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into the largest insurance company in the world.

AIG’s principal threat to U.S. financial stability came not from its regular insurance operations but from its large-scale entry into the derivatives business. In 1987, Greenberg had created a subsidiary of the holding company called AIG Financial Products, or AIG FP. Although AIG FP traded many types of financial instruments, by the late 1990s a centerpiece of its business amounted to selling insurance by a different name. The customers were U.S. and European banks and other financial institutions that wanted protection against the possibility of large losses in their collateralized debt obligations, which packaged together many types of private debt (in this case, mostly mortgages and other real estate–related debt). In exchange for regular payments—insurance premiums, essentially—AIG agreed to make good any losses to those securities exceeding specified amounts. This insurance was offered through derivatives called credit default swaps.

It looked like a win-win proposition. Because of AIG’s high credit rating, its CDO insurance customers did not insist that AIG put aside significant reserves against loss. Meanwhile, the banks and other institutions buying this insurance were able to show their regulators that they had secured protection against the possibility of large losses on their CDOs, which in turn allowed them to reduce the capital they held to meet regulatory requirements. AIG did not increase its capital when it sold protection, so the total amount of capital in the financial system standing behind the CDOs was effectively reduced.

A well-run insurance company, under the watchful eye of its regulator, will protect itself from the risk of catastrophic loss by holding substantial capital and reserves, limiting its exposure to any single risk, and selling off part of the risks it assumes to other insurers (a practice known as reinsurance). From an economic point of view, AIG FP was selling insurance, but it was effectively unregulated and its transactions were not subject to rules that governed conventional insurance. Nor did it take precautions on its own, which left it unprepared for the shock of the crisis.

Hank Greenberg had long been aware of the riskiness of AIG FP’s derivatives positions. In 1993, after the unit stumbled badly and lost $100 million on a single bet, he decided to replace the subsidiary’s founding president, Howard Sosin. Greenberg reportedly told the new president, Tom Savage: “You guys up at FP ever do anything to my triple-A rating, and I’m coming after you with a pitchfork.” But Greenberg was evidently unwilling or unable to curtail AIG FP’s risky activities. Most of the credit default swaps that brought AIG FP to grief were originated between 2003 and 2005. Greenberg lost his own job in March 2005. The AIG board forced him to resign after the Securities and Exchange Commission and the Department of Justice discovered fraudulent accounting practices that ultimately cost the company a ratings downgrade and a $1.6 billion fine. Greenberg was replaced by longtime AIG executive Martin J. Sullivan. Sullivan in turn was replaced by Willumstad, who had joined AIG’s board after Greenberg’s resignation.

AIG FP’s risk was compounded by the difficulty in valuing its highly complex positions, in part because the securities that the company was insuring were themselves so complex and hard to value. As

early as 1998, Fortune magazine reported, “Fact is, many Wall Streeters have given up really analyzing this company: it is so complex that they think it inscrutable. They just fall back on faith, telling themselves that Greenberg will keep turning out earnings.” When Robert Willumstad became CEO, he announced his intention to focus on core insurance businesses. If those plans had been completed (Willum-stad had suggested an announcement could be made in September), it seemed possible that AIG FP, along with other odd components like the company’s airplane leasing business, could be sold off or gradually dismantled.

The OTS, AIG’s nominal regulator, showed little concern about the riskiness or opacity of AIG FP. In a July 2007 review, the OTS judged AIG FP’s risk-management program adequate and called the level of credit risk it faced moderate. The OTS noted that the securities that AIG FP was insuring were highly rated by the credit agencies, and added that the subsidiary had stopped offering protection on transactions with subprime exposure in December 2005. Based on this review, the OTS saw little reason to take action. However, although AIG had not added to its bets after 2005, neither had it taken steps to reduce or hedge its existing subprime exposures.

