It Was Not a Free Lunch: The True Cost of the AIG Bailout

James Tilson and Robert E. Prasch

“If it’s too good to be true, it probably is.”  This old adage came to mind on December 11, 2012 when the U.S. Treasury made the announcement, reiterated unthinkingly by the press, that the AIG bailout was coming to an end with American taxpayers making a tidy profit on the deal.  In an effort to capitalize on the news, AIG has spent millions of dollars on a primetime ad campaign thanking America for the bailout, highlighting its success:  “We’ve repaid every dollar America lent us.  Everything, plus a profit of more than 22 billion.”  Unfortunately, this cleverly designed public relations maneuver deceives the taxpayer by distorting the perception of what has been a contentious use of government funds.

THE BAILOUT

Readers may remember that AIG’s bailout began on September 16, 2008.  That day, AIG’s stock dropped 60 percent at the opening of the New York Stock Exchange.  Investors feared the imminent collapse of the insurance giant from a series of collateral calls on its derivative contracts.  With a ratings downgrade the night before, AIG needed to deliver collateral of over $10 billion.  Later that evening, the Fed created a 24-month credit-liquidity facility from which AIG could draw up to $85 billion in exchange for a 79.9 percent equity stake in the company.  By May 2009, this and other programs of support from the Federal Reserve and the United States Treasury amounted to more than $180 billion.

The White House, Treasury, and the Fed have never failed to remind the citizenry that the several bailouts of 2008-09 “succeeded” in the narrow sense that most of the nation’s largest financial services firms survived.  By contrast to these privileged firms, over 400 smaller banks were allowed to fail, millions of people lost their jobs, and millions lost homes to foreclosure, many of the latter in proceedings later found to be of dubious legality.  We should also remember that when these bailouts were authorized, there was no clear expectation that the loans would be paid back in full.  In fact, a report by Bloomberg revealed that a draft of a presentation summarizing the Treasury’s proposed investments described them as “highly speculative.”

As things stand today, the Treasury has completely exited its AIG investment.  Its December 11, 2012 sale of stock resulted, we are told, in the full recovery of the government’s commitment along with an approximately $22.7 billion combined return for the Treasury and the FRBNY, marking an incredible reversal of the original expectation of catastrophic loses.  Sadly, the Treasury’s statements are highly misleading.  In its accounting for the AIG bailout, the Treasury simply left out a number of salient facts when it announced that American taxpayers made a profit.  Stated simply, we did not.

The Treasury claims to have achieved a return of $5.0 billion, but neglects to mention that the Federal Reserve gifted them more than 500 million shares of AIG.  Moreover, they simply ignored the unique and preferential tax treatment accorded to the company that is estimated to have inflated its share price by at least $5.  Additionally, its estimates fail to compensate taxpayers for the true cost of capital or the risk assumed in its investments.  After adjusting for the aforementioned factors, we find that the Treasury’s investment in AIG was actually very costly for taxpayers.

As mentioned, the bailout began on September 16, 2008.   After a series of complicated restructurings and additional government support, the Fed’s credit facility was repaid in full, including interest and expenses.  By the time it was all over, the Treasury had acquired a 92 percent common equity stake in the company, which was sold over time subject to market conditions at an average price of $31.18. At least initially, the terms of the secured loan were designed to protect the interests of the U.S. government and taxpayer.

Share Gifting

Among the shares the Treasury sold were 562,868,096 gifted to them from the Credit Facility Trust.  This trust had previously been established by the Federal Reserve Bank of New York for the sole benefit of the Treasury Department.   When these shares are taken into account, only 65.99% of the total returns from the Treasury’s sale of AIG common stock can be attributed to its original TARP investment, and the remainder should be credited to the FRBNY.  The Treasury’s calculation, however, does not adjust for this transfer of shares.  The effect is to artificially boost the returns on its politically contentious TARP investment at the expense of the Federal Reserve.  Not counting these gifted shares, the Treasury assumes a break-even price of $28.73, but if we examine its investment in isolation, the true break-even is $45.53.  After adjusting all cash flows associated with sale of stock, the Treasury’s profit of $5 billion becomes a loss of $12.7 billion.

