So it seemed only fair for them to bear part of the cost of the bailout, which they could have done by accepting a "haircut" on the amounts A.I.G. owed them.
Krugman is arguing that when the taxpayer assumed the liabilities, the Fed could have forced banks to accept something less than 100 cents on the dollar to settle the contracts.
So it seemed only fair for them to bear part of the cost of the bailout, which they could have done by accepting a "haircut" on the amounts A.I.G. owed them. Indeed, the government asked them to do just that. But they said no — and that was the end of the story.
He is missing the point – and is letting the Fed off the hook on this.
He is wrong.
So, bear with me as I explain why.
The exact scenario of AIG had been played out six months earlier, in March – when Bear Stearns was about to go under.
The Fed stepped in with guarantees to backstop Bear portfolio losses in their sale to JP Morgan, but JP Morgan assumed all Bear Liabilities. Bear Stearns had written a ton of protection as well – primarily on corporate bonds in the form of Credit Default Swaps. Bear also had many derivative contracts where they were the counterparty. In essence, Bear had made the exact same kind of promises to the self same Wall Street banks (and other firms doing business with them).
And yet, when Bear was taken over, JP Morgan did not ‘settle the contracts’ with any of the counterparties across the board. JP simply assumed the liabilities of Bear and went on its merry way.
Why was that the case?
The answer lies in the accounting of derivative contracts, especially Credit Default Swaps.
A Credit Default Swap is an insurance policy on an underlying asset. The party writing the protection will pay off, but only if the default occurs. This is called a contingent liability – which is the case with all forms of insurance.
Companies engaged in this transaction are required to record the value of this contract on their books. Accounting rules call for recording this at current market value – so called mark-to-market accounting. So, companies are faced with the interesting problem of how to value these contracts.
What is the value of an insurance contract? Insurance companies which write large swaths of protection, use actuarial methods to figure out what they are likely to pay out and they assign a book value. Because life insurance contracts are not traded daily in public markets, there is no market value for these contracts – only an actuarial (or book) value.
But the accounting standards require that a Credit Default Swap be marked to market. So, how does the industry do that? You start from the principle that the premium received on a set of insurance contracts, over time, should roughly equal the expected losses on that pool of contracts plus some provision for unexpected outcomes. Without getting into the math, suffice to say, the market value of a Credit Default Swap, for accounting purposes, is set based on the expectations of the likelihood of a default on the underlying bond.
There are simple models and complex models, but at the end of the day, the market value of a credit default swap is based primarily on an expectation of a likelihood of default. Therefore, if the market thinks that a default is less likely, then the market value of the CDS starts to go down (less potential liability for the insurer).
If you have followed me so far, you can anticipate where I am going with this: the market value of a CDS, used for accounting / trading purposes, bears only a passing resemblance to the actual payout that may result in the future – because, and this is important, the CDS is a contingent claim.
This means that no matter what the market value of Bear Stearns’s promises were, the actual obligation of Bear to make a payment did not exist until an underlying bond actually defaulted. JP Morgan knew this, so they were OK with taking on Bear Stearns’ contract.
So, when Krugman says that AIG’s promises became taxpayer liabilities, he is not fully correct – they were contingent liabilities that AIG had to make provision for (in the form of collateral posted), but did not actually have to pay out – like a bill to a vendor.
Because of that error, he misses the real nature of what went on here: when AIG was taken over by the Fed, no payments were due from AIG to Goldman. AIG simply had to place assets in escrow, but Goldman had no right to the money until an actual failure occurred.
By settling the contracts at full, the Government essentially said that every bond that AIG insured will default. That is the same as saying that every person whose life is insured by MetLife will die.
I said before that AIG simply had to put money in escrow as the value of the CDS went up. If the CDS went down in value (things got better...) then AIG could claw back the escrow.
If AIG was purchased by someone with a worse credit rating than AIG, more money would have been placed in escrow. By the same token, if the acquirer was better rated, they would place less in escrow.
Since the US Government is the safest credit there is, they would post nothing in escrow. So, here is how it should have played out
Geithner (to Goldman): The US Government just bought 80% of AIG. Therefore, we are your new counterparty. We are rated AAA – which means we post nothing in escrow. That also means we are clawing back whatever has already been placed in escrow. If your bond actually defaults, come back to us and we will pay you off. Otherwise, have a nice day. In the meanwhile, we will now be sending you the quarterly bill for the insurance premium.
So why didn’t they?
Three days after lehman failed, Goldman was on the brink of collapse. They had the same liquidity problem that Lehman faced a week earlier. The fed needed to get some money into Goldman and do it quickly. By ‘settling’ the CDS contracts in full, the Fed took taxpayer money and just gave it to Goldman as a cash infusion.
I cannot think of another explanation that makes sense.