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AIG Scandal: Fed as Chump or Fed as Crony?

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No matter which way you look at it, the picture that is emerging of the Federal Reserve, as revealed by the ongoing probes into its AIG bailout, is singularly unflattering.

The explanations for its actions can only support one of two interpretations: that the Fed was a chump, taken by the financiers, or a crony, and was fully aware that it was not just rescuing AIG, but doing so in an overly generous way so as to assist financial firms in a way it hoped would not be widely noticed or understood. The problem with this sort of back-door subsidy, aside from its dubious propriety, is that at best, it's sorta random (who benefits isn't necessarily who is in most need or more deserving of help, just who happens to be lucky enough to be associated with AIG train wreck), and at worst, it rewards stupidity and duplicity.

For the Fed, if it was mainly engaged in "Fed as crony" behavior, that bodes ill for the central bank's future, since it means it has been lying to the public as to why it did what it did. As investigators keep digging, for they will be certain to find evidence that the various explanations that the Fed has given for its actions will be at odds with its internal debates. If you think the Fed's reputation is bad now, just wait to see what happens if it emerges that it was engaged in deception.

Although the focus of press and public attention has been the decision to pay out "100%", this issue has not been framed as crisply as it should be. Remember, the underlying transactions were crap CDOs that the banks (or bank customers, a subject we will turn to later) owned, and on which the banks had gotten credit default swaps from AIG. The Fed in fact paid out WELL MORE than 100% on the value of the AIG credit default swaps by virtue of also buying the CDOs.

Recall the sequence:

1. Fed authorized $85 billion credit facility in September 2008

2. In early October, AIG pays out an additional $18.7 billion to its CDO counterparties, bringing their total collateral to $35 billion (against CDOs with a par value of $62.1 billion) So the dealers had already received 56% of par value at this point (remember, possession is 9/10 of the law).

3. In early November, it looks as if AIG will have to pony up more to its counterparties if it is downgraded, as it presumably will be once it releases crappy earnings. Resulting collateral calls might exceed the remaining amount of the $85 billion loan facility. Fed goes into panicked overdrive, decides of all its options for dealing with the AIG black hole, the best is to buy the CDOs, thus eliminating the need to worry about those pesky CDS.

What we need to stress here, before going into the chump vs. crony theories, is that buying the CDOs in order to terminate credit default swaps is not normal protocol. The Fed could have negotiated a cash settlement (which probably would have amounted to letting the counterparties keep the collateral, with some further adjustments based on the usual arm wrestling. This by the way, could have constituted a 100% payout on the credit default swaps (ie. the decision to pay out in full on the CDS was separate from the decisions to acquire the CDOs), but it would have left the banks with the CDOs. That would have been well short of $62.1 billion; all the dealers felt then that the CDOs had some value (while their marks also said that, dealers have been known to mark paper at unduly high prices to avoid reporting losses; with AIG's credit-worthiness in doubt, the bankers' accountants presumably required markdowns on the credit default swap hedges, which might give some banks an incentive to be less aggressive in reducing the value of their CDOs). That implies the credit defaults swaps themselves were worth considerably less than 100 cents on the dollar.

Buying the CDOs was an unnecessary step and increased the amount paid by the Fed, through AIG, to the counterparties. Moreover, the Fed has gone to unusual, even bizarre, lengths to keep matters regarding the CDOs themselves secret (a good bit of the discussion at the House Oversight Committee hearings on Wednesday today revolved around this issue; we've discussed previously why the Fed's arguments for secrecy do not add up; we will return to this subject at later today at Naked Capitalism).

So let's see how these theories stack up. Each has supporting evidence.

Fed as Chump

This viewpoint boils down to the old saw about poker: if you sit down at a poker table and you don't know who the mark is, by definition, it is you.