WILLUMSTAD WAS BUSY over Lehman weekend. His company needed a great deal of cash, fast. He worked with Eric Dinallo, the New York State supervisor of insurance companies, on a plan to obtain $20 billion for AIG’s holding company from its subsidiaries. He and his team were also trying to raise funds from private equity firms, including J.C. Flowers & Co. and Kohlberg Kravis Roberts (KKR).

Like Lehman, AIG seemed slow to comprehend the gravity of its position. On Saturday morning, Don Kohn reported that the company viewed its predicament as a temporary cash crunch and, notwithstanding its talks with J.C. Flowers and KKR, it wasn’t considering selling core assets (such as one of its insurance subsidiaries) or finding a partner to make a major investment. I was concerned that the company was not taking its own situation seriously enough and told Don to try to get them to develop a specific and credible plan to address their problems. Reluctantly, I was already considering the possibility that we would have to step in. “I would be willing to consider lending to them against good collateral,” I wrote Don, “if we have explicit and public commitments regarding the actions they will take to wean themselves and restore stability.”

Don recommended that we wait and see what private-sector solutions might emerge, in the spirit of the strategy that Hank and Tim were taking with Lehman. He acknowledged that short-term Fed lending to help AIG meet its cash crunch might ultimately prove necessary but said we should do everything possible to avoid that outcome. I agreed.

On Sunday, even as Lehman was unraveling, AIG again commanded our attention. Every time we heard from the company and its potential private-sector rescuers, the amount of cash it needed seemed to grow. The value of the securities that AIG had insured was dropping, and its counterparties were demanding more collateral to protect themselves should the company prove unable to meet its

commitments. Moreover, AIG—through another subsidiary—had unwisely doubled down on its bet on the mortgage market by investing in large quantities of private-label mortgage-backed securities, whose value was now also sharply declining. AIG had financed its holdings of private-label MBS through a form of financing called securities lending—for practical purposes, an activity equivalent to borrowing in the repo market—using securities owned by its subsidiary insurance companies as collateral. The providers of the funding to AIG had the right to demand the return of their cash on one day’s notice, and, as the concerns grew about AIG’s stability, many of them exercised that right. By Sunday evening, it looked like AIG needed $60 billion in cash to meet its contractual obligations. By Monday morning, some projections of the company’s cash needs exceeded $80 billion.

Meanwhile, AIG’s negotiations with potential investors had not gone well. On Sunday morning, J.C. Flowers and KKR made offers for parts of the company, but AIG’s board rejected them as inadequate. And as estimates of the company’s cash needs grew, the interest of potential buyers waned. With the company apparently days away from being unable to pay its creditors, its representatives—including its vice chairman, Jacob Frenkel, a onetime University of Chicago economist and former governor of the central bank of Israel—began passing the word to Don Kohn and others that it likely would need Fed assistance to survive.

By Monday we had little doubt about the magnitude of the danger that AIG posed. The company was so large and interconnected with the rest of the financial system that the ramifications of its failure would be massive, if hard to predict. With financial markets already in turmoil, what would the collapse of the world’s largest insurance company do to investor confidence? What, indeed, would it do to public and investor confidence in the insurance industry, which itself constituted a large part of the financial system? I, for one, did not want to find out.

Early Monday afternoon, Paulson denied at a White House news conference that the government was working on a loan for AIG. “What is going on right now in New York has got nothing to do with any bridge loan from the government. What’s going on in New York is a private-sector effort,” he said. At that point Hank, frustrated by our inability to save Lehman and trapped between growing anti-bailout rage and the prospect of a collapsing financial system, was still hoping against hope for a private-sector AIG deal. But that outcome looked more and more unlikely.

At 5:00 p.m. Monday, Mike Gibson, a Board economist who would later head our banking supervision division, filled me in on a call he and other Board staff had had with AIG, the New York state insurance regulator, and the New York Fed. AIG’s plan was evolving. Its executives had stopped talking about a private equity deal, Mike said. They were hoping now for a Federal Reserve loan collateralized by a grab bag of assets ranging from its airplane-leasing division to ski resorts.

