A bizarre reminder of some of the most terrifying moments in U.S. financial history just kicked off in Washington: Former AIG CEO Hank Greenberg's hubris-filled case against the government went to trial on Monday. Greenberg claims that the 2008 bailout AIG received from the government was illegal, and he's demanding $25 billion in damages.
Greenberg’s case is a combination of compelling, maddening, and fascinating. He claims that the government wasn’t authorized to bail out AIG, that AIG's management wasn't authorized to accept the money, and that the firm was coerced by the government to take it. (Greenberg wasn't a part of the bank's management at the time. He resigned in 2005 in the midst of an accounting scandal, but remained a large shareholder.) He's also arguing that the specific terms of the bailout -- an $85 billion loan that came with an initial 14 percent interest rate and a 79.9 percent stake in the company -- were illegal as well.
The lawsuit cuts to the question of how the government should have bailed out failing firms during the financial crisis. Greenberg raises the question many of us are still wrestling with today: Did the bailed out banks get off too easy?
First, a reminder of just how bad things were for AIG back in September 2008: The global insurance giant was close to collapse. The culprits were credit default swaps, a way to insure bonds, that it had sold to investors and traders. But the bonds AIG had insured began to default, or come very close to default, and AIG had to pay. It couldn’t. AIG had strayed from its traditional business of insuring physical things to insuring financial instruments, and it had completely misjudged the risks of those financial instruments. An insurance company had become a speculator, and it was paying the price.
An AIG bankruptcy would have been catastrophic for the financial system, possibly taking down many companies with it.
The underlying behavior of AIG and the banks that would be bailed out was very similar: Traditional businesses were shunted aside for dealing in new, complex financial instruments, and pretty much everyone vastly underestimated how risky those shiny new things were. Greenberg is asking why AIG was bailed out on harsher terms than other banks, when everyone got into trouble in essentially the same way. The banks should have been forced, he implies, to accept a high-interest loan and give the government the lion’s share of their stock. Instead, the banks largely escaped that fate, and sold preferred shares to the Treasury Department.
Greenberg is also arguing that the government was wrong to pay the full value to AIG's counterparties to exit the derivatives contracts that were sinking the firm. These were companies AIG had insured bonds for. The contracts they had with AIG said they were due to receive a certain amount of money. A lot had changed since those contracts were written -- AIG was failing and financial markets were haywire -- and so, Greenberg says, AIG could have negotiated to pay a smaller amount than was contractually owed.
Should regulators have bargained a bit harder with AIG’s counterparties instead of just paying them 100 cents on the dollar to exit derivatives contracts? It's hard to say no to that: Nobody really bargained with AIG’s counterparties at all.
The maddening parts of the case are almost everything else. If AIG hadn’t received a bailout, shareholders would have been wiped out: AIG’s value to shareholders with a bailout is a number greater than zero; without a bailout, it’s zero. How can a loan to a company constitute an illegal government seizure of equity, when that loan itself is the only thing that allows the company to continue to have any equity value? As the government argues, “This benefit cannot also be a punishment.” And faced with a failing company unable to obtain a private loan, it’s good public policy for the government to drive a hard bargain -- were he lending the money, Greenberg would certainly do the same.
Perhaps the most fascinating argument Greenberg makes is that the bailout wasn’t just punitive, it was also discriminatory.
There was no way to know what the going rate for a multibillion-dollar bailout of a global financial institution was on Sept. 15, 2008, the day before AIG was bailed out. But by Sept. 17, the government had effectively set the going rate, Greenberg argues.
Then, on October 14, it drastically lowered that rate by bailing out nine banks on different terms. The banks only sold preferred equity with a 5% annual dividend to the government. Those bailouts were done through the Troubled Asset Relief Program (TARP), which was passed by Congress and gave the Treasury Department wide latitude to spend $700 billion to stabilize financial markets.
These bank bailouts are the factual basis for Greenberg’s lawyers to claim that “many financial institutions who engaged in much riskier and more culpable conduct than AIG received Government assistance without the punitive equity confiscation terms required of AIG." The government, Greenberg’s lawyers say, “acted wrongfully if It discriminated against AIG.”
Greenberg isn't just arguing that AIG should have been offered the same deal as TARP. He's saying that if the banks had been forced to take a tougher bailout, AIG’s bailout would have been legal. Or at least, non-discriminatory: Either AIG’s bailout terms were right and TARP’s were wrong, or AIG’s bailout terms were wrong, and TARP’s were right. This is clearly an awkward argument for the government to engage in.
Regardless of the outcome of this case, the structure of future bailouts has already been set. The Dodd-Frank financial reform legislation altered the Federal Reserve’s emergency lending powers. It prohibits the Fed from bailing out an individual firm, requiring that any extraordinary lending be made available to a broad class of firms. It also sets the rate of any broad-based rescue package at the Fed's discount rate (the rate at which the Fed routinely lends to banks).
Whenever the next bailout comes, legislation has ensured that it won’t be punitive, and it certainly won’t be discriminatory.