The Needless Rescue of AIG and Wall Street
n the second decade of the twenty-first century, america is faltering under the weight of a dual crisis. Its public sector teeters on the ragged edge of political dysfunction and fiscal collapse. At the same time, its private enterprise foundation has morphed into a speculative casino which swindles the masses and enriches the few. These lamentable conditions are the Janus-faces of crony capitalism—a mutant régime which now threatens to cripple the nation’s bedrock institutions of political democracy and the free market economy.
A decisive tipping point in the evolution of American capitalism and de- mocracy—the triumph of crony capitalism—took place on October 3, 2008. That was the day of the forced march approval on Capitol Hill of the
$700 billion TARP (Troubled Asset Relief Program) bill to bail out Wall Street. This spasm of financial market intervention, including multitrillion- dollar support lines provided to the big banks and financial companies by the Federal Reserve, was but the latest brick in the foundation of a funda- mentally anti-capitalist régime known as “Too Big to Fail” (TBTF). It had been under construction for many decades, but now there was no turning back. The Wall Street bailouts of 2008 shattered what little remained of the old-time fiscal rules.
There was no longer any pretense that the free market should determine winners and losers and that tapping the public treasury requires proof of compelling societal benefit. Not when AAA-rated General Electric had been given $30 billion in taxpayer loans and guarantees to avoid taking modest losses on toxic assets it had foolishly funded with overnight borrowings that suddenly couldn’t be rolled over.
Even more improbably, Goldman Sachs had been handed $10 billion to save itself from alleged extinction. Yet it then swiveled on a dime and gener- ated a $29 billion financial surplus—$16 billion in salary and bonuses on top of $13 billion in net income—for the year that began just three months later.
Even if Goldman didn’t really need the money, as it later claimed, a round trip from purported rags to evident riches in fifteen months stretched the bounds of credulity. It was reminiscent of actor Gary Cooper’s immortal 1950s expression of suspicion about Communism. “From what I have heard about it,” he told a congressional committee, “it isn’t on the level.”
Nor was Washington’s panicked bailout of Wall Street on the level; it was both unnecessary and targeted at the wrong problem. The so-called finan- cial meltdown was not the real crisis; it was only the tip of the iceberg, the leading edge of a more fundamental economic malady. In truth, the US economy was heading for the wringer because a multi-decade spree of un- sustainable borrowing, speculation, and financialization of the national economy was coming to an abrupt end.
In the years after 1980, America had undergone the equivalent of a na- tional leveraged buyout (LBO). It was now saddled with $30 trillion more in combined public and private debt than would have been the case under the time-tested canons of financial discipline and prudence which pre- vailed during the nation’s long economic ascent. This massive debt burden had fueled a three-decade prosperity party by mortgaging the nation’s fu- ture. Now the bill was coming due and our national simulacrum of pros- perity was over.
This rendezvous with the limits of “peak debt,” however, did not mean that the Main Street economy was in danger of collapse into an instant de- pression. That was the specious claim of the bailsters. What did threaten was a deeper and more enduring adversity. The demise of this thirty-year debt super cycle actually meant that it was payback time. Instead of swip- ing growth from the future, the American economy would now face a long twilight of debt deflation and struggle to restore household, corporate, and public sector solvency.
This abrupt turn in the road should not have been surprising. America’s fantastic collective binging on debt, public and private, had no historical precedent. During the century prior to 1980, for example, total public and private debt on US balance sheets rarely exceeded 1.6 times GDP. When the national borrowing spree reached its apogee in 2007, however, the $4 tril- lion of new debt issued by households, business, banks, and governments amounted to 6 times that year’s $700 billion gain in GDP. Plain and simple, what was being recorded as GDP growth was little more than faux prosper- ity borrowed from the future.