As the panic worsened, problems metastasized. I received a message from the San Francisco Fed, reporting that Washington Mutual would be downgraded by S&P and likely also by Fitch. “Deposits are ‘slipping,’” the report added. “No lines or signs of chaos, but a definite reduction in deposits.” Don

reported that he and Randy Kroszner had spoken again with both John Reich at the OTS and Sheila Bair at the FDIC. Sheila, concerned about the risks that WaMu posed to the deposit insurance fund, continued to push for a sale of the company as soon as possible. Nonfinancial companies were also feeling the pressure. I was told that Ford Motor Company, which relied on the commercial paper market to finance much of its daily operations, was concerned about its funding and wanted to talk to us. I felt like I was juggling hand grenades. Financial panics are a collective loss of the confidence essential for keeping the system functioning. If we couldn’t find a way to stabilize the situation soon, I thought, it would get radically worse.

Tim Geithner and staff at the New York Fed worked late into the night on Monday, trying to find a solution for AIG. (Tim’s energy and ability to concentrate for long stretches always astonished me. His metabolism seemed supercharged. At FOMC meeting breaks he would inhale doughnuts, but nevertheless remained slim.) Michelle Smith reported that Tim thought “there’s some real possibility” the AIG rescue would fail. I called Tim and we agreed it made sense for him to skip the FOMC meeting the next morning and stay in New York to keep working on AIG. His first vice president, Christine Cumming, would represent the New York Fed at the meeting.

ON TUESDAY MORNING, an hour before the scheduled start of the FOMC meeting, I was on a conference call about AIG that included Paulson, Geithner, and Board members Kevin Warsh and Betsy Duke. With the private equity firms out of the picture and no nibbles from investment banks that had reviewed AIG’s assets, the solution—if there was one—would have to involve Fed lending. Tim outlined a plan to save the company that had been developed overnight. Paulson and I urged him to push ahead and to get back to us as soon as possible.

The call ran long, making me nearly half an hour late to the FOMC meeting. Normally, I entered the boardroom precisely at the stroke of nine. This morning, curious looks greeted me as I hurried to my seat at the table. With so much still unresolved and with time from the meeting already lost, I did not share much, only noting that the markets were “continuing to experience very significant stresses” and that AIG was an increasing concern. That, I said, explained Geithner’s absence.

Monetary policy and the Lehman fallout were not the only topics of the meeting. As planned, I also asked the Committee for authority to provide additional currency swap lines to other central banks. A shortage of dollars abroad was among the factors driving up short-term interest rates for both U.S. and foreign banks. Expanding the swaps program would allow us to supply more dollars to foreign central banks, who could then lend to their own domestic banks, with the hope of calming those funding markets. The Committee expanded the limits on the existing swap lines with the European Central Bank and the Swiss National Bank and authorized new swap lines with the Bank of England, the Bank of Canada, and the Bank of Japan.

Bill Dudley’s briefing on the markets was grim. The Dow, after falling nearly 4-1/2 percent on

Monday, had resumed its decline. Short-term borrowing costs continued to increase rapidly. Pressure was also mounting on Goldman Sachs and Morgan Stanley. Their funding was drying up, other firms were reluctant to enter into derivatives contracts with them, and hedge funds and other important customers, worried that one or both companies might follow the path of Lehman, were moving their accounts elsewhere. Perhaps even worse, panicked investors were reportedly pulling out of a money market fund called the Reserve Primary Fund. If withdrawals spread to other money market funds, it would open a new front in the crisis.

Money market funds, which are regulated by the SEC, are mutual funds that generally invest in very safe and liquid assets, like short-term Treasury securities and highly rated commercial paper. They mimic bank accounts by allowing check-writing and by fixing the price of a share at $1—meaning investors could reasonably expect to suffer no losses. Many individual investors kept some cash in money funds, usually in connection with a broader brokerage account. Institutions, including corporations, municipal governments, and pension funds, also found money funds to be a convenient place to park their cash.

