The Real Truth About the Wall Street Bailouts

It was probably inevitable, which doesn’t make it any less absurd. And it is certainly a reflection of their remarkable success, which doesn’t make it any less unfair. But six years after the spectacularly unpopular Wall Street bailouts, the government rescuers are under fire again—this time, not for their alleged generosity to financial firms, but for their alleged stinginess.

On Monday, a trial began in a lawsuit filed by AIG shareholders who claim the government somehow violated their rights when it rescued the busted insurer and salvaged their worthless investments. But even commentators who have admitted the lawsuit is “asinine” (in the New York Times) and “mostly insane” (in The New Republic) have suggested it’s nonetheless performing a public service, because it’s going to reveal the truth about the Wall Street bailouts. And on Tuesday, the Times ran a blockbuster story quoting unnamed sources who claim the government also could have bailed out Lehman Brothers, the venerable investment bank whose implosion nearly cratered the global economy. Again, the implication is that the official story is askew.

In fact, the lawsuit over the $182 billion AIG bailout is precisely as asinine and insane as it sounds. The government officials who stabilized the world’s most dangerous financial firm were the ones who performed a public service. And they absolutely would have rescued Lehman as well if they could have. Unfortunately, Lehman was hopelessly insolvent, and the government had no legal or practical way to save it without a private buyer willing to take on at least some of its risks. As for the truth about the Wall Street bailouts, well, the truth is already out there.

I have a bias here; I helped former Treasury Secretary Tim Geithner, who helped rescue AIG and tried to rescue Lehman when he was president of the New York Fed, with his memoir, Stress Test. I was even peripherally involved in the AIG case, when Greenberg’s lawyers sought access to transcripts of my conversations with Geithner.

But I wrote a pretty high-octane defense of the AIG bailout back in January 2010, before I ever met Geithner. And it stands up pretty well, except for the part where I said taxpayers would take a hit; in fact, taxpayers ended up earning a $22.7 billion profit on their investment in AIG.

Overall, taxpayers have made more than $100 billion on the bailouts. More importantly, the aggressive U.S. financial response—along with similarly aggressive monetary and (initially) fiscal policies—helped rescue a free-falling economy that was crashing at an 8 percent annual rate. We’ve recovered better than the rest of the developed world—Europe still has 11 percent unemployment—and much better than nations that endured much less damaging financial crises in the past. It’s kind of amazing that we’re still arguing about an emergency response that turned out so much better than anyone, even the emergency responders, expected at the time.

But here we are. Critics still doubt the official story that Lehman could not be saved. They also insist the Fed could have forced AIG’s senior creditors to accept less than 100 cents on the dollar; they’re excited about the lawsuit because they expect it to expose shocking evidence about why the government didn’t insist on haircuts. In fact, these questions have been asked and answered. Geithner tells the story of Lehman and AIG at length in Stress Test. You can find a quick explanation of why Lehman couldn’t be rescued in on pages 206-208 and a quick summary of why AIG’s counterparties didn’t absorb haircuts on pages 246-248. Again, I’m biased, but if you’re interested in this stuff, you should read the whole thing.

Here’s a shorter version. The old conventional wisdom that Geithner and his colleagues were desperate to prevent big Wall Street firms from collapsing during the crisis was basically correct, although I’d say they were right to be desperate. The firms were all dangerously interconnected with the rest of the global financial system at a time when markets had lost confidence in their housing-related assets, and it was clear that any one of them defaulting on its obligations could further depress confidence and spark runs on the others. That’s why when Bear Stearns was failing in March 2008, the Fed helped engineer a deal for JP Morgan Chase to acquire it and stand behind its obligations, providing an emergency loan backed by some of Bear’s sketchiest mortgage securities. And when Lehman was failing that September, Geithner and his colleagues worked feverishly to recruit a buyer for a similar deal, holding a series of emergency meetings documented in crisis books like Too Big to Fail and In Fed We Trust.

So what happened? The only bank willing to buy Lehman and its toxic assets that chaotic weekend was the British firm Barclays—and British regulators balked before a deal could be finalized. That left the Fed without options. It’s only allowed to lend against plausibly solid collateral, and Lehman looked hopelessly insolvent. At the time, then-Fed chair Ben Bernanke and then-Treasury Secretary Hank Paulson suggested publicly that they had chosen to let Lehman fail, because they didn’t want to accelerate the panic by making the government appear powerless. But really, they had been powerless. They knew the consequences of failure would be disastrous. They would have been thrilled to find a way to save Lehman.