In fact, by the time of the financial crisis total US debt outstanding was $52 trillion and represented 3.6 times national income of $14 trillion. Ac- cordingly, there were now two full turns of extra debt weighing on the nation’s economy. And the embedded math was forbidding: at the historic leverage ratio of 1.6 times national income, which had prevailed for most of the hundred years prior to 1980, total US public and private debt would have been only $22 trillion at the end of 2008.
So the nation’s households, businesses, and taxpayers were now lugging around the aforementioned $30 trillion in excess debt. This staggering financial burden dwarfed levels which had historically been proven to be healthy, prudent, and sustainable. TARP and all its kindred bailouts and the Fed’s ceaseless money printing could not relieve it. And Washington’s reckless use of Uncle Sam’s credit card to fund the Obama stimulus actually made it far worse by attempting to revive the false prosperity of the bubble years. The obvious question remains: Why did this plague of debt arise? Did the American people suddenly become profligate and greedy through a mysterious process of moral and social decay?
There is no evidence for the greed disease theory but plenty of reason to suspect a more foreboding cause. The real reason for the current crisis of debt and financial disorder is that public policy had veered into the ditch, permitting an unprecedented aggrandizement of the state and its central banking branch. In the process, the vital nerve center of capitalism, its money and capital markets, had been perverted and deformed. Wall Street has become a vast casino where leveraged speculation and rent seeking have displaced its vital function of price discovery and capital allocation.
The September 2008 financial crisis, therefore, was about the need to drastically deflate the Wall Street behemoths—that is, dangerous and unstable gambling houses—fostered by decades of money printing and market rigging by the Fed. Yet policy veered in the opposite direction, propping them up and thereby perpetuating their baleful effects, owing to a predicate that was dead wrong.
A handful of panic-stricken top officials, led by treasury secretary Hank Paulson and Fed chairman Ben Bernanke, proclaimed that the financial system had been stricken by a deadly “contagion” that had come out of nowhere and threatened a chain reaction of financial failures that would end in cataclysm. That proposition was completely false, but it gave rise to a fateful injunction—namely, that all the normal rules of free market capitalism and fiscal prudence needed to be suspended so that unprecedented and unlimited public resources could be poured into the rescue of Wall Street’s floundering behemoths.
AIG WAS SAFE ENOUGH TO FAIL
As it happened, Washington drew the red line at AIG the day after the Lehman failure. Yet the relevant facts show that an AIG bankruptcy would not have started a chain reaction—that there never was a financial dooms- day lurking around the corner. In fact, none of the bailouts were necessary because the meltdown was strictly a matter confined to the canyons of Wall Street. It would have burned out there on its own had Washington allowed the free market to have its way with a handful of insolvent institutions that needed to be taken out: Morgan Stanley, Goldman, and Citigroup, among others.
In short, the financial “contagion” predicate, which triggered the bailout madness of the Bush White House and the Bernanke Fed, had no basis in fact. And the proof starts with AIG, the bailout poster child itself, and the alleged catalyst for the purported chain reaction. The plain fact of the mat- ter is that AIG was structurally incapable of starting a contagion. Any mod- est hit to the balance sheets of a handful of its huge, global banking customers owing to the collapse of its bogus credit default insurance (CDS) would have caused a healthy purge of busted assets. At the same time, its millions of insurance policy holders were never in harms’ way; they were always a pretext to obfuscate the real purposes of the Washington bailsters. At the time of the crisis, 90 percent of AIG was solvent and no danger to the financial system or anyone else. Its $800 billion balance sheet consisted mostly of high-grade stocks and bonds that were domiciled in a manner which utterly invalidated the “contagion” theory. Indeed, this giant asset total was a statistical artifact of AIG’s consolidated financial statements: its massive horde of high-grade assets was actually parceled out into scores of insurance subsidiaries subject to legal and regulatory jurisdictions scat- tered all over the globe. Those lockups both protected policyholders and ensured that there would be no massive asset-dumping campaign by AIG,
the presumptive catalyst for the contagion.