The Reserve Primary Fund—which was managed by Reserve Management, the company that opened the first money market fund in 1971—took more risks than many, which allowed it to pay higher returns on average. The higher returns attracted investors, and the fund grew rapidly. However, as we would learn, the Reserve Primary Fund had invested about $785 million in Lehman’s commercial paper. With that commercial paper now essentially worthless, the Reserve Primary Fund’s assets were now worth less than $1 per share. In the jargon of Wall Street, it had “broken the buck,” the first mutual fund to do so in fourteen years. Hoping to escape before the Reserve Primary Fund’s managers decided to halt withdrawals at the fixed price of $1 per share, investors had started pulling out their cash, and a run on the fund had begun. About $40 billion would be withdrawn by the end of the day on Tuesday, almost two-thirds of the fund’s value. In subsequent days the run would spread to other money market funds, threatening the stability of the entire industry and endangering the cash holdings of households, corporations, and nonprofit organizations. And, with money flowing out of the funds, financial institutions and nonfinancial companies alike would have difficulty selling the commercial paper they depended upon to meet payrolls and finance inventories.

But these concerns, as serious as they were, were not the greatest that we faced that day. “Of course, we have the issue of AIG,” Bill continued. AIG, although not a bank, was also experiencing something like a run. Lenders and other counterparties were increasingly reluctant to deal with it, and the firms that had purchased AIG insurance on their collateralized debt obligations were demanding more cash as a guarantee that AIG would make good on its commitments. The race was on to find a solution, but neither Bill nor I had anything concrete yet to report.

With time very short, the rest of the meeting was compressed. Many participants saw signs of further slowing in the economy and saw inflation concerns as a bit reduced. I reiterated my view that we were probably already in a recession. At the end of the discussion we modified our planned statement to note

market developments but also agreed, unanimously, to leave the federal funds rate unchanged at 2 percent. In retrospect, that decision was certainly a mistake. Part of the reason for our choice was lack of time

—lack of time in the meeting itself, and insufficient time to judge the effects of Lehman’s collapse. Don and I had worked hard the previous week to achieve a consensus for the relatively neutral course of no change in our target interest rate, which seemed the right decision given what we knew then. In a shortened meeting, trying to change that outcome could have provoked a contentious split. There was also substantial sentiment at the meeting in favor of holding our fire until we had a better sense of how the Lehman situation would play out. Consequently, I did not push to cut rates, even though some financial market players expected that we might.

AS WE DISCUSSED monetary policy in Washington, Geithner and his team in New York rushed to draft terms for lending AIG the cash—now up to $85 billion—necessary to avoid its imminent failure. Unlike Lehman, AIG appeared to have sufficiently valuable assets—namely, its domestic and foreign insurance subsidiaries, plus other financial services companies—to serve as collateral and to meet the legal requirement that the loan be “secured to the satisfaction” of the lending Reserve Bank. Still, in lending to AIG we would be crossing a new line, and not only because AIG was an insurance company. Unlike every other loan the Fed made during the crisis, the collateral would not be loans or securities but the going-concern value of specific businesses. AIG’s collateral was thus harder to value or sell than the collateral we normally accepted, and the protection it afforded was reduced by the fact that, if the AIG holding company failed, its subsidiaries serving as collateral would also lose substantial value. But we didn’t see an alternative. The marketable securities available to AIG were not nearly sufficient to collateralize the size of the loan it needed.

Geithner’s proposed terms for the loan—which drew heavily on the work of bankers he had asked to explore options for private financing for AIG—included a floating interest rate starting at about 11.5 percent. AIG would also be required to give the government an ownership share of almost 80 percent of the company.

Tough terms were appropriate. Given our relative unfamiliarity with the company, the difficulty of valuing AIG FP’s complex derivatives positions, and the extreme conditions we were seeing in financial markets, lending such a large amount inevitably entailed significant risk. Evidently, it was risk that no private-sector firm had been willing to undertake. Taxpayers deserved adequate compensation for bearing that risk. In particular, the requirement that AIG cede a substantial part of its ownership was intended to ensure that taxpayers shared in the gains if the company recovered.