Deferred Tax Assets

As is well known, AIG’s rescue was necessitated by the enormous operating losses it had accrued by recklessly insuring mortgage-backed securities (“Net Operating Losses” or NOLs).  Now, United States’ tax law typically allows corporations to carry forward NOLs to offset future tax liabilities, but with one exception: “In general, the rules of section 382 apply to limit a corporation’s ability to utilize existing net operating loss carryovers once the corporation experiences an ‘ownership change.’” ()  Stated simply, if a company files for bankruptcy or is taken over, it sacrifices any pre-existing NOLs.  For this reason, AIG should have lost its ability to carry forward these NOLs since a controlling stake in the company had passed to the federal government in the course of its rescue.  In late 2008, however, the Treasury issued a series of IRS Notices regarding § 382, which stated that the rule did not apply to the government’s investments—both its purchase and, within limitations, its subsequent sale of shares in private companies. ()   Consequently, AIG claimed “Deferred tax assets: Losses and tax credit carryforwards” of $26.2 billion and an additional “Unrealized loss on investments” of $8.7 billion in its 2009 Annual Report.

An accurate evaluation of the Treasury’s investment in AIG should incorporate the effects of this tax advantage.  So, rather than an average sale price of $31.18, a more telling number would be the share price controlling for this preferential tax treatment.  According to estimates by analysts at Bank of America and JPMorgan Chase, doing so would reduce AIG’s share price by $5 to $6 dollars a share. ( )  If we were to adjust the sale price by $6 per share, the Treasury’s return is reduced from nearly $5 billion to a loss of more than $5 billion.  Compounding this adjustment with that from the shares gifted by the Federal Reserve described above, the Treasury’s return is further reduced to become more than a $19 billion loss.

When questioned about the rule bending, officials claimed AIG’s tax benefit would help taxpayers by raising the insurer’s share price.  One might suppose that the federal government would come out close to even because, as the major shareholder, it was the primary beneficiary of this artificially inflated stock price.  The drawback was that this tax-enhanced share price also benefited AIG’s private stockholders and AIG executives, as the latter were heavily compensated through stock options.  Damon Silvers, former member of the Congressional Oversight Panel for TARP explained, “By doing it this way…billions of dollars leak out to the benefits of private parties, who really should not be benefiting from public policy in this way.”   Most importantly for our purposes, “This special tax deal also masks the true cost of TARP by increasing the value of the government’s AIG stock at the expense of future tax revenue.”

Discounting Returns

Had the government actually earned the $5 billion profit that they claim, the bailout would appear to be a successful investment (although one might continue to raise questions of favoritism).  However, adjusting for the level of risk and the “opportunity cost” of money in these investments drastically alters the picture.  If the government were to extend a 30-year loan at a fraction of a percent of interest, and be repaid in full, it could claim to have made a profit.  But this is not how accounting is ordinarily done.  When evaluating an investment, it is necessary to take into account both the cost of capital, in this case the interest expense on Treasury bonds, and the level of risk assumed.  For instance, if one were to discount the cash flows received by even the modest rate of 2 percent, the Treasury’s return falls from roughly $5 billion to $1.5 billion.

Moreover, the normal procedure would discount returns by a rate that also accounts for the level of risk implicit in the transaction.  Let us recall that the government initially believed that its investments were “highly speculative.”  If, for instance, we were to discount returns by the initial rate charged by the FRBNY for the revolving credit facility (12 percent), the adjusted return would be a $10.8  billion loss before factoring in the tax advantage and gifted shares, and a $32.9 billion loss if we account for the latter.  The latter number, we believe, is closer to the cost of the AIG bailout (so far).

PROTECTING TAXPAYERS

            Finally, and beyond the three adjustments described here, a complete analysis of the government’s investment in AIG would include the full range of social costs that are not typically captured by the profit and loss statement of a private firm.  One would have to consider the cheap money the Federal Reserve used to keep the financial system afloat: one consequence of which is depressed rates for savers.  Additionally, the government ultimately provided AIG and its counterparties with a sweetheart deal that, whether intended or not, in effect preserved and even exacerbated the problem of “Too Big to Fail” financial institutions and the perverse incentives and outcomes that such a doctrine promotes.  The implications of this policy decision are as of yet unknown, but it is at least arguable that it has set the stage for the next financial disaster.

CONCLUSION

            With the sale of the last of its stake in AIG, the Treasury has reported a $5 billion profit.  Given the “creative” nature of the accounting used to derive this number, one is inclined to speculate on the motivations behind this announcement.  Perhaps the Treasury hoped to reduce the public’s anger over a series of bailouts that appeared to exhibit the worst features of crony capitalism.  As described above, Treasury’s estimate neglected to mention that approximately one-third of the AIG stock it sold came from the Federal Reserve rather than the initial TARP investment.  Special tax treatment afforded uniquely and singularly to AIG also buoyed the share price — and will continue to provide AIG with billions of dollars in tax liabilities over the coming decade.  The Treasury also failed to discount their returns by an amount even remotely reflecting the degree of risk involved.  By including these omissions in the estimate it can only be concluded that the Treasury, and thereby United States’ taxpayers, actually lost money in the course of bailing out AIG.

