GAO Report Raises Questions About New York Fed in 2008 AIG Bailout

November 2, 2011

A new report from the U.S. Government Accounting Office chronicles the government’s handling of AIG bailout in 2008. In all, the government had invested and made loans worth more than $182 billion for the insurer.

The 152-page report, titled “Financial Crisis: Review of Federal Reserve System Financial Assistance to American International Group Inc.,” was released publicly on Oct. 31.

Buying Up Toxic Assets

One major part of the bailout involved creating a special purpose vehicle (SPV) called Maiden Lane III.

The Federal Reserve Bank of New York loaned money to this SPV, which was set up to buy bond investments known as collateralized debt obligations (CDOs) from more than a dozen major financial institutions. CDOs are bonds backed by various debts such as mortgage-backed securities, whose values plummeted as the housing market went bust.

These financial institutions had earlier bought insurance-like contracts, called credit default swaps, from AIG, which protected against default of CDOs. As the value of the CDO assets continued to decline, AIG was required to provide additional collateral to its counterparties.

By directly buying these bond investments that were under stress, the New York Fed was able to get these institutions to agree to terminate credit default swaps, which were a significant source of AIG’s liquidity problems. Ultimately, more than $62 billion in CDOs were sold to Maiden Lane III, the report says.

‘Too Generous’ to Financial Institutions?

The GAO report suggests, however, that the New York Fed didn’t put in enough of an effort to extract concessions or discounts from these financial institutions. The New York Fed officials had instead decided to pay the companies the full, “fair market” amount.

“Our review found that Federal Reserve Bank of New York made varying attempts to obtain concessions and halted efforts before some of the counterparties responded to the Bank’s request for the discounts,” the report said.

The New York Fed defended its action by saying that they had little bargaining power and would have faced difficulty in getting all counterparties to agree to a discount.

But the GAO report says various financial institutions were facing different circumstances, with different levels of exposure to AIG. Their CDOs also varied in quality.

Some Federal Reserve Board governors also raised concerns that the financial institutions receiving par value on CDOs could appear too generous, noting that these companies would receive accounting benefits from the transaction and no longer be exposed to AIG credit risk.

Lessons From AIG Bailout

The report added that the government’s experience with AIG offers insights that could guide future government actions and improve oversight of systemically important financial institutions.

Already, the Dodd-Frank Act seeks to broadly apply lessons learned from the financial crisis in regulatory and oversight areas. For example, the act contains oversight provisions in the areas of financial stability, depository institutions, securities, brokers and dealers, and financial regulation.

GAO said its review of Federal Reserve System’s assistance to AIG identified additional areas where lessons learned could be applied. They are:

• Identifying ways to ease time pressure in situations that require immediate response;

• Analyzing collateral disputes to help identify firms that are coming under stress; and

• Conducting scenario stress testing to anticipate different impacts on the financial system.

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