Unfamiliar Fed Saw ‘Exceptional’ Risks in AIG Situation, Says Geithner

By and | October 9, 2014

American International Group Inc.’s unique set of risks was seen by one of the primary orchestrators of its rescue as requiring tough conditions that included the government’s taking most of the insurer’s stock.

The fight over whether those terms were fair is set to continue today in a federal trial in Washington.

“I thought we were taking an enormous, unprecedented risk,” said Timothy Geithner, who was the head of the Federal Reserve Bank of New York in September 2008 when it agreed to lend AIG $85 billion. “We might lose billions or tens of billions of dollars.”

Timothy Geithner arriving at court. Bloomberg Photo/Andrew Harrer
Timothy Geithner arriving at court.
Bloomberg Photo/Andrew Harrer

Geithner, scheduled for a third day of testimony today, will be followed by another architect of the bailout, Ben Bernanke, the former chairman of the Federal Reserve Board of Governors.

Maurice “Hank” Greenberg’s Starr International Co., which was AIG’s largest shareholder before the bailout, accuses the government of illegally taking 80 percent of the company’s equity in consideration for the loan and seeks more than $25 billion in damages. Starr, whose chief executive officer Greenberg led AIG until 2005, is seeking to show that the insurer was treated unfairly, as evident by what one of its lawyers contends was an “extortion rate” of 14 percent interest on the loan.

The Fed, which authorized him to make the loan, acted with “a huge amount of trepidation and reluctance,” Geithner said yesterday in response to questions by Kenneth Dintzer, a Justice Department lawyer.

Exceptional Risks

As an insurance company, AIG wasn’t regulated by the Fed, leaving the central bank with little insight into “the risks they were taking,” Geithner testified.

“We had no formal supervisory relationship with AIG,” he said.

AIG’s circumstances “created an exceptional set of moral hazards risks,” Geithner testified, referring to the economics term for consequence-free risk taking.

Geithner said he overcame an initial reluctance to intervene when he was convinced that a failure of New York-based AIG would cause catastrophic damage to the economy. The company had financial links to a range of institutions including banks and retail insurance companies across the globe, he said.

He said his change of mind occurred about the time of the Sept. 15, 2008, collapse of Lehman Brothers Holdings Inc. An AIG failure would have been even more damaging than Lehman’s demise, Geithner said.

‘Crazily High’

An e-mail presented as evidence in the trial disclosed that a New York Fed vice president complained that a “crazily high” interest rate was forced on it by others. While Geithner said he discussed the “core conditions” for the AIG bailout with Bernanke and Donald Kohn, then the Fed’s vice chairman, he said, “Ultimately, I was responsible.”

The interest rate he picked was by design “substantially higher” than one considered by a group of investment banks which contemplated and dropped a private AIG bailout days before the Fed stepped in, Geithner said.

Geithner said he wanted the interest rate and other terms of the loan to be “tough enough that they were not viewed as attractive” to other companies that might seek a government bailout.

The terms “were designed to avoid creating an undue windfall for the existing shareholders,” Geithner said. He said he also wanted some protection in case collateral posted by AIG, the stock in its insurance subsidiaries, dropped in value.

Possible Bankruptcy

The Fed was “trying to assess the potential value of a set of insurance companies,” Geithner testified. If AIG went bankrupt, the subsidiaries’ stock “would decline sharply,” he said.

Geithner was named Treasury Secretary by President Barack Obama, a Democrat, in January 2009, serving until January 2013. He currently is president and managing director of Warburg Pincus LLC.

He said in court that he rebuffed a last-ditch request by Robert Willumstad, AIG’s CEO at the time, to soften the conditions of the bailout.

“You can’t let firms negotiate the terms of their rescue without creating terrible moral hazard,” Geithner testified.

He acknowledged brushing off Greenberg’s efforts to inject himself into discussions of government involvement in AIG, once the world’s largest insurer.

“It wasn’t clear that his presence would help” or that his former firm “would have welcomed” his involvement, Geithner testified.

Moral Hazard

Former Treasury Secretary Henry Paulson, the first of three bailout architects to testify in the trial, said Oct. 6 that regulators wanted to send a message to markets that government help would cost them.

“It was important that terms be harsh because I take moral hazard seriously,” Paulson said.

Under questioning by Starr lawyer David Boies, Geithner testified that “the scale of AIG’s financial needs, the potential losses relative to those facing other firms at the time, were a result, by definition, substantially of the management decisions by the company.”

When asked by Boies about whether any detailed analysis had been done to determine the causes of AIG’s financial distress, Geithner said he was “not sure you could analyze the extent to which that might be the case.”

Proportional Punishment

After Boies introduced a draft article by Geithner stating that the government forced losses on AIG shareholders proportional to the mistakes of the firm, he asked him whether other companies needing government assistance, such as Morgan Stanley, were similarly punished.

Geithner said they were. He said requiring Morgan Stanley and other banks to raise more common equity relative to their capital needs was punishment proportional to the penalties imposed on AIG.

Geithner also faced questions from Boies about his use of what’s known as the Doomsday Book, a private Federal Reserve Bank of New York manual describing the agency’s powers in financial emergencies.

Boies said he had three versions of the book, including a current version and one dating from the time when Geithner led the New York Fed. Two were admitted into evidence under seal on Oct. 7. A lawyer for the New York Fed urged the judge not to allow the manual to be disclosed to the public.

Boies asked Geithner whether the book was an “integral” part of his decision-making during the financial crisis.

“I don’t know that it would be fair to say that I consulted it extensively during that period, because, again, we were operating really outside the boundaries of established precedent,” Geithner said.

The case is being heard without a jury by U.S. Court of Federal Claims Judge Thomas Wheeler.

The case is Starr International Co. v. U.S., 11-cv-00779, U.S. Court of Federal Claims (Washington).

–With assistance from Laura Davison and Zachary Tracer in New York.

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