So the crisis did not implicate AIG’s vast assets. It was actually all about its hemorrhaging CDS liabilities—which could have been easily ring fenced. They were domiciled exclusively in AIG’s holding company and accounted for less than 10 percent of its consolidated liabilities. These obligations could have been readily liquidated in bankruptcy without any disruption to the insurance companies, their solid assets, or their policyholders.
Nevertheless, AIG was handed a massive and wholly unwarranted taxpayer-funded infusion that ultimately totaled $180 billion. Hank Paul- son, the most destructive unguided missile ever to rain down on the free market from the third floor of the US Treasury Building, later claimed, “If AIG went down, we faced real disaster. More than almost any financial firm I could think of, AIG was entwined in every part of the global system, touching businesses and consumers alike.”
That was balderdash and subterfuge. A “global” firm by definition has a global footprint in the same manner as a zebra has stripes. But that obvious factoid doesn’t prove that free market exchange is a transmitter of commu- nicable economic disease, which was what Paulson and his fellow bailsters constantly implied. In fact, the unjustified largesse granted to AIG was not designed to inoculate the masses from harm, but to save the bacon of a few dozen speculators.
The paper trail uncovered by congressional investigators shows that the
$400 billion (notational value) of busted CDS insurance issued by the AIG holding company was held by a very small number of the world’s largest fi- nancial institutions, and virtually none of it was held by the banks of Main Street America which were allegedly being shielded from AIG’s imminent collapse. Moreover, the worst-case loss faced by the dozen or so giant in- stitutions actually exposed to an AIG bankruptcy would have amounted to no more than a few months’ bonus accrual.
Yet there is not a shred of evidence that the panic-stricken amateurs sur- rounding Paulson ever investigated which institutions held the CDS con- tracts or their capacity for absorbing losses. Instead, in one of the most egregious derelictions of duty every recorded, Paulson and his posse of Goldmanite hotshots hastily and blindly shielded these behemoths from even a dollar of loss on their AIG insurance policies.
As the congressional investigators later determined, AIG’s big-bank cus- tomers were actually supplied cash from a multitude of bailout spigots that aggregated to truly stunning magnitudes. This evidence also shows that each and every recipient institution had the balance sheet capacity to ab- sorb the AIG hit, so the bailout was all about protecting short-term earn- ings and current-year executive and trader bonuses. That is the shocking truth of what the AIG bailout actually accomplished. Saddling innocent taxpayers with business enterprise losses generated on the free market is always an inappropriate exercise of state power, but shattering policy rules and precedent in order to vouchsafe the bonuses of a few thousand bankers is beyond the pale.
Not surprisingly, Goldman Sachs was the largest beneficiary of taxpayer largesse and was paid out nearly $19 billion on its various claims against AIG. But many of the other financial behemoths were not far behind, with a total of $17 billion going to France’s second largest bank, Société Générale, while $15 billion was transferred to Deutsche Bank, $14 billion to Bank of America and Merrill Lynch, and nearly $10 billion to London- based Barclays, which also got the corpse of Lehman as a consolation prize.
8 | THE GREAT DEFORMATION
It goes without saying that given the enormous balance sheet girth of these institutions—all of them were greater than $1 trillion in size—the amount of losses could have easily been absorbed without help from the taxpayers. In the case of Goldman, the largest recipient, the taxpayer funds amounted to less than eight months of profit and bonus accruals during the very next year.
In fact, at the time of the crisis the dozen or so giant international banks that got the AIG bailout money had $20 trillion in assets among them. By contrast, even in a worst-case outcome in which the banks lost eighty cents on the dollar for the mostly AAA paper (i.e., “super-senior”) insured by AIG, their collective exposure to losses amounted to $80 billion at most.
Washington thus threw stupendous sums of money at AIG in a craven, discombobulated panic, yet these subventions amounted to just 0.5 per- cent of the elephantine balance sheets of its big global bank customers.