The Fed has long believed that the financial crisis was a liquidity event, that investors panicked, but the prices of securities of all sorts fell below "rational" levels. From Bernanke on down, the Fed has made various pronouncements taking up the theme that securities prices, particularly in the October 2008 through March 2009 time frame, reflected irrational despondence. Funny how once Greenspan dared admit in 1996 there might be such a thing as irrational exuberance, not only that turn of phrase, but the very concept, seems to have been expunged from permitted reasoning at the central bank. Not only does the Fed seem constitutionally unable to admit that it was asleep at the switch during the rise of a global credit bubble, but that cheap credit leads to overvalued assets. So asset prices will fall as cheap credit is withdrawn. The Fed has fought this process tooth and nail, believing it can validate asset prices by pulling the right levers (see here for a long-form version of this logic and my objections to it).

So why did they buy the CDOs? Get this: one argument is that they wanted the upside. Huh? That means:

1. They seem to have forgotten that where there is upside, there is also downside. They took a speculative position. This went well beyond what was necessary to deal with the AIG mess

2. They thought they had a better perspective on value than the banks themselves. This is staggering. They have NO idea how these deals are structured, no day-to-day involvement in the subprime, Alt-A, or commercial real estate markets. They are at a massive information disadvantage. The idea that the Fed could make a better trading bet than the banks themselves is a remarkable combination of hubris and stupidity.

While there might be reason to think that prices of liquid assets had overshot on the downside, assets like CDOs that don't trade and are (in this case) priced on cash flows which reflect, among other things, expected defaults and loss severities, are quite another matter. And here, the Fed (its valuation claims to the contrary) looks to have gotten it badly wrong. Per Tom Adam's analysis, at the time Maiden Lane III (the vehicle that bought the CDOs) was created, 19% of the portfolio had been downgraded to junk. Currently, it's 93% below Baa3 according to Moody's, the more conservative of the two major ratings agencies.

More confirmation of the "Fed as chump" theory comes via its reliance solely on BlackRock for advice on the CDOs, particularly once it had set up Maiden Lane III (and recall BlackRock is also managing Maiden Lane I, the Bear bailout entity, and Maiden Lane II, which was created to deal with AIG's securities lending mess). I'd be curious to hear additional reader input, but I am told that private managers of portfolios of this size would have at least two portfolio mangers to give them different views and to compete. But the government would set its criteria for these assignments in such a way that Pimco and BlackRock were the only viable candidates. By contrast, there are asset managers and consultants that are not as large but are very skilled in the CDO space.

The Fed was also played by the French regulators, and perhaps their banks. One of the arguments for the Fed not pushing for a haircut on the credit default swaps, as other banks had accepted in dealing with a distressed insurer, was that French law prohibited it. But this was false, since Societe Generale and BNP Paribas took very large haircuts to close out credit default swaps with Ambac, another bond insurer.

Other examples of Fed naivete comes from e-mails recently made public as a result of the House Oversight Committee investigation: its surprise that AIG might have to make disclosures regarding the bailouts, its clumsy and aggressive efforts to keep matters under wraps, and its reluctant recognition that too many people were party to what went down to maintain secrecy.

Fed as Crony

Although we'll set forth the fact pattern that gives credence to this notion, the most powerful support comes from the Fed's seeming desperation to maintain secrecy, particularly around Maiden Lane III. The Fed's arguments here do not hold up. In Congressional testimony today, the Fed, particularly the general counsel of the New York Fed, Thomas Baxter, argued that keeping transaction-level detail secret, was necessary to maximize value of Maiden Lane. As we have discussed earlier, and continue in more detail in a related post, that is bunk. And that begs the question of why the Fed is so insistent on holding the line here. While it may be imperial overreach and fear of starting down a slippery slope of disclosure, the Fed's bobbing and weaving under the hot lights FEELS like a cover-up.

Moreover, the Fed has withheld information requested via subpoena from both SIGTARP and the House Oversight Panel. That says they are awfully keen to hide...something. That sort of intransigence is a red flag before a bull. The fact they hoped they could get away with it is troubling, and strongly suggests something is amiss.

Now mind you, the Fed's cronyism does NOT have to come about via corruption or other nefarious reasons (the stonewalling could be to protect Geithner and Bernanke; for instance, they could have given testimony that is contradicted by internal evidence). The Fed appears to be captured by the industry, so badly that it is unable to recognize how distorted its perspective has become. This means it will vociferously defend the industry and individual firms.

