I offer 50. You demand 100. Let's compromise on 100

A.I.G. basically offered the world the following deal: “Anyone who gives us a dollar today will receive $500 if the economy weakens.” Financial institutions around the world tripped over themselves racing to make such a great bet.

Once A.I.G.’s mountain of incredibly stupid bets failed in 2008, A.I.G. was bankrupt and owed other financial institutions hundreds of billions of dollars it could not pay.

Normally, unpayable private debt is resolved by partially paying off creditors (often via bankruptcy). Generally, the debtor and the creditor will sit down and reach an agreement by which the debtor promises to pay a fraction of what it owes and the creditor agrees to accept that amount as full payment. If the parties cannot agree, then the courts — often the bankruptcy courts — will impose a settlement by which creditors each receive some fraction of whatever they are owed.

But as I explained in March in “If I owe you $10K, I’m in trouble; if AIG owes you $400 billion, taxpayers are screwed”, the Federal Reserve basically said, “Don’t worry, A.I.G. We’ll pay off your debts for you.”

By dangling the prospect of paying off A.I.G.’s private debts, the Fed possessed incredible bargaining power. If A.I.G.’s creditors refused to accept partial payment from the Fed, the Fed was under no obligation to pay them a penny.

The Fed asked major bank creditors to suggest settlement terms: 50 cents on the dollar; 60 cents on the dollar; 70 cents; whatever.

We now know that seven of the eight banks offered to “settle” for 100 cents on the dollar! The eighth bank — UBS — offered 98 cents on the dollar!

So the Fed decided to “compromise” by giving banks 100 cents on the dollar!

The key problem: “The Fed ‘refused to use its considerable leverage,’ [wrote] Neil M. Barofsky, the special inspector general for the Troubled Asset Relief Program” because “The banks and the regulator were confident that the New York Fed was not willing to push A.I.G. into bankruptcy.”

The insane refusal of the Fed and the government to let bankrupt financial institutions declare bankruptcy has cost Americans trillions of dollars. And the number will rise as some of these zombie firms take on excessive “heads-we-win-tails-taxpayers-lose” risks.

Posted by James on Tuesday, November 17, 2009