Tuesday, March 24, 2009

Once begun, a financial crisis can spread unpredictably

TO BE NOTED: From Real Time Economics:

Bernanke’s Congressional Testimony on AIG

The prepared remarks of Fed Chairman Ben Bernanke about American International Group before the House Committee on Financial Services.

Chairman Frank, Ranking Member Bachus, and other members of the Committee, I appreciate having this opportunity to discuss the Federal Reserve’s involvement with American International Group, Inc. (AIG). In my testimony, I will describe why supporting AIG was a difficult but necessary step to protect our economy and stabilize our financial system. I will also discuss issues related to compensation and note two matters raised by this experience that merit congressional attention.

Reasons for Our Original Lending Decision

We at the Federal Reserve, working closely with the Treasury, made our decision to lend to AIG on September 16 of last year. It was an extraordinary time. Global financial markets were experiencing unprecedented strains and a worldwide loss of confidence. Fannie Mae and Freddie Mac had been placed into conservatorship only two weeks earlier, and Lehman Brothers had filed for bankruptcy the day before. We were very concerned about a number of other major firms that were under intense stress.

AIG’s financial condition had been deteriorating for some time, caused by actual and expected losses on subprime mortgage-backed securities and on credit default swaps that AIG’s Financial Products unit, AIG-FP, had written on mortgage-related securities. As confidence in the firm declined, and with efforts to find a private-sector solution unsuccessful, AIG faced severe liquidity pressures that threatened to force it imminently into bankruptcy. ( NB DON )

The Federal Reserve and the Treasury agreed that AIG’s failure under the conditions then prevailing would have posed unacceptable risks for the global financial system and for our economy. Some of AIG’s insurance subsidiaries, which are among the largest in the United States and the world, would have likely been put into rehabilitation by their regulators, leaving policyholders facing considerable uncertainty about the status of their claims. State and local government entities that had lent more than $10 billion to AIG would have suffered losses. Workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk that their stable value funds would decline in value would have seen that insurance disappear. Global banks and investment banks would have suffered losses on loans and lines of credit to AIG, and on derivatives with AIG-FP. The banks’ combined exposures exceeded $50 billion.1 Money market mutual funds and others that held AIG’s roughly $20 billion of commercial paper would also have taken losses. In addition, AIG’s insurance subsidiaries had substantial derivatives exposures to AIG-FP that could have weakened them in the event of the parent company’s failure.

Moreover, as the Lehman case clearly demonstrates, focusing on the direct effects of a default on AIG’s counterparties understates the risks to the financial system as a whole. Once begun, a financial crisis can spread unpredictably( NB A CALLING RUN DON ). For example, Lehman’s default on its commercial paper caused a prominent money market mutual fund to “break the buck” and suspend withdrawals, which in turn ignited a general run on prime money market mutual funds, with resulting severe stresses in the commercial paper market. As I mentioned, AIG had about $20 billion in commercial paper outstanding, so its failure would have exacerbated the problems of the money market mutual funds. Another worrisome possibility was that uncertainties about the safety of insurance products could have led to a run( NB DON ) on the broader insurance industry by policyholders and creditors. Moreover, it was well known in the market that many major financial institutions had large exposures to AIG. Its failure would likely have led financial market participants to pull back even more from commercial and investment banks, and those institutions perceived as weaker would have faced escalating pressure. Recall that these events took place before the passage of the Emergency Economic Stabilization Act, which provided funds that the Treasury used to help stem a global banking panic in October. Consequently, it is unlikely( NB DON ) that the failure of additional major firms could have been prevented in the wake of the failure of AIG. At best, the consequences of AIG’s failure would have been a significant intensification of an already severe financial crisis and a further worsening of global economic conditions. Conceivably, its failure could have resulted in a 1930s-style global financial and economic meltdown, with catastrophic implications for production, income, and jobs. ( I AGREE COMPLETELY )

