.

In a letter accompanying the inspector general's report, the Fed claims it "acted appropriately" in its dealings with AIG's counterparties. It said its intervention in the insurer was designed to prevent a system-wide collapse. Curiously, it couldn't use its leverage as a regulator because it was acting on behalf of AIG. So instead of protecting the interests of taxpayers, whose money the Fed seems to have no trouble risking at every turn, it was protecting the interests of the bankrupt insurer that blew itself up through sheer greed and stupidity.

According to the WSJ's account of the inspector general's report, AIG's counterparties played hardball with the Fed because the Fed had already made it clear it wouldn't allow AIG to go bankrupt. They claimed they were contractually due the full value of the securities and that they had a fiduciary duty to their shareholders. Lucky for them, the Fed fell for it. The article goes on to say that the Fed's lack of leverage was rooted in decisions it made earlier in the fall, in September 2008, when the Fed felt confident that the banking industry would solve AIG's problems. After Lehman's failure, it tried to get the banks to pony up $75 billion for a loan to AIG, during which time AIG tried unsuccessfully to get the banks to accept less than full payment to cancel the swaps it had written. When those negotiations fell apart, the Fed itself lent the insurer $85 billion and then took over negotiations in early November to try to get the banks to accept haircuts. With the exception of UBS, who agreed to a 2% haircut, the banks refused. The Fed then decided that the only way to stop the cash bleed was to buy out the securities at par and cancel the swaps. There was another way, of course. It could've just given the banks the finger and let AIG fail. But then that's what a good negotiator would've done.


Mr Wrightwood said...

Oooh, four aces! Yeah, but what if they have five? Better fold.

Mike said...

I strongly believe that until the government addresses the basic structural problems in our financial system of too much debt and the ability to create money out of thin aie, we won't have a sustainable recovery. So while the stock market can stay irrational in the shorter term, in the long run I believe it will go back to reflecting the fundamentals of our boom and bust economy. And that's why I continue to feel that for long term investors a better portfolio allocation is in cash and gold. This morning I actually read a very useful piece on gold and the US dollar as a result of the Federal Reserve's continued attempts to debase our currency and continue to try to solve a debt crisis with more debt: Gold Price Breaks $1,180 as US Dollar Sinks

here’s an excerpt: “While the Fed minutes indicate the maintenance of current dovish policy for quite some time, a positive factor for the gold price and gold mining sector, other portions of the minutes suggested that the Federal Reserve may indeed have evidence to begin to withdraw the easy monetary policies used to combat the credit crisis.”