Bailouts Revisited: Who Got Rescued and Who Got Screwed?

Bank of America got bailed out, but Lehman Brothers was allowed to fail. The insurance company American International Group (AIG) was rescued, but in July federal authorities refused to bail out a significant lender to small and medium-sized businesses, the CIT Group (not to be confused with Citigroup, which did get bailed out).

What is the logic behind these decisions? Who is being bailed out—and who should be? The AIG story offers an instructive case study, one that sheds light on these and other questions.

Last September, the Federal Reserve Board announced that it was lending AIG up to $85 billion to prevent the firm’s collapse. Unless it bailed out AIG, the Fed warned, financial markets could panic, loans could become more difficult to get, and many more businesses, jobs, and homes could be lost. To counter public anger over the bailout, the Fed argued that the ultimate beneficiaries would be the American people.

Citing proprietary information, AIG initially released few details about how it paid out the money it received. But this March, AIG’s plan to pay $165 million in bonuses to employees at its Financial Products unit hit the headlines. An angry firestorm erupted: why should public bailout money be used to pay excessive bonuses to the very people who had caused the problem? U.S. officials and AIG CEO Edward Liddy denounced the payments as outrageous, but claimed they could not rescind the bonuses because they were bound by legal contracts. As it turned out, many AIG employees returned the bonuses voluntarily. And in a rare display of bipartisanship, the House of Representatives voted 328 to 93 to enact a 90% tax on bonuses paid to executives at companies that had received at least $5 billion in bailout money.

But the AIG bailout involved billions of dollars. The Financial Products employees only got millions. Who got the rest of the money? Under mounting public pressure, and after consulting with the Federal Reserve, AIG finally revealed who the beneficiaries were.

It’s the Banks!

Yes, the money went primarily to large banks, those same banks that took their own large risks in the mortgage and derivatives markets and that are already receiving billions of dollars in federal bailout money. The banks are using AIG’s bailout money to avoid taking losses on their contracts with the company.

Why did AIG, an insurance company, have such extensive dealings with the large banks, and why did those transactions cause so much trouble for AIG?

The story begins with AIG’s London-based Financial Products unit, which issued a large volume of derivatives contracts known as credit default swaps (CDSs). These were essentially insurance contracts that provided for payments to their purchasers (known as “counterparties”) in the event of losses on collateralized debt obligations (CDOs), another kind of derivative. Many of the CDOs were based in complicated ways on payments on home mortgages. When the speculative housing bubble popped, mortgages could not be repaid, the CDOs lost value, and AIG was liable for payment on its CDSs.

By September 2008, AIG’s situation had deteriorated to the point where its credit ratings were downgraded; this meant the company was required to post collateral on its CDS contracts, i.e., to make billions of dollars in cash payments to its counterparties to provide some protection for them against possible future losses. Despite its more than $1 trillion in assets, AIG did not have the cash. Without assistance it would have had to declare bankruptcy. After attempts to get the funding from private parties, including Goldman Sachs and JPMorgan Chase, failed, the Federal Reserve stepped in. The initial $85 billion credit line was followed by an additional $52.5 billion in credit two months later. By March 2009 the Treasury had invested $70 billion directly in the company, after which the Fed cut back its initial credit line to $25 billion.