In September 2008, as the financial system was in free fall, the Federal Reserve Bank of New York loaned AIG $85 billion in return for 79.9% of the company.
Though the loan enabled AIG to avoid bankruptcy, the terms allowed the government to retain its ownership in the insurer even after the company repaid the money. That exceeded the government’s authority, a federal judge has ruled in a lawsuit brought by Maurice “Hank” Greenberg, the company’s former CEO and one of the largest holder’s of AIG’s stock before the takeover.
As Andrew Ross Sorkin noted in the Times, the ruling may leave policymakers less able to bail companies out in the future. At a minimum, the ruling seems likely to cause policymakers to rethink how they address crises to come. For now, the ruling adds to the list of literature about the crisis and constitutes a must-read for anyone who continues to ponder how the financial crisis came to be and who, like I do, remains fascinated by the ripples that reverberate through the economy nearly seven years later.
The problems that precipitated AIG’s inability to borrow money or raise capital in the private sector and culminated in a takeover of the company by the New York Fed had their roots in the combination of low interest rates and risky lending practices by mortgage lenders and banks that bought and securitized loans in the years that preceded the meltdown. As Judge Thomas Wheeler of the US Federal Court of Claims explained in a decision released June 15:
“There were five major causes of the September 2008 financial crisis: (1) the so-called ‘housing bubble’; (2) the floating interest rates of subprime mortgages; (3) the rating agencies misrepresentations of the riskiness of certain securities such as collateralized debt obligations (‘CDOs’); (4) the ‘originate-to-distribute’ business model; and (5) the collapse of the alternative banking system.”
Wheeler recounts how low interest rates led to a surge in the market for housing and spurred banks and others to lend money to borrowers for houses they could not afford. Thereafter, a combination of rising rates and falling home prices that began in 2006 led many borrowers to fall behind on their mortgages or default.
The practice of originating to distribute meant that lenders, rather than hold mortgages on their books as receivables, transferred or sold the loans to entities that would pool the loans and sell securities that entitled their owner to revenues to be paid form the mortgages that made up the pool.
That “increased the amount of money available for housing loans and resulted in a mortgage originator’s paying less attention to a borrower’s credit and making loans without ‘sufficient documentation or care in underwriting’ because the risk of non-payment had been transferred to others,” Wheeler noted.
Of course, these observations echo similar analyses elsewhere. “We conclude collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis,” the Financial Crisis Inquiry Commission found in its report, which was published in 2011.
As Wheeler recounts, an alternative banking system—consisting mainly of investment banks and broker dealers that extended credit similar to that extended by traditional banks but in a less regulated setting—emerged to provide short-term loans to companies such as AIG. Compared with traditional banks, which profit from the difference between the cost of funds they borrow and the rate of interest on money they lend—the alternative banking system depended on deals for its profits.
In particular, so-called repurchase agreement or “repo” financing—a major form of lending during the run-up to the crisis—was susceptible to shocks because it had to be renewed daily. According to Wheeler, in the six months that preceded AIG’s collapse, the size of the repo market tumbled 20%, to $3.5 trillion.
By August 2008, AIG faced downgrades to its credit rating that stemmed from volatility in the company’s earnings and a deterioration of its portfolio, which consisted primarily of so-called credit default swaps that became riskier as home loans that backed the securities became more susceptible to default. Even Greenberg and his fellow plaintiffs “concluded that a significant portion of AIG’s 2008 liquidity problems was the result of its failures in risk management,” wrote Wheeler.
Though the rescue of AIG by the New York Fed may have avoided “mass panic on a global scale,” as former Treasury Secretary Timothy Geithner testified at trial, the remedy constituted an illegal exaction, Wheeler ruled. “An illegal exaction occurs when the government requires a citizen to surrender property the government is not authorized to demand as consideration for action the government is authorized to take,” he explained.
For his part, Greenberg vows to appeal the ruling, which awarded the plaintiffs none of the $40 billion in damages they seek. “The inescapable conclusion is that AIG would have filed for bankruptcy, most likely during the week of September 15-19, 2008,” wrote Wheeler. “In that event, the value of the shareholders’ common stock would have been zero.”
In short, the shareholders lose either way. An epitaph, perhaps, for an economy in peril.