12 Responses to It Was Not a Free Lunch: The True Cost of the AIG Bailout

  1. Those ad nauseum AIG tv ads are on par with those of BP extolling how great things now are down the the Redneck Riviera owing to their tireless and selfless work.

    I just finished watching Frontline’s “The Untouchables.” We are so f&^@d.

  2. Seeing as how we made so much profit bailing out AIG, and seeing as how the Government is short on funds, maybe the solution to the debt crisis is lies in the Government bailing out even more financial institutions. Sounds reasonable to me.

    [note: sarcasm]

  3. James and Robert,

    Great essay, but I don’t really understand the point about share gifting. Whether or not the returns from those shares are really returns on Treasury investments, isn’t it good for the taxpayers either way? If the Fed created dollars and swapped them for shares, and then gave the shares to the treasury, then the Treasury and taxpayer benefit, right?

    • Payment Due

      “For thousands of years, the struggle between rich and poor has largely taken the form of conflicts between creditors and debtors—of arguments about the rights and wrongs of interest payments, debt peonage, amnesty, repossession, restitution, the sequestering of sheep, the seizing of vineyards, and the selling of debtors’ children into slavery. By the same token, for the past five thousand years, with remarkable regularity, popular insurrections have begun the same way: with the ritual destruction of debt records—tablets, papyri, ledgers; whatever form they might have taken in any particular time and place. In the throes of the recent economic crisis, with the very defining institutions of capitalism crumbling, surveys showed that an overwhelming majority of Americans felt that the country’s banks should not be rescued—whatever the economic consequences—but that ordinary citizens stuck with bad mortgages should be bailed out. This is quite extraordinary, as Americans have, since colonial days, been the population least sympathetic to debtors. (Back then, the ears of an insolvent debtor would often be nailed to a post.) The notion of morality as a matter of paying one’s debts runs deeper in the United States than in almost any other country, which is odd, since America was settled largely by absconding debtors. Despite the fact that the Constitution specifically charged the new government with creating a bankruptcy law in 1787, all attempts to do so were rejected on “moral grounds” until 1898, by which time almost all other Western states had adopted one.

      The change was epochal. Those charged with moderating political debate in our media and legislatures have decided that this is not the time for another such change. The US government effectively put a three-trillion-dollar band-aid over the problem, changing nothing. Financiers were “bailed out with taxpayer money”—in other words, their imaginary money was treated as if it were real—while mortgage holders were mostly left to the tender mercy of the courts, subjected to a bankruptcy law that, the previous year, Congress had made far more exacting against debtors. We have even seen a backlash against small-scale debtors, one driven by financial corporations that have now turned to the same government that bailed them out to apply the full force of the law against ordinary citizens in financial trouble…

      The Great & Groovy Guru Graeber, “To Have is to Owe,”>/i> Triple Canopy.

      http://canopycanopycanopy.com/10/to_have_is_to_owe

    • I am also confused about the significance of the shares gifted in the analysis. How did the Fed come to own these shares?

  4. When banks create debts, they also create deposits. Without addition of gov’t funds, when those debts go bad and need to be destroyed, the deposits must also be destroyed. Historically, this led to bank runs. In 2008, a high proportion of the banking sector saw its debts go bad. If those banks went under, debts owed to those banks would be destroyed, but that would require also destroying the deposits. Privately created money only exists if an associated debt exists.

    Doesn’t the FDIC cover such deposits, creating a fund from which to draw when debts are destroyed? Only those deposits in actual banks. But banks haven’t paid interest on deposits since the ’80s, so many, if not most, people have moved their savings into money-market funds and other such financial assets, which are not covered by FDIC. That meant a very high proportion of the population, anyone with savings of any kind, found themselves in the circumstance where a sizeable proportion of their savings (deposits) would need to be destroyed if the gov’t accepted that all those debts in MBSs were destroyed. Rather than accept that outcome, the Fed has acted to confirm, through publicly created money, by first flooding the banks with cash, then by gradually building its portfolio of MBS assets, the existance of those deposits.

    • Without infusions of gov’t spending, the interest on bank created money can only continue be paid if the interest rate declines exponentially.

    • Derryl Hermanutz

      “When banks create debts, they also create deposits. Without addition of gov’t funds, when those debts go bad and need to be destroyed, the deposits must also be destroyed. Historically, this led to bank runs. In 2008, a high proportion of the banking sector saw its debts go bad. If those banks went under, debts owed to those banks would be destroyed, but that would require also destroying the deposits. Privately created money only exists if an associated debt exists. Doesn’t the FDIC cover such deposits, creating a fund from which to draw when debts are destroyed?”

