Wednesday, November 18, 2009

The View from the Ivory Tower

Paul Krugman disagrees with my "legal argument" on the AIG counterparties issue because, according to Krugman, "Wall Street doesn’t work like that, and never has." Oh Paul, won't you please tell us more about how Wall Street works? Seriously though, I'm flattered that Krugman, who's practically a hero of mine, actually read my post. Unfortunately, his vast Wall Street experience fails him. The AIG counterparty negotiations were completely different from the LTCM rescue, because when the banks were negotiating the LTCM rescue, the Fed hadn't already signaled that it wasn't willing to let LTCM fail. When the NY Fed was negotiating with the AIG counterparties, it had already bailed AIG out, and had told the entire world that it wasn't willing to let AIG fail. With LTCM, the Fed could use the threat of bankruptcy to force the banks to agree to a rescue. That simply wasn't the case with the AIG counterparty negotiations, because the Fed couldn't credibly commit to putting AIG in bankruptcy. That's a fundamental, elephant-in-the-room -like difference. Another huge difference is that the AIG counterparty negotiations weren't about saving the system from meltdown. They were purely distributional—this was about justice, not the stability of the financial system. In all of Krugman's examples, the Wall Street firms were better off if they cooperated to save the system. In the AIG situation, there was absolutely no benefit to collective action. None. Finally, Krugman points to TED's speech as proof that the NY Fed could have negotiated haircuts. While TED's speech was admittedly inspiring, and had me reaching for my checkbook, there's one glaring problem: the speech was predicated on the NY Fed having the support of the French regulators, which, as the SIGTARP report makes clear, was not the case. From the SIGTARP report:

The Commission Bancaire spoke again with FRBNY and forcefully asserted that, under French law, absent an AIG bankruptcy, [SocGen and Calyon] could not voluntarily agree to less than par value for the underlying securities in exchange for terminating the swap contracts.
SocGen and Calyon, by the way, held over a third of the $62bn CDS book that AIG was trying to terminate. With SocGen and Calyon explicitly prohibited from agreeing to haircuts, the NY Fed's negotiations were DOA.


Anonymous said...

getting AIG to pony up ... "this was about justice ..."


The Epicurean Dealmaker said...

Damn French. They're always wrecking my hypotheticals.

If their country wasn't so beautiful, I'd suggest we pave the place and make it a parking lot for Germany.

Luis Enrique said...

well ... maybe. Are you so sure Krugman is wrong to say that a more aggressive Fed couldn't have banged some heads together and suggested that it was in the banks interests to voluntarily accept haircuts even though they didn't have to?

I accept it might be asking a lot to ask the Fed to risk playing tough in the middle of trying to prop up the banking system, but still.

Anonymous said...

This is exactly what I mean

For some totally irrational reason - they HATE Saddam Sach - they want to bail out AIG and then hold a bankruptcy

It's sheer idiocy

I've made this argument on the HuffPo about two dozen times, and the blood in their faces apparently has rendered them stupid

Barry said...

What it really came down to was the Goldman Sachs had prominent people in the US government, so G-S was negotiating with itself.

Which was pretty much the whole goal of the neoliberal, Federalist Society, Chicago School movement.

Anonymous said...

Your basic argument is that the Fed (which I'll use as shorthand to refer to all government entities involved) got screwed out of getting a deal because it did not have time to negotiate before it took over AIG. If it waited too long (possibly a day or two), it possibly would've been too late and the global economy would've crashed. So because they acted quickly, bankruptcy is now out of the option, and because AIG was resolved though government means instead of bankruptcy court, the banks get no haircuts. If the Fed had time, it most likely could have negotiated cuts with the banks.

So do you admit that there's something awfully wrong when the banks get away with receiving no haircuts (i.e., have no legal obligation to accept a haircut) only because the Fed did not have time? You might say that the banks would've called the Fed's bluff and assumed bankruptcy would never be used, and thus wouldn't have accepted haircuts. I'll get to that in a second, but let's say that's not an issue. Again, do you admit that there's something wrong with the Fed (and taxpayer) getting no haircuts only because time was of such an essence that they had to bail out AIG before they could negotiate deals?