The decision by the Federal Reserve on September 16, 2008, with the full support of the Treasury, to lend up to $85 billion to AIG should be viewed with this background in mind. At that time, no federal entity could provide capital to stabilize AIG and no federal or state entity outside of a bankruptcy court could wind down AIG. Unfortunately, federal bankruptcy laws do not sufficiently protect the public’s strong interest in ensuring the orderly resolution( NB DON ) of nondepository financial institutions when a failure would pose substantial systemic risks, which is why I have called on the Congress to develop new emergency resolution procedures. However, the Federal Reserve did have the authority to lend on a fully secured basis, consistent with our emergency lending authority provided by the Congress and our responsibility as central bank to maintain financial stability. We took as collateral for our loan AIG’s pledge of a substantial portion of its assets, including its ownership interests in its domestic and foreign insurance subsidiaries. This decision bought time for subsequent actions by the Congress, the Treasury, the Federal Deposit Insurance Corporation, and the Federal Reserve that have avoided further failures of systemically important institutions and have supported improvements in key credit markets.

The Federal Reserve’s Ongoing Involvement with AIG

Having lent AIG money to avert the risk of a global financial meltdown, we found ourselves in the uncomfortable situation of overseeing both the preservation of its value and its dismantling, a role quite different from our usual activities. We have devoted considerable resources to this effort and have engaged outside advisers. Using our rights as creditor, we have worked with AIG’s new management team to begin the difficult process of winding down AIG-FP and to oversee the company’s restructuring and divestiture strategy. Progress is being made on both fronts. However, financial turmoil and a worsening economy since September have contributed to large losses ( NB DON ) at the company, and the Federal Reserve has found it necessary to restructure and extend our support. In addition, under its Troubled Asset Relief Program (TARP), the Treasury injected capital into AIG in both November and March. Throughout this difficult period, our goals have remained unchanged: to protect our economy and preserve financial stability, and to position AIG to repay the Federal Reserve and return the Treasury’s investment as quickly as possible.

In our role as creditor, we have made clear to AIG’s management, beginning last fall, our deep concern surrounding compensation issues at AIG. We believe it is in the taxpayers’ interest for AIG to retain qualified staff to maintain the value of the businesses that must be sold to repay the government’s assistance. But, at the same time, the company must scrupulously avoid any excessive and unwarranted compensation. We have pressed AIG to ensure that all compensation decisions are covered by robust corporate governance, including internal review, review by the Compensation Committee of the Board of Directors, and consultations with outside experts. Operating under this framework, AIG has voluntarily limited the salary, bonuses, and other types of compensation for 2008 and 2009 of the CEO and other senior managers. Moreover, executive compensation must comply with the most stringent set of rules promulgated by the Treasury for TARP fund recipients. The New York Attorney General has also imposed restrictions on compensation at AIG.

Many of you have raised specific issues with regard to the payout of retention bonuses to employees at AIG-FP. My reaction upon becoming aware of these specific payments was that, notwithstanding the business purposes that might be served by this action, it was highly inappropriate to pay substantial bonuses to employees of the division that had been the primary source of AIG’s collapse. I asked that the AIG-FP payments be stopped but was informed that they were mandated by contracts agreed to before the government’s intervention. I then asked that suit be filed to prevent the payments. Legal staff counseled against this action, on the grounds that Connecticut law provides for substantial punitive damages if the suit would fail; legal action could thus have the perverse effect of doubling or tripling the financial benefits to the AIG-FP employees. I was also informed that the company had been instructed to pursue all available alternatives and that the Reserve Bank had conveyed the strong displeasure of the Federal Reserve with the retention payment arrangement. I strongly supported President Dudley’s conveying that concern and directing the company to redouble its efforts to renegotiate all plans that could result in excessive bonus payments. I have also directed staff to work with the Treasury and the Administration in their review of whether the FP bonus and retention payments can be reclaimed. Moreover, the Federal Reserve and the Treasury will work closely together to monitor and address similar situations in the future.

