Geithner Gets a Bad Rap in the AIG Scandal

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Andrew Harrer / Bloomberg / Getty

U.S. Treasury Secretary Timothy Geithner

If you're the kind of person who would be outraged if a paramedic smudged your lipstick while giving you mouth-to-mouth resuscitation, you should definitely be outraged by the latest AIG "scandal." House Republicans have unearthed e-mails suggesting that at the height of the financial panic of 2008, lawyers at the Federal Reserve Bank of New York — then led by current Treasury Secretary Timothy Geithner — may have discouraged AIG from disclosing details about payments it made to banks with its government rescue money. It's not at all clear that's what happened, and in any case it looks like Geithner had nothing to do with the situation. But if you booed Lassie for tracking mud on the carpet after saving that kid in the well, you might want to join the angry chorus calling for Geithner's head.

On the other hand, if you're the kind of person who believes at least some good deeds should go unpunished, you might want to cut Geithner and his colleagues at the Fed some slack for their performance during the worst financial crisis since the 1930s. They did, after all, help save the world from a second Great Depression. A House committee has dragooned Geithner into testifying about AIG on Jan. 27, but the constant second-guessing over the specific details of the AIG rescue — Why not impose haircuts on creditors? Why allow bonuses for executives? — is only distracting attention from the real AIG scandal and the efforts to make sure it never happens again.

The AIG bailout, in short, was the ugliest in a series of ugly bailouts of institutions that were deemed too big to fail, a $180 billion government reward for spectacularly reckless private-sector behavior. But it was also absolutely necessary and ultimately successful. The scandal was not the rescue, but the necessity of the rescue — as well as constraints on the rescuers that made their fix even uglier.

The first thing Fed bashers should remember about the AIG bailout is the chaotic circumstances. The Fed barely knew how to spell AIG before the panic of September 2008; it didn't regulate insurance companies, and its leaders had no idea that a division of this particular insurance company had turned itself into a giant and overleveraged hedge fund, much less that AIG was entangled with other giant and overleveraged institutions through exotic financial gambles ultimately backed by sketchy mortgages. According to accounts of the crisis like David Wessel's In Fed We Trust and Andrew Ross Sorkin's Too Big to Fail, Geithner first discovered that AIG posed a potentially catastrophic risk to the global economy just as he and the rest of the Fed were frantically trying to persuade Bank of America to take over Merrill Lynch while searching for a buyer for Lehman Brothers in order to prevent the largest bankruptcy in the history of the planet. It's not easy to improvise a bailout for a company you knew nothing about the day before while the world is going to hell.

Lehman collapsed on Sept. 15, triggering a freefall in the markets and a cascade of margin calls that required AIG to put up tens of billions of dollars it didn't have. Fed Chairman Ben Bernanke, Geithner and then Treasury Secretary Henry Paulson quickly realized that a default by AIG — which not only sold insurance to 30 million Americans and 100,000 companies but suddenly owed big bucks to many of the world's largest financial institutions — would trigger bank runs around the world. The failure of Lehman had shocked the system; the failure of a dozen more huge financial firms would have crippled it. So on Sept. 16, the AIG bailout began.

It wasn't pretty. The creditors for AIG's bad bets — including Goldman Sachs and several large foreign banks — were paid in full. Critics have blasted the government for failing to impose haircuts, essentially providing a backdoor bailout for those banks in the name of AIG, but nobody has explained how or with what authority anyone could have invalidated AIG's contracts with all those far-flung institutions on the fly, or why that wouldn't have worsened the panic. Perhaps the public officials should have devised some way to limit the future bonuses AIG would pay its executives, but it's understandable that they weren't thinking about a few million dollars in theoretical perks when trillions of actual dollars and the entire financial system were at stake.

The second and most important thing to remember about the AIG bailout and the rest of the extraordinary government interventions during the crisis is that they worked. For all the populist fury about taxpayer giveaways for Wall Street, they did quell the panic. And they did so at a price that seemed exorbitant at the time but now looks like relative peanuts. Research by the Cleveland Fed has documented that financial crises usually end up costing national governments at least 5% to 10% of their GDP in payouts; the tab to the Treasury for this panic will be well under 1% of GDP. In fact, the Fed is about to return a record $45 billion in profits to the Treasury because the vast majority of its emergency loans have been paid back with interest. Meanwhile, the wildly unpopular $700 billion Troubled Assets Relief Program (TARP) is on track to cost only about $100 billion, including the giveaways for automakers, and the Obama Administration has proposed a bank tax that would bring that figure to zero.

As for AIG, the initial Fed loan that triggered the latest kerfuffle looks like it won't cost taxpayers a dime; in short, the exotic assets the Fed took as collateral because they became radioactive during the panic are turning out to be worth what the Fed thought they were worth. And the controversy itself is ridiculous. Congressman Darrell Issa has charged that the New York Fed tried to cover its tracks by crossing out proposed language in an AIG disclosure stating that its counterparties were paid 100 cents on the dollar. But the language was replaced with a less accessible but more precise explanation of how the counterparties were paid 100 cents on the dollar. Anyway, by that time, Geithner had already recused himself from AIG issues.

Taxpayers will take a big hit on some of the subsequent cash infusions to AIG — the company really had made hideous bets. But after Lehman collapsed, the AIG rescue sent a powerful message to markets and ordinary Americans with money in bank accounts and retirement accounts that the government was going to do whatever it took to make sure the financial system survived. Unfortunately, there was no way to do that without rewarding the jerks who imperiled the system in the first place.

The outrage that has been blasted at the decision makers who made the best of a horrible situation ought to be directed at the compulsive gamblers who created that situation — and channeled into fixing the regulatory system that allowed it to develop. AIG was a financial behemoth and should have been subject to federal financial oversight, including strict limits on leverage and strong capital requirements. The shadowy derivatives market that AIG was using as its casino also desperately needs adult supervision. Many of AIG's complex securities were based on subprime mortgages issued by unregulated brokers who had no incentive to seek creditworthy borrowers, but ratings agencies with equally strong conflicts of interest deemed the securities completely safe. And once the government had to come to the rescue, it had no emergency mechanism to wind down failed firms in an orderly fashion and impose haircuts on bondholders and other counterparties without imperiling the entire system.

In fact, the House of Representatives — with strong support from Geithner and the Obama Administration — has passed a financial-reform bill designed to address all those problems. It aims to provide stronger consumer protection, ensure that all financial firms and complex financial instruments are subject to strict oversight, and create a "resolution authority" so that no firm will be too big to fail during a crisis. And it received a grand total of zero votes from the House Republicans who are trying to fan the flames of the latest Geithner pseudo scandal. The Senate is trying to hash out a bipartisan bill, but for now the system in place is the system that failed. If that sounds outrageous to you, don't blame the firefighters who put out the last fire. Demand some real fireproofing.