Now, let's say that the banks would've called the Fed's bluff. So in short, if you have a situation where it's believable that the Fed won't bail out an institution because it will "only" cause a "tolerable" recession (arguenda, LTCM), then the banks will accept a haircut to prevent their own possible collapse. But if you have a situation where the lack of a bailout would cause a second Great Depression so the banks will succeed at calling the Fed's bluff, then the banks need not accept any haircuts and will still prevent their own possible collapse. Isn't there something completely wrong when the ability of the banks to get off with no haircuts is increased by the greater the likelihood that a non-bailout will result an economic collapse?

Perhaps your answer to all of this is, "It doesn't matter." They had no legal obligations to accept haircuts, and hence had a legal obligations to refuse haircuts, because of shareholder obligations. But maybe -- just maybe -- this is the one time (and really, the only one time) where a private company should do the "right" thing, particularly given that any or all of these banks could have collapsed absent the bailout (and even if the European banks couldn't have accepted a haircut). Or maybe this is the one time where it would have been OK for the Fed to "abuse" its authority (ends justify the means, or think of Big Ben as the Dirty Harry of the banking industry).

One last thing: I think it would be a great legal exercise (or law review article) to try to argue that the banks were legally required to accept haircuts under implied contract theories (e.g., you would've accepted a haircut if time allowed us to negotiate, you don't get the benefit now of not accepting a haircut just because time was of the essence). Not saying it would work, but it'd be interesting.

Anonymous said...

Barry, your argument does not fly

Goldman Sachs was owed the money fair and square

The whole world apparently thinks it would have been just peachy keen to steal it from them

Try to ask yourself why you think robbery is okay

Also, I think EoC means it was about justice from the perspective of the counter parties; from the perspective of the Treasury it was about saving the economy within the limits of the rule of law - justice

The advocates of screwing the counterparties have failed totally, a void in their hysterical need to screw Saddam Sachs "the evil doers" the size of the Great American Desert, to demonstrate how screwing the counterparties would have been beneficial (it would have been nonsensical):

"Whoops, we screwed Saddam Sach, YIPPEE, but now we're in a systemic crisis (OH NO!), and systemic disaster is on the doorstep - what do we do now?"

Errrr, loan Saddam Sachs around 100 billion in TARP, and the other counterparties around 300 billion in TARP

Anonymous said...

I thought your analysis was totally correct. Krugman's claim to evaluate it based on "how Wall Street works" was a joke.

Richard Smith said...

I think your argument proves too much; it doesn't necessarily help Geithner. The Fed isn't off the hook; it ends up impaled more firmly on a different one.

It's getting harder and harder to see why the Fed stepped in at all. Let's see. There's $60Bn of CDS at issue, of which:

GS's piece ($10Bn? $15Bn?, covered anyway by collateral calls and AIG CDS)

Calyon and SocGen: $20Bn

Deutsche,IIRC: $4Bn
Barclays, IIRC: $5Bn

That leaves a whole bunch of lesser counterparties to soak up $16-$21Bn. Risk distribution.

So where's the "systemic risk" gone? GS is in the clear, (assuming their counterparty risk on CDS written on AIG mysteriously disappears). Let the French wear their bit, if they're so keen. Then you have miscellaneous worldwide banks that will take hits and can be sorted out by their local authorities, FDIC, whatever.

All doable. But possibly only if you scoped the problem in advance and frightened all the interested parties a bit. Banking regulators do do that, sometimes (see LTCM).

A look at AIG's counterparty list a few months before the bust might have been a good idea. It's not as if no-one knew about AIG during early '08.

Anonymous said...

earnest question:

what were the legal issues involved in granting bank holding status overnight to two investment banks?

were shortcuts taken or no?

Anonymous said...

then the problem was that the govt / fed showed its cards too quickly. maybe they should have tried a LTCM / 1907 like huddle first before riding in with the white horse.

Anonymous said...

"then the problem was that the govt / fed showed its cards too quickly. maybe they should have tried a LTCM / 1907 like huddle first before riding in with the white horse. ..."

To what end?

You are yet another person who thinks there was something beneficial to forcing a haircut on the counter parties.