Equally important, tough terms helped address the unfairness inherent in aiding AIG and not other firms, while also serving to mitigate the moral hazard arising from the bailout. If executives at similarly situated firms believed they would get easy terms in a government bailout, they would have little incentive to raise capital, reduce risk, or accept market offers for their assets or their company. The Fed

and Treasury had pushed for tough terms for the shareholders of Bear Stearns and Fannie and Freddie for precisely these reasons. The political backlash would be intense no matter what we did, but we needed to show that we got taxpayers the best possible deal and had minimized the windfall that the bailout gave to AIG and its shareholders.

My job was to help sell the deal to official Washington, insofar as that was possible. The first and most important sale would be to my own Board. I had briefed the Board members on AIG and the work at the New York Fed during a break in the FOMC meeting, and when the FOMC meeting ended, a Board meeting commenced—first in my office, then, as the Reserve Bank presidents headed for their planes, in the boardroom. By the time the meeting had moved to the boardroom, we had received copies of Geithner’s proposed set of terms, and Tim had joined the meeting by phone.

A critical question was whether the proposed $85 billion line of credit would in fact save the company. For us, the ultimate disaster would be to lend such an enormous amount and then see the company collapse. We didn’t know for sure, but, based on both outside and internal reviews, we believed AIG as a whole was likely viable even though it lacked the cash to meet immediate demands. AIG FP was like a hedge fund sitting on top of a giant insurance company, and it, along with the securities lending operation, was the principal source of AIG’s cash drain. If AIG FP had been a stand-alone company there would have been no hope. But the insurance subsidiaries and other businesses owned by AIG were for the most part healthy, as far as we could tell, and their value potentially offered the necessary collateral to secure our loan.

There was some circularity here: If the loan to AIG helped stabilize financial markets, then AIG’s companies and assets would likely retain enough value to help repay the loan over time. But if financial conditions went from bad to worse, driving the economy deeper into recession, then the value of AIG’s assets would suffer as well. And, in that case, all bets on being repaid would be off. We had to count on achieving the better outcome.

We also considered whether we could let AIG go and hope financial markets would stabilize anyway. With the markets reeling from Lehman’s failure, the answer was obvious, at least to me. AIG was about the size of Lehman and Bear Stearns combined and, like those firms, deeply interconnected with the global financial system. Its failure would create chaos in so many ways: by raising doubts about the solvency of its creditors and derivative counterparties, which in many cases were critical financial institutions; by imposing losses on holders of its commercial paper (losses on Lehman’s commercial paper had already triggered the run on money market funds); and by draining available cash from state funds set up to protect customers of failing insurance companies. (In some cases, state guarantee funds relied on after-the-fact assessments of the industry, so the cash would have to come directly from other insurance companies.) The drain on state insurance funds, together with the likely seizure of AIG’s insurance subsidiaries by state regulators if AIG declared bankruptcy, would in turn reduce confidence in the rest of the insurance industry. We might see a wave of policy redemptions and a funding crunch for

other insurance companies. AIG’s many other financial activities included insuring popular investment products in retirement plans. A rapid sell-off of AIG’s assets would also cause stock and bond prices to fall further, pushing more companies toward insolvency. And doubtless there were consequences we hadn’t even considered yet.

I saw no alternative to the loan, conditional on the AIG board’s accepting our terms. All five Fed Board members voted to approve it, fulfilling the requirement to invoke 13(3). The minutes of the meeting summarized our rationale, albeit blandly, given the circumstances: “Board members agreed that the disorderly failure of AIG was likely to have a systemic effect on financial markets that were already experiencing a significant level of fragility and that the best alternative available was to lend to AIG to assist in meeting its obligations in an orderly manner as they came due. Board members also agreed that the terms of the loan should protect the interests of the U.S. government and the taxpayers.”