Lessons Learned from AIG

To conclude, I would note that AIG offers two clear lessons for the upcoming discussion in the Congress and elsewhere on regulatory reform. First, ( 1 )AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now. Second,( 2 ) the AIG situation highlights the need for strong, effective consolidated supervision of all systemically important financial firms. AIG built up its concentrated exposure to the subprime mortgage market largely out of the sight of its functional regulators. More-effective supervision might have identified and blocked the extraordinarily reckless risk-taking at AIG-FP. These two changes could measurably reduce the likelihood of future episodes of systemic risk like the one we faced at AIG.


1. In addition, many of these same banks had borrowed securities from AIG’s securities lending program for which they had given AIG cash as collateral. Upon an AIG bankruptcy, the banks would have taken possession of the securities instead of receiving back their cash, exposing them to possible losses on those securities."


Geithner’s Congressional Testimony on AIG

The prepared testimony of Treasury Secretary Tim Geithner on American International Group at a hearing of the House Financial Services Committee.

Good morning, Chairman Frank, Ranking Member Bachus, and other members of the Committee. Thank you for the opportunity to testify about the federal government’s dealings with the American International Group, Inc. (AIG). I am pleased to be here with Chairman Bernanke and President Dudley.

AIG highlights broad failures of our financial system. Our regulatory system was not equipped to prevent the build up of dangerous levels of risk. Compensation practices encouraged risk-taking and rewarded short-term profits over long-term financial stability, overwhelming the checks and balances in the system. The U.S. government does not have the legal means today to manage the orderly restructuring of a large, complex, non-bank financial institution that poses a threat to the stability of our financial system.( NB DON )

I share the anger and frustration of the American people, not just about the compensation practices at AIG and in other parts of our financial system, but that our system permitted a scale of risk-taking that has caused grave damage to the fortunes of all Americans.

We must ensure that our country never faces this situation again. To achieve that goal, the Administration and Congress have to work together to enact comprehensive regulatory reform and eliminate gaps in supervision. All institutions and markets that could pose systemic risk will be subject to strong oversight, including appropriate constraints on risk-taking. Regulators must apply standards, not just to protect the soundness of individual institutions, but to protect the stability of the system as a whole. Finally, we must create a new resolution authority so that the federal government has the tools it needs to unwind an institution of the size and complexity of AIG.

Before the financial crisis, AIG was one of the largest insurance companies in the world with operations in 130 countries and a trillion dollar balance sheet. AIG’s businesses provide insurance and retirement services for millions of individuals and businesses. AIG directly guarantees over $30 billion of 401(k) and pension plan investments and is a leading provider of retirement services for teachers and educational institutions.

AIG’s Financial Products division (AIGFP) was a counterparty on thousands of over-the-counter derivatives contracts to major financial institutions and other entities across the globe. This division was an unregulated entity operating in unregulated markets.

In September, at a time of unprecedented financial market stress, losses on derivatives contracts entered into by AIG’s Financial Products group forced the entire company to the brink of failure.

The U.S. Department of the Treasury (Treasury), the Federal Reserve Board, and the Federal Reserve Bank of New York agreed that the collapse of AIG could cause large and unpredictable global losses with systemic consequences — destabilizing already weakened financial markets, further undermining confidence in the economy, and constricting the flow of credit. A disorderly failure of AIG risked deepening and prolonging the current recession.

There is no effective legal mechanism to unwind a non-bank financial institution like AIG. Therefore, on September 16th, the Federal Reserve Board authorized an $85 billion revolving credit facility to provide liquidity and avoid default. As a condition of government assistance, the government installed new management at AIG and began the process of restructuring the board. We initiated a strategy to return AIG to its core insurance business by winding-down its derivatives trading operation and selling non-core businesses. This loan was the beginning of a sustained effort to stabilize the company, which required additional commitments of capital in November and March.

In November, as part of the government’s infusion of capital, Treasury imposed the strictest level of executive compensation standards required under the Emergency Economic Stabilization Act. When we were forced to take additional action in March, we required AIG to also apply the Treasury rules that will be promulgated based on the executive compensation provisions in the American Reinvestment and Recovery Act.

On March 10th, I received a full briefing on the details of AIGFP’s pending retention payments, including information on the payments to individual executives.