So what is sus about the Fed's conduct? Consider:

1. The Fed's unusual step of buying the CDOs provided nearly $30 billion more in liquidity to a small number of banks. To put that in context, the first of the Fed's emergency rescue programs, the Term Auction Facility, was at its outset a $40 billion program open to a much larger universe of firms and provided 28 day loans, not a permanent transfer.

2. The insistence that the Fed was up against a hard deadline of November 10. In response to questions today, Baxter insisted that the Fed had to have a new program in place by November 10, because that was when AIG would announce earnings and a rating agency downgrade seemed inevitable, which would lead to more collateral calls.

But that is misleading. First, even if the rating agencies issued their downgrades that very day, the collateral payment was not due that day. There would be some sort of time delay, not long, but I would guess 3-5 days (I assume expert readers will advise me and I will revise the post accordingly). Perhaps more important, it is typical when parties are negotiating to agree on waivers. How hard would it be for the Fed to obtain a waiver if it were negotiating an exit from the AIG CDS? Answer: not very if good faith negotiations were under way. At worst, the Fed could have had AIG make a partial collateral payment out of the remain credit line while discussions continued.

3. The Fed had done nothing to understand the CDS market or prepare for a crisis. Many observers believe the reason that Bear was not allowed to fail was that it was a significant counterparty in the credit default swaps market, that letting any big CDS player go could produce a domino effect, creating a wave of counterparty failures that would lead to systemic collapse. Aside from the backlash against the Bear rescue, Lehman was presumably dispensable despite its larger size because it was not as big a participant in the CDS game.

Since the CDS market was obviously a major source of risk and firms that were big CDS players (Merrill, Morgan Stanley, UBS) were seen as vulnerable, it would seem to be Job Number One of the Fed/Treasury to do some meaningful investigating to see how big the risks were and do some contingency planning (don't even try telling me the Neel Kashkari "break glass" memo mentioned in Sorkin's Too Big To Fail amounted to "planning". You can't plan if you don't understand the terrain. And the "plan" was clearly too high concept to be useful when the dominoes did start to fall).

Now of course, preparation for an investment bank bankruptcy, which would lead (among other things) to a hard look at the credit default swaps market; failure to do so could fit the "Fed as chump" theory, that the authorities dropped the ball, big time. But the powers that be have shown a remarkable lack of interest in real diagnostics throughout. By contrast, the Bank of England, twice a year, puts out a Financial Stability Report than runs rings around anything I have seen the Fed prepare. When UBS got itself in so much hot water that it needed a rescue, the Swiss Banking Federation made it conduct an internal investigation (conducted by outside parties) and make two reports: one to the public, in the form of a report to shareholders that was very detailed, and an even more extensive one to the authorities.

The lack of interest in either post-mortems or planning suggests that the Fed does not want to know. And who would that lack of curiosity benefit? The Fed itself (as in not exposing past policy failures) and of course, the industry (not exposing incompetence and misconduct).

If that is not a misguided set of (implicit) priorities, I don't know what is.

4. As we discuss separately (the new post on this will be up later today), the Fed keeps trying to keep transaction-level detail on Maiden Lane III under wraps, even though its arguments defending this action make no sense. That suggests there must be other reasons. One is that ML III is really not doing so well, despite valuation reports that say otherwise; the second is that digging into the transactions would be embarrassing to the Fed or the counterparties themselves.

5. A look at transaction detail (that is, the stuff the Fed has been desperate to hide), and counterparty exposures (which we have put together, not just CDS counterparty, but lead bank on the CDO, which in a surprisingly large number of cases is different than the CDS counterparty), suggests at a minimum pervasive patterns of really abysmal counterparty risk maangement amongst the AIG counterparties; notably, massive Goldman exposure, along with apparent efforts to conceal it. Thus the reluctance of NY Fed to disclose information about the counterparties begins to look like a possible case of regulatory capture. Or maybe, yet another case of credulity of experts.

As much as the Fed seems awfully eager to close this chapter, enough parties with subpoena are taking interest that l'affaire AIG is going to be scrutinized in exhaustive detail. The dirt will come out. Given the Fed's past record on disaster planning, if there is something serious they are hiding, they are likely to be inadequately prepared for the blowback.