The next stop on that seemingly endless Tuesday, September 16, was a 3:30 p.m. meeting at the White House, where Paulson and I had previously arranged to update the president on the general state of the markets. We had even more to talk about than we had expected. Also attending were Vice President Cheney; Chris Cox of the SEC; Walt Lukken of the Commodity Futures Trading Commission; Erik Sirri, a senior SEC staff member; and various Treasury and White House officials, including the president’s chief of staff, Josh Bolten, formerly the director of the Office of Management and Budget; my successor as chair of the Council of Economic Advisers, Eddie Lazear; and the current budget director, Jim Nussle. We made our presentation to a hushed room. After asking a few questions, the president said that we should do what was necessary, and that he would try to provide political support. He suggested that we talk to Congress as well.

We agreed, and at 6:30 p.m. Paulson and I met with the congressional leaders, including Senate majority leader Harry Reid, House minority leader John Boehner, and Senate Banking Committee chairman Chris Dodd. Judd Gregg, the senior Republican on the Senate Budget Committee, arrived in a tuxedo without a tie. House Financial Services Committee chairman Barney Frank wore a rumpled shirt with the tail hanging out. Everyone stood. The room was so small it lacked a table and chairs.

Paulson and I briefly explained the situation and again took questions. I don’t recall any of the legislators disputing the need to intervene. Barney Frank wanted to know where the Fed was going to get the $85 billion to lend to AIG. I didn’t think this was the time to explain the mechanics of creating bank reserves. I said, “We have $800 billion,” referring to the pre-crisis size of the Fed’s balance sheet. Barney looked stunned. He didn’t see why the Fed should have that kind of money at its disposal. I explained that the Fed, under 13(3), had the authority to make loans as necessary to stem financial crises; and that was precisely what we were trying to do.

We would be doing it on our own responsibility, as Harry Reid would make clear. I believe that most of the attendees understood why we had little choice. But we could expect little if any public support from Congress.

BETWEEN MEETINGS I was briefed several times on developments in New York. Willumstad had presented Geithner’s terms, now approved by the Fed Board, to his own board. In the course of the discussions, Hank had also told Willumstad that he would be replaced by Ed Liddy, who had served as president of Allstate from 1999 to 2005. I doubt Willumstad could have done a great deal more to avoid AIG’s problems, given his short tenure. But we believed that the magnitude of AIG’s debacle demanded new leadership. Willumstad accepted the decision without protest.

AIG board members reacted to Geithner’s terms with dismay. They shouldn’t have been surprised, given the terrible situation that the company had created for itself, for the Fed, and, most importantly, for the U.S. financial system and economy. “We are faced with two bad choices,” Willumstad reportedly told his board. “File for bankruptcy tomorrow morning or take the Fed’s deal tonight.” The board asked Geithner if the terms could be negotiated. Tim said no—that he was prepared to let AIG go if it rejected the terms. I strongly supported Tim’s position and told him so; we had gone as far as we could go, and the terms being offered were completely reasonable, given the circumstances. Still, I admired Tim’s poker player cool. We all knew how important it was to prevent AIG’s collapse.

Just before 8:00 p.m., Tim’s deadline, Willumstad phoned to tell him the deal would be accepted. Tim called to let me know. All that was needed now was to put out the press release. Before reviewing it with Michelle Smith, I thought once more about what we were doing. Things had been moving so fast, with little time for careful reflection. But I concluded that there was no choice. By 9:00 p.m., the news of our rescue was moving on financial news services.

NO ONE (INCLUDING ME) felt much sympathy for AIG. It got itself into trouble. Congress, which had shown little ability to agree on any subject, soon united in virulent opposition to this bailout. In the months that followed I would testify many times before angry legislators trying to explain why we had to do what we did. Congress, of course, was only reflecting American public opinion.

Date: 2016-04-22; view: 757