In its carefully hedged, anonymously sourced story, the Times is now suggesting some New York Fed officials were “leaning toward the opposite conclusion—that Lehman was narrowly solvent and therefore might qualify for a bailout.” Put it this way: Their bosses did not agree, and neither did the market; as the Times noted, Bank of America had estimated Lehman’s net worth at about negative $66 billion that weekend. In fact, a subsequent study by economists William R. Cline and Joseph E. Gagnon—a study not mentioned by the Times—found that Lehman was at least $100 billion and perhaps $200 billion in the hole at the time.

“Our overall judgment on Lehman is that it was deeply insolvent,” Cline and Gagnon concluded.

One more point about Lehman: Even if the Fed had broken the law to lend into a run on an insolvent firm, and had somehow managed to stabilize Lehman rather than kiss its cash goodbye, it wouldn’t have defused the larger crisis. The government still lacked the authority to inject massive amounts of capital into the financial system—and a Congress that initially refused to grant that authority through the notorious TARP even after Lehman’s failure certainly wouldn’t have granted it before a failure of similar magnitude. Whatever. I guess some people find it comforting to believe the government could have snapped its fingers and ended the crisis early. It’s not a reality-based belief.

The perennial question is how, if the Fed lacked authority to rescue Lehman, it somehow found the authority to rescue AIG the next day. The short answer is that AIG, despite the awful misjudgments of a subsidiary that insured trillions of dollars worth of mortgage securities, had valuable revenue-generating businesses and a plausible claim to solvency. While Lehman was really nothing more than the sum of its toxic assets and shattered reputation as a venerable brokerage, AIG had solid collateral that the Fed could lend against with a decent expectation of repayment.

Ultimately, AIG would receive an astonishing $182 billion in government financing, and it would pay back every dime with interest. Its shareholders, who would have received nothing if the government had let the firm collapse, are now complaining in court that they should have gotten more. In his Times op-ed, Noam Scheiber aptly compared them to “a formerly starving man insisting he deserved filet mignon rather than a rib-eye.” Yet Scheiber argued that their filet mignon demand “may end up serving a constructive purpose.” He thinks the trial underway in Washington will reveal the real reason AIG’s creditors didn’t face haircuts; he doesn’t think the official explanation—that voluntary haircuts were impossible, and involuntary haircuts would have accelerated the panic—makes any sense. Times columnist Gretchen Morgenson not only called the lawsuit a “public service,” she actually portrayed AIG as an innocent victim in the financial crisis, “the patsy at the poker table.”

Uh…no. AIG was as rapacious and reckless as any bank. The government did push for modest haircuts for its creditors that might have saved taxpayers as much as $1 billion, but seven of the eight top creditors flatly refused. Unfortunately, the Fed could not force them to change their minds; several of them weren’t even U.S. firms. And the Fed could not impose the haircuts without forcing AIG into default; the creditors logically concluded a government that was spending $182 billion to avoid a default wasn’t going to create a default on purpose to save $1 billion.

This is the key: In a financial crisis, default is the enemy. The fear that secured debts won’t be repaid in full is the fear that drives panics. The Federal Deposit Insurance Corporation learned this the hard way a week later when it foolishly haircut Washington Mutual’s creditors, instantly triggering a run on the next-weakest bank, Wachovia; its ten-year bonds lost two thirds of their value the day after the haircuts. The whole point of the bailouts was to avoid defaults. This is not “counterintuitive” (Scheiber’s word) to anyone who has endured a financial crisis.

But the critics—who were wrong when they predicted the bailouts would cost trillions, and when they warned that the banking system could not be saved without mass nationalization, and in so many other ways—think the frivolous AIG lawsuit will reveal some dirty backroom deal where Geithner and Lord Voldemort conspired to rip off widows and orphans on behalf of Goldman Sachs. “Traumatic historical episodes often require a high-profile public reckoning before the country can move on,” Scheiber wrote. OK, he then admitted, the financial crisis inspired a litany of those, “but none fully exposed the weakness of Mr. Geithner’s logic.”

Hmm. Maybe it’s someone else’s logic that’s weak. And maybe it’s already time for the country to move on.