The September 2008 bailouts thus represented an outbreak of madness at the very top of the political system. The crisis was defined by the Paulson-Bernanke cabal in such Armageddon-like terms that all checks and balances disappeared. Every one of Washington’s lesser players, in- cluding the president and the congressional leadership, stood down in the face of an immense urban legend that had materialized, as if out of whole cloth, in a matter of hours after the Lehman bankruptcy filing.
Panic-stricken Fed and Treasury officials had issued a financial ukase; namely, that an AIG bankruptcy had to be prevented at all hazards because it would bring the entire financial system tumbling down. Never in the in- glorious history of Washington’s financial misdeeds has such a large propo- sition been based on such a threadbare predicate.
The pretentious young men flitting around Secretary Hank Paulson, who was temperamentally unfit for the job and had by then seemingly come unglued, apparently did not even bother to review AIG’s publicly filed financials. If they had they would have seen that its mammoth bal- ance sheet resembled nothing so much as a clam shell. The lower half of the shell was comprised of dozens of major insurance subsidiaries and was asset rich with the previously mentioned $800 billion of mostly high- quality stocks, bonds, and other investments. They would have also recog- nized that the liabilities of these insurance subsidiaries were of the slow and sticky variety, consisting mainly of the current and future claims of its life, property, and casualty policyholders.
Unlike bank deposits, these insurance liabilities could not be subject to a panic “run” by retail policyholders. Instead, they would come due over years, and even decades, as eligible loss claims matured. So if they had
PAULSON’S FOLLY | 9
done even a modicum of homework, they would have recognized that the balance sheet foundation of AIG was stable and was neither exposed to “contagion” nor a transmitter of it.
Had they sought out competent legal advice, they would have also dis- covered that in the event the parent company filed for bankruptcy, the dozens of solvent AIG insurance subsidiaries would have been pounced upon and, if necessary, legally sequestered by their regulators in the states and foreign jurisdictions where they were domiciled. These protective ac- tions, in turn, would have paved the way for policyholders of these quar- antined units to satisfy their claims in the normal course or through an orderly judicial process.
Furthermore, had they consulted knowledgeable Wall Street analysts they would have been quickly disabused of the simple-minded notion that an AIG corporate failure would trigger a global contagion. At the practical operating level, AIG was not remotely the globe-spanning octopus about which Paulson regaled frightened congressmen. Despite Hank Greenberg’s fifty years of empire building, AIG was actually a late bull market concoc- tion, a jerry-built monument to the economically senseless takeover arbi- trage which emanated from the stock market bubble the Greenspan Fed had fueled in the late 1990s.
With a high-flying PE multiple of 35 times earnings, AIG had engineered a flurry of takeovers by swapping its high-value paper for the stock of its targets, which generally sported more earthbound valuations. Accordingly, between 1998 and 2001 AIG had acquired a string of large life and casualty insurers including Western National, SunAmerica, Hartford Steam Boiler, and American General. Just these four takeovers were valued at a com- bined $45 billion and helped boost AIG’s total assets by $140 billion to nearly $450 billion over this three-year period.
The giant catch-22 embedded in this spasm of bubble-era financial en- gineering, however, was entirely lost on the rampaging posse on the third floor of the Treasury Building: namely, that AIG was a glorified insurance industry mutual fund. It had grown to giant size by acquisitions and invest- ments, but it did not have automatic access to the assets sequestered in its far-flung subsidiaries.
Yes, SunAmerica alone had millions of retirement annuity customers, American General had billions of life insurance outstanding, and Hartford Steam Boiler provided fire and accident protection to a significant share of the industrial facilities in the nation. From AIG’s small New York City head- quarters, Greenberg and his successors could control business plans, staffing, executive compensation, underwriting standards, and much else.
But they could not extract cash or capital from any of these insurance sub- sidiaries without complying with state insurance commission rules de- signed to protect policyholders and ensure solvency.
