Journalism in the Public Interest

Does AIG Really Need to Pay Its Counterparties in Full?

The logo of American International Group (AIG) is seen at their offices in New York. (Eric Thayer/Reuters)Since AIG’s bailout, the company has forked over $52 billion to Goldman Sachs, Deutsche Bank and others who bought credit default swaps. The payments have raised a chorus of disapproval, with many arguing that AIG’s new owners—that’d be taxpayers—shouldn’t be paying out the full contracts.

Treasury Secretary Timothy Geithner has countered that the government’s hands were tied and AIG had no choice but to pay out the full value of the swaps, which are complicated financial bets that often function like insurance but can also be more like a bet with a Vegas bookie.

“We came into this crisis as a country without the tools necessary to contain the damage of a financial crisis like this,” Geithner told George Stephanopoulos on ABC’s “This Week.” The government, he said, “had no meaningful ability to come in [and] change contracts where necessary.”

Geithner went on to tell Stephanopoulos he is asking for more authority to renegotiate such payouts in the future, but the question asked by members of Congress, expert observers and plenty of disgruntled taxpayers remains: Did Geithner really have to pay out on the contracts at full value?

Though the $52 billion is already out the door, the debate is much more than academic. AIG has said it has hundreds of billions of dollars more in overall exposure with counterparties.

It turns out, Geithner does have options—but each carries risks.

Part of the problem is though the federal government now officially owns about 80 percent of AIG, it has been struggling to avoid the appearance of actually taking control, said Roger J. Dennis, a dean of the law school at Drexel University. “They’re not managing AIG, so they can’t really go in and order AIG’s management to say, ‘As you unwind these swaps, force the counterparties to take a haircut.’”

Of course, given that AIG is relying on the government for a lifeline, can’t Geithner engage in some more informal type of persuasion?

“Clearly he could have gone in and as a practical matter jawboned the AIG people to try to get haircuts,” Dennis said, using an industry term for getting discounts on contracts. “But could he have ordered them? Under the current conditions, probably not.”

Another option is to break the contracts and let the counterparties—many of which are themselves beneficiaries of federal bailouts—sue the federal government, if they dare.

“I don’t see why it would have been necessary to pay out to the counterparties at all,” said Timothy Canova, a professor of international economic law at Chapman University in California.

Such a suit may not fare well in court because some legal questions swirl around whether the bulk of credit default swaps are legally enforceable.

Some of the swaps function like insurance policies on corporate bonds. Purchasers of such credit default swaps know that even if the bond issuer defaults, they will limit their losses. But many other swaps are more like bets (akin to buying “insurance” on another person’s house), and it is unclear from a legal perspective if there is enough of an insurable interest to make the contracts enforceable.

“I say let them litigate it and let the courts decide whether they have any kind of insurable interest,” Canova said.

If the federal government is willing to renegotiate contracts with, say, the United Auto Workers, it should also be willing to force haircuts on elite institutions, Canova added.

“The Treasury is willing to exercise its muscle to change contracts with ordinary workers,” Canova said, “but when it comes to gambling debts for Wall Street, those are somehow sacrosanct.”

A third option, advocated most prominently by Lucian Bebchuk, director of the Program on Corporate Governance at Harvard University, is for AIG to simply file for Chapter 11 bankruptcy. A bankruptcy court would then have powers to renegotiate the company’s swaps and demand substantial concessions from counterparties.

Of course, just because Geithner can exercise these options, does not mean they’re a good idea.

There’s no equivalent to an open stock exchange for credit default swaps, meaning no one knows how far-reaching the effects of AIG’s refusal to pay all or some of its obligations would be.

“Many people think the domino effect is overstated,” said Burt Ely, president of Ely and Company, a financial services consultancy, referring to the idea that stopping the payments could in turn topple firms AIG made deals with. “But the problem is, no one knows.”

It’s also unclear how to prioritize the many different kinds of counterparties AIG may have, said Dennis of Drexel University.

Would you, for example, force the same haircut on state and local governments as, say, Deutsche Bank?

“If you start to push people to take haircuts, even if they don’t take deep ones, it creates the kind of uncertainty in the marketplace that the bailout was supposed to ameliorate,” Dennis said.

The purchasers of these counterparty credit default swaps were anything but novice investors. They knew exactly what they were doing. They were taking a position that the economy would crash and they would be richly rewarded for a reletively small investment. They probably also knew that the issuer of the swaps (AIG) was very highly levereged and couldn’t possibly pay off all the CDS holders if the economy did do what they were betting it would do. If I gamble, I know there is a possibliity I may lose my money. These creeps gambled with other peoples lives. Because of them, retirees are losing pension benefits that they earned and taking huge hits to their retirement savings. The taxpayers are being forced to accept never before seen levels of debt. For What? To pay off a bunch of rich gamblers? If this continues, thees creeps are going to have to pay everything they own/stole just to buy protection from an outraged public.

Michael Blomquist

April 7, 2009, 11:15 p.m.

I thought fraud negated all contracts.  Very little due diligence by the government would find rampant fraud in the securities protected by the CDS contracts. 

i.e. 3 pack a day smoker misrepresenting his health/habit on insurance application

I am a contract attorney, and Geithner’s claims simply don’t hold up.  First, they confuse principal and agent. 

Yes, taxpayers are now shareholders in AIG.  But shareholders are not personally responsible for the debts of the corporation.  Like any other shareholder, the federal government has no obligation to pay any of AIGs debts, they can walk away. 

Second, what about the well known exception to contract performance for unanticipated changes in circumstance?  I doubt that when the parties drew up these contracts, they had in mind, the global financial crisis, the near-collapse of AIG, it’s extreme insolvency, the massive infusions of public capital required to stave off a meltdown and and 80% nationalization of the company.

These are not complex legal concepts.  They are things a law student typically learns in the first year of law school.  Which makes Geithner’s comments all the more troubling.

Michael Blomquist

April 8, 2009, 8:51 a.m.


You make a valid argument, but if there were any due diligence they would determine that the swaps were sold to protect fraudulent securities.  Securities that EVERYONE knew would default and were worthless.  The complexity that Paulson et. al. speak of is nothing more than a code word for fraud. 

Our Nation has been highjacked by liars and thieves.  We need to start impeaching some of these treasonous criminals or we will fail.

patrick the painter

April 8, 2009, 9:02 a.m.

They should retroactively RENEGE on all contracts dating back to 2005.  That is the year, that Tim Geithner, then head of NY Fed, “took the CDS market from pencil and paper” to the big time electronic exchange.  Since this $42 TRILLION dollar maket was not even regulated at the time, or now, and Tim Geithner repeatedly stopped efforts by the CFTC, along with Rubin and Greenspan for any regulation of these contracts.

Why cant they getthese guys on racketeering charges?

It is not by coincedence, that these items listed below happened at the the same time.

1. Complete Failure at the regultory agencies (SEC and the CFTC)

2. Complete failure of the rating agencys.If not fraud.

3. Freddie,Fannie May INdy Mac being forced feed real estate(sub primeloans)

4. AIG slips through the cracks of regulation because they are a insurance company

5. Wall St creates and sells all around the world it’s “investment-in-a-box”

6. AIG Guarnteed whatever was in the box.

These things were are conspired over 5-10 years ago.

Some firms like AIG and Citi were made to be the fall guys.  That is they were purposely inflated to the point they would implode, knowing the gov would come with the bailout.



Since this $42 Trillion dollar market was just between a handle of MERCHANT banks betting on each others demise and the direction of the real estate market, they should renege on these contracts.  They have no real effect on the real economy.

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