A Fateful Divide: The Handling of the AIG Bankruptcy J. Bradford DeLong U.C. Berkeley and NBER delong@econ.berkeley.edu The first half of September 2008 was a very busy time in American financial markets. On Sunday September 7 the U.S. government nationalized the two large mortgage government-sponsored enterprises, Fannie Mae and Freddie Mac, thus reversing the 1968 decision to privatize them. On Sunday September 14, the investment-banking house of Merrill Lynch was forcibly merged into Bank of America. On Monday September 15 the investment-banking house of Lehman Brothers simply did not open: Lehman went into an uncontrolled and unsupervised bankruptcy, and all financial-market expectations that the Federal Reserve and the Treasury would, as they had in Bear Stearns, stand behind and guarantee the unsecured debt of every substantial investment bank in America went out the window. Wednesday September 17 saw the nationalization of the American International Group: while Lehman had not been too big to fail, AIG was--and the government began injecting cash into AIG that went straight through it and out the other end like grain through a goose in amounts that may total $300 billion before we are through. In the aftermath of these first half of September events, the risk tolerance of the private market collapsed. People became much less willing to hold risky assets at any price. The interest rate on 30year Treasury bonds fell to __. And all the large banks of America were presumed bankrupt if they were forced to mark to market: their survival depended on their (a) not having to sell any assets until asset prices recovered to something like normal levels, and (b) the availability of enough government money at cheap enough prices to give them the ability to avoid selling any assets at distress fire-sale prices. The events of the first half of September--the bankruptcies of Fannie, Freddie, Lehman, and AIG; the collapse of risk tolerance; the fall in the prices of risky assets worldwide; the shutdown of the flow of funds through financial markets as everyone presumed that whoever they entrusted their money to might go bankrupt as well--set us on the course that has turned the crisis that began in August 2007 from the smallest to the largest post-WWII recession. Yet if you go to the big banks of Wall Street right now, most of them will say: "What is the problem?" And they will deny that any changes in how they run their businesses are called for. "Sure there were a few scary moments," they say, "but big shocks cause scary moments. And our fundamental business model is sound." Indeed, as Paul Kedrosky points out http://paul.kedrosky.com/archives/2009/06/what_is_this_le.html, if you look at the stock prices of Goldman, JPMorgan, Barclays, and Morgan Stanley, they are back where they were in late August of 2008 before the serious unpleasantness started. (Citi, however, is still down 75% and Bank of America is still down 67%.) So, they say, there is no need for government investments in or control over their business; no need for restrictions on how much they can pay whom or for what; no need to restrict how much leverage they assume or what they invest in or how much capital they must hold. The smart banks, they say, figured out that the mortgage market was headed for a crash in time, and so profited from the boom and were not destroyed by the bust. It was only the dumb banks--BearStearns, Lehman, AIG, Fannie, Freddie, and to a lesser degree Citi and Bank of America--that
suffered severely, and that is how the market works. But there is a slightly different world in which things were handled slightly differently last September and in which the situation is very different. Suppose that on the 17th of September the Federal Reserve had announced not that it was buying up the stock of AIG and would make sure that all of AIG's debts were paid, but rather that AIG was bankrupt--but that the Federal Reserve would pay out cash at par for contracts with AIG provided that it also got (a) upside warrants in the bank and (b) an illiquid long-dated note the value of which would be determined by formula after the crisis passed. Then Goldman, JPMorgan, Barclays, Morgan Stanley, Citi, and Bank of America would still have been qble to function--they would have enough cash to pay their bills and enough assets to match their liabilities--but they would now be owned by the government, for all the money passed through AIG to the banks would not be a loss for the government but would rather have been government investments in still-solvent banks. And the resulting tremendous expansion of the banks' share issue would leave their stock prices today a shadow of their values last August. For when American high finance decided that it needed to hedge its mortgage risk, it did so by buying derivative from AIG--and it did not do due diligence to figure out if AIG could in fact meet its obligations in those states of the world in which they came due. This failure to perform due diligence was a mistake that cost American high finance an amount that may ultimately reach $300 billion. It would have been a fatal mistake if the government had not stepped in. It would have been obvious that it was a mistake if the government had stepped in by discounting AIG paper in return for warrants and notes at fair market values. It is only because when the Federal Reserve and Treasury stepped in last September they stepped in by nationalizing AIG and guaranteeing its debts that American high finance now has healthy stock prices, and that the senior executives of the big banks--save for Citi, B of A, Lehman, and Bear-Stearns--are congratulating themselves at being swift and smart and skillful enough to run the boom and then get off the bull in time to be only scratched and not eaten by the bear. Now nobody--or nobody in the right place at the right time--knew then that the AIG mess was as big as it has in fact turned out to be. And in the heat of the moment in the midst of chaos you do things that after the fact you determine were not the wisest of the things that you could have done. I know that had I been in Henry Paulson's seat at the Treasury or Ben Bernanke's at the Board of Governors or Tim Geithner's at the New York Fed that I would have made bigger mistakes (probably different mistakes, but surely bigger mistakes) than they have made in handling the crisis. Nevertheless, the fact that the rescue of the banking system last September took the form of nationalization of AIG and the honoring of its paper rather than the discounting of its paper and equity investments by the government in the banks has led to a situation in which most of Wall Street and at least a third of Congress are telling themselves a false story about what happened last fall. They are telling themselves of a banking system that was fundamentally sound and that merely needed a little temporary liquidity to tide itself over a panic. But the true story is one of an overleveraged banking system that was insolvent save for a $300 billion present from the government in the form of honoring the worthless paper of AIG. This matters: what story we tell about last fall determines what form financial market regulation will take in the next few decades, and how vulnerable we will be to the next wave to come.