Hank Paulson was running around Washington with his hair on fire, but contrary to the message he repeated over and over to purposely petrify congressmen his true mission was not to save middle-American annui- tants and retirees; they were already being protected by insurance regula- tors from Connecticut to California. Instead, this alleged threat to millions of policyholders was a beard—behind which stood the handful of giant fi- nancial institutions which had purchased what amounted to wagering in- surance from the AIG holding company.
To be sure, AIG’s giant financial customers like Bank of America or So- ciété Générale had not reached their tremendous girth due to their prowess as legitimate free market enterprises. They were lumbering wards of the state and, as will be seen, products of the cheap debt, moral hazard, and serial speculative bubbles being fostered by the Fed and other central banks. Not surprisingly, therefore, they were now desperately petitioning the treasury secretary for help in collecting their gambling debts from AIG. Needless to say, Paulson did not hesitate to throw the weight of the pub- lic purse into the arena on behalf of these gamblers, because it resulted in an immediate boost to the stock price of Goldman Sachs and the remnants of Wall Street. Hank Paulson thus desecrated the rules of the free market, and for the most deplorable of reasons: namely, to make Goldman, Deutsche Bank, and the rest of the banking giants whole on gambling claims which had been incurred to carry out an end run around regulatory
standards in the first place.
As previously indicated, all of the CDS gambling debts in question had been incurred at the holding company, which is to say, in the “upstairs” half of the AIG claim shell. The holding company was essentially bereft of liquidity because its assets, while massive, consisted almost entirely of the illiquid private stock of the endless string of insurance subsidiaries AIG had acquired or created over decades. And the not so secret reality was that in- variably insurance regulators had imposed protective barriers, or “dividend stoppers,” to protect policyholders from capital depletion by parent- company stockholders.
This meant that in the event of a bankruptcy there would be no raid on the insurance company assets to satisfy holding company liabilities. It also meant there would be no contagion—that is, the AIG holding company was in no position to engage in a fire sale of insurance subsidiary assets in order to satisfy the margin calls and loss claims against the CDS policies issued by the holding company. The insureds—the giant global banks—would have been flat-out stiffed and have faced severe losses on the value of their CDS contracts. That would have been the end of the matter: an honest resolution under law and the rules of the free market.
The key to free market justice in this instance was the “dividend stop- pers,” and I had learned the everlasting truth about them during my days doing LBOs at Blackstone in the 1990s. We had come close to buying a state-regulated property and casualty (P&C) insurance company, and our plan for hitting the jackpot was to do, oddly enough, the very thing which proves there was no need to bail out AIG in September 2008. We intended to buy the target P&C insurer through an unregulated (“upstairs”) holding company funded with 80 percent debt, and then strip-mine cash from the insurance subsidiary.
Stated more politely, the insurance company profits would be “up- streamed” as dividends to pay interest on the holding company debt. After collecting a generous return on the small amount of equity we had in- vested in the holding company, we would flip the insurance company stock to a new investor—perhaps even an insurance conglomerate like AIG—and thereby close out what promised to be a highly lucrative deal.
On the way to this easy money, however, Blackstone’s pertinacious co- founder, Steve Schwarzman, became worried that an unfriendly state in- surance commission could shaft us by forbidding payment of dividends in the name of “conserving assets” for the benefit of policyholders. That risk became the infamous “dividend stoppers” in our internal deliberations, and after much digging and expert advice to find a way around it, Schwarz- man finally threw in the towel, pronouncing that it wasn’t “safe” to plant a leveraged holding company atop a state-regulated insurance company.
Upon learning of the AIG bailout fifteen years later the salience of that episode was unmistakable. By then Steve Schwarzman was a billionaire LBO king and proven Midas. So if even he hadn’t been able to find a way to get insurance company cash past a “dividend stopper,” then it couldn’t be done at all. In fact, AIG’s holding company was massively leveraged, by way of its margin obligations under the CDS contracts, and it was now bankrupt just as Schwarzman had feared, leaving the punters who bought $400 billion of its worthless CDS insurance contracts high and dry.