Fed's choices 'severely limited' savings on AIG

The Federal Reserve Bank of New York gave up efforts to save taxpayer money on American International Group Inc’s rescue after the insurer’s biggest trading partners refused to make concessions, said a Treasury watchdog.

The regulator made “limited efforts” over two days in November 2008 to negotiate discounts on $62.1 billion in protection from AIG clients including Societe Generale SA, Goldman Sachs Group Inc and Deutsche Bank AG, said Neil Barofsky, special inspector for the Troubled Asset Relief Program, in a report released on Monday.

The Fed “made several policy decisions that severely limited its ability to obtain concessions,” including telling the banks that participation in talks was voluntary, Barofsky said. The Fed also opted not to use its “considerable leverage” as regulator of some of AIG’s counterparties to force them to accept so-called haircuts, he said.

Banks received the full value on credit-default swaps purchased from New York-based AIG to protect against declines in mortgage-linked investments, prompting lawmakers including Representative Darrell Issa to call the insurer’s rescue a “backdoor bailout” for finance firms. AIG, once the world’s largest insurer, was saved last year with a package of loans and investments that has swelled to $182.3 billion.

The Fed’s “policy decisions came with a cost — they led directly to a negotiating strategy with the counterparties that even then-New York Fed President Geithner acknowledged had little likelihood of success,” Barofsky said.

Timothy Geithner, now Treasury Department secretary, led the New York Fed when it negotiated with the banks in November 2008. The Fed contacted eight of AIG’s biggest counterparties to ask for discounts, Barofsky said. Only Zurich-based UBS AG was willing to take a haircut, a 2 per cent discount, and that was under the condition other banks agreed to similar terms, Barofsky said. The Fed decided that all counterparties would receive full payment.

The French bank regulator, overseer for Societe Generale and Credit Agricole SA’s Calyon, “forcefully asserted” that the banks couldn’t accept less than full value on swaps unless AIG went bankrupt, Barofsky said. Because the Fed had already committed to preventing an AIG collapse, regulators had reduced leverage in negotiations, he said. Other counterparties included Merrill Lynch & Co, Barclays Plc and Bank of America Corp.

In a letter to Barofsky included in his report, the Fed said it “would not have been appropriate to use our supervisory authority on behalf of AIG to obtain concessions from domestic counterparties.” Doing so would have been a “misuse” of power that would have given an advantage to non-US banks, the Fed said.

The Fed weighed two other options for stanching the flow of cash caused by AIG’s swaps, which threatened to cause another ratings firm downgrade, Barofsky said. One included asking counterparties to cancel their swaps and selling the underlying assets for an investment in a vehicle that would assume ownership of the securities. Another would be to a Fed-backed vehicle to take over the protection offered by the swaps.

The first alternative was deemed too time consuming and the second made regulators uncomfortable because it would give them “long-term credit relationships with supervised institutions,” Barofsky said.