I found these payments deeply troubling. After consulting with colleagues at the Fed and exploring our legal options, I called Ed Liddy and asked him to renegotiate these payments. He explained that the contracts for the retention payments were legally binding and pointed out the risk that, by breaching the contracts, some employees might have a claim under Connecticut law to double payment of the contracted amounts.

I demanded that Liddy reduce future payments by hundreds of millions of dollars. He committed to renegotiate the remaining retention awards on terms consistent with the American Recovery and Reinvestment Act, and the Administration’s compensation guidelines.

Additionally, Treasury is now working with the Department of Justice to determine what legal avenues may be available to recoup retention bonuses that have already been paid. Treasury will also impose on AIG a contractual commitment to pay the Treasury, from the operations of the company, the amount of the retention awards just paid. Finally, Treasury will deduct from the $30 billion in recently committed capital assistance an amount equal to the amount of those payments.

The issue of excessive compensation extends beyond AIG and requires reform of the system of incentives and compensation in the financial sector.

On February 4th, the President and Treasury announced new restrictions on executive compensation for financial institutions that are receiving government assistance as part of the Financial Stability Plan. These measures are designed to ensure that public funds are focused on the public interest and that the compensation of top executives in the financial community is aligned not only with the interests of shareholders and financial institutions, but with the interests of taxpayers providing assistance to those companies.

On February 17th, the President signed additional limits on executive compensation into law as part of the American Reinvestment and Recovery Act. These limits included a requirement to recoup bonuses already paid in cases of misrepresentation or malfeasance. Treasury is currently working to promulgate rules to implement these provisions and to develop a program under the original TARP legislation to review certain bonus awards already paid. We will work with Congress on any new legislation proposed in this area.

We need to strike the right balance between encouraging investment and prudent risk-taking to get our financial system moving again, and, on the other hand, placing limits on executive compensation to avoid taxpayer funded rewards for failure. The objective is to promote long-term value and growth for shareholders, companies, workers and the economy at large, and to reduce the risk of financial crises like the current one from occurring again.

In addition to problems with executive compensation, the financial crisis has revealed systemic gaps in the regulatory structure governing our financial markets. The lack of an appropriate regulatory regime and resolution authority for large non-bank financial institutions contributed to this crisis and will continue to constrain our capacity to address future crises. I will testify before this committee on Thursday to discuss our regulatory reform proposals – particularly those relating to mitigating systemic risk – in more detail.

As we have seen with AIG, distress at large, interconnected, non-depository financial institutions can pose systemic risks just as distress at banks can. The Administration proposes legislation to give the U.S. government the same basic set of tools for addressing financial distress at non-banks as it has in the bank context.

The proposed resolution authority would allow the government to provide financial assistance to make loans to an institution, purchase its obligations or assets, assume or guarantee its liabilities, and purchase an equity interest.

The U.S. government as a conservator or receiver would have additional powers to sell or transfer the assets or liabilities of the institution in question, renegotiate or repudiate the institution’s contracts (including with its employees), and prevent certain financial contracts with the institution from being terminated on account of the conservatorship or receivership.

This proposed legislation would fill a significant void in the current financial services regulatory structure with respect to non-bank financial institutions. Implementation would be modeled on the resolution authority that the FDIC has under current law with respect to banks.

Before taking any emergency action, the Treasury Secretary would need to determine that resolution authority is necessary upon the positive recommendations of the Federal Reserve Board and the appropriate federal regulatory agency.

This is an extraordinary time and the government has been forced to take extraordinary measures. We will do what is necessary to stabilize the financial system, and with the help of Congress, develop the tools that we need to make our economy more resilient and our system more just. Financial crises contain a basic and tragic unfairness – that those who were prudent and responsible in their personal and professional judgments are harmed by the actions of those were less careful and less prudent.

The actions that we take will help restore confidence in our markets and revive the flow of credit to households and businesses. They will create an environment where it is safe to save and invest and where all Americans can trust the rules governing their financial decisions. The process of repair will take time, but our actions will succeed. For all the challenges that we face, we still have a diverse and resilient financial system. Together we will help prevent future crises and the costs they would impose."

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