Think it all the way through.

AIG is a systemic threat because it can't pay its counter parties in full.

So, we have to save AIG.

There, that done, we need to not pay the counter parties in full??????

Sinking in yet? If that ain't the Keystone Cops of steer roping, this cowboy doesn't know what would be.

Is Geithner the only intelligent person left on the planet?

Everybody thinks the goal should have been to scr*w the counter parties. Why? Explain the benefit. And don't say it would have saved the taxpayer money because clearly it would not; instead, it would have made the exercise of stabilizing the markets far far far more expensive for the taxpayer.

Anonymous said...

i don't think it's screw the counterparties per se.

i think it's more like since these counterparties were made whole, they went on to make an insane amount of money. maybe we are owed something...

just making an observation, not saying who's right or who's wrong.

Brett said...

It's a real pity with Krugman. His tendency to make weak comments on subjects he's largely ignorant on is marring what he really is brilliant at - international trade (he won a Nobel Prize in Economics related to it).

Anonymous said...

> Everybody thinks the goal should have been to scr*w the counter parties. Why? Explain the benefit. And don't say it would have saved the taxpayer money because clearly it would not; instead, it would have made the exercise of stabilizing the markets far far far more expensive for the taxpayer.

it would clearly have saved taxpayer money. the govt is (very likely) to lose a lot of money on AIG.

at least govt could have traded the payout for warrants/stock in bailed out aigfp counterparties.

also govt could have avoided a bailout of non-aigfp businesses (and parent company obligations) saving tens of billions of dollars.

Anonymous said...

It's unlikely it would have saved the taxpayer money; in fact, it's likely it would have cost the taxpayer far more money.

Because it doesn't end there. You would have 16 severely weakened counter parties. You would have the dangerous repercussions of the chilling message just sent to the markets by the bailed-out AIG's default, and the uncertainty of all the litigation that would have followed.

And then the taxpayer would have gotten the bill for that mess.

In hindsight most outraged internet bloggers admit killing Lehman was a huge mistake. Had Geithner drilled down on the counter parties, they would be saying the same thing about that.

The Barofsky report is just incredibly superficial.

Anonymous said...

The "legalities" theme is nonsense for the reasons pointed out by TED. But the theme also is nonsense as to law. The government almost never has to play by the rules. Put down the structured finance papers and go to Westlaw or Findlaw. Search for cases seeking to estop the government in order to hold it to what it its agents said it would do. You will NOT find cases binding the government. To the contrary, myriad citizens have lost those cases. Goldman would not have done any better. The FED, etc all were free to disregard the past and do what needed to be done.

anne said...

What the SIGTARP report shows beyond a shadow of a doubt is that when the economy crashed into an iceberg last year, the bankers used all their might and power to ensure they got all the lifeboats.

Legally their right, perhaps. But "caving" into bankers' demands (as the WSJ recently characterized the AIG bailout) was not the best option for the country. Especially if "confidence" in our financial system is required to move out of crisis into growth.

Danny said...

Anne, care to point out where in the SIGTARP report it says that?

Anonymous said...

Yes, the deepfreeze into which forcing a crew cut on the counter parties would have sent the world economy would have gone a long way toward reenforcing confidence that there was going to be a systemic disaster.

That means a huge disaster.

People can try and claim forcing a haircut on the counter parties, a bankruptcy-type action, would have had some rejuvenating magical power all they want, it would not have. It would have sent the patient into a death spiral.

Because of what Geithner has done, in total, it's looking like we've had a minor great recession.

Anonymous said...

I think your quote of Paul Krugman was a bit unfair. Here is a larger excerpt.

"Yes, you can make the legal argument: the TARP isn’t a bankruptcy court, so the Feds had only two choices: let AIG go into bankruptcy, with possibly disastrous consequences, or pay up its contracts in full.

But Wall Street doesn’t work like that, and never has.

Big financial institutions are a small club, with a shared interest in sustaining the system. Ever since the days of JP Morgan it has been standard practice, in times of crisis, to get major players together in a room and get them to forgo short-term profit maximization on behalf of the industry interests. "

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