      The FDIC covers money that banks owe to their depositors, in the case the bank goes under and the bank doesn’t have enough money to pay out its depositors. This is a separate issue from a bank’s loan losses. To repay a bank loan the borrower first deposits money in his bank account. Then the bank debits that account balance by the amount of the loan payment, and reduces the borrower’s outstanding loan balance by the same amount. If the borrower defaults because he has no money in his deposit account, the bank can’t make up for that by debiting somebody else’s bank deposit balance.

      When a bank suffers loan losses, the bank has to use its own money to cover the losses. If a no recourse mortgagor owes $500k of outstanding principal balance, and defaults, and the bank forecloses and sells the house for $300k, the bank simply absorbs that $200k loss of outstanding loan principal out of its current operating profits. Were it not for the loan loss that the bank had to pay out of its own money, the bank would have enjoyed an additional $200k of profit that year, some of which it would have paid out as dividends to the bank’s owners and some it would have kept on its balance sheet as retained earnings. Retained earnings (which is after tax profit that has not been paid out in dividends or otherwise distributed to the company’s owners) form part of a corporation’s “capital”, which is the money that the company owes to its owners. You have to remember that a corporation is a separate legal entity from the people who own the corporation. So if you say, “My company owes me $400k”, that means you currently have $400k of capital invested in your company.

      On any corporate balance sheet, including banks, asset = liabilities. To distinguish between owner’s equity and the company’s other liabilities, a bank balance sheet can be written as A = K + L: assets = capital + liabilities. Assets include physical wealth like buildings owned, and money that is owed “to” the company. Liabiities include all the money that is owed “by” the company.

      The deposit balances in a bank’s customer accounts are a “liability” to banks because of the legal requirement that the bank must be able to convert that bank-issued deposit money into Fed-issued “cash” money, which is “currency”. Banks can “create” deposits, but they have to “acquire” currency from their central bank. They do this via an asset swap, usually by giving the Fed a Treasury security in exchange for currency.

      Until the 1990s central banks used their monopoly control over currency issuance, combined with “statutory” currency reserve requirements, to control commercial bank issuance of new credit money. If banking regulators stipulated that banks hold 10% of the total of their customers’ current account balances in the form of cash (or central bank reserve account balances which the central bank will readily convert to cash), and if the central bank wanted to restrict credit-money growth, the central bank could restrict the amount of cash and reserves balances it made available to banks.

      This “direct” approach didn’t work because banks found ready ways around it, so now CBs use the “market” approach to monetary policy, influencing interest rates to try to reduce or increase customers’ desire to take out new loans by raising or lowering the interest cost of borrowing money. Instead of trying to control the banks’ ability to “lend” new money, CBs now try to influence the economy’s willingness to “borrow” new bank money. And because banks can readily create bank deposit money in order to purchase assets like Treasury securities, and those Treasurys can be traded to the Fed for cash, there is no longer any real restriction on banks’ acess to cash. So “fractional reserve banking”, which ultimately means fractional reserves of “cash”, is now an irrelevant concept.

      The interest bearing loans that banks made are the banks’ assets, their source of interest income. Vault cash is also an “asset” to a bank (though a “non-performing” asset because vault cash pays no interest), just like our pocket cash is an asset to you or me, because that cash is now the bank’s own money. When a customer withdraws cash from his bank, the bank debits his deposit account balance and hands over the same sum of cash. Debiting the deposit reduced the bank’s liabilities, and paying out the cash reduced its assets in the same amount.

      Cash merely converts bank deposit money to cash money without altering the total money supply. After a cash withdrawal “the economy” now has a reduced total of bank deposit money and an increased total of cash money. M2, which is a measure of the economy’s immediately spendable or “circulating” money supply, includes checkable bank account balances and cash held outside banks, but doesn’t include cash held in bank vaults as part of the economy’s money supply, because the banking system “issues” the money supply, so cash owned by banks has not yet been issued to the economy.

      So when you add the sum of the positive numbers in the left (assets) column to the sum of the negative numbers in the right (liabilities) column, the balance sheet balances to $zero. Every bank loan is a bank balance sheet expansion that adds new assets on the left side and new labilities on the right side. Our signed mortgage note (or other promissory note) promissing to pay interest and repay the loan principal is the bank’s new “asset”. The new money the bank created in our deposit account to “fund” the loan is the bank’s new “liability”.

      Banks that make large loans usually require that the borrower pledge some saleable collateral as “security” against his “promise” to pay. But the primary assets held by banks are government and private sector “debts”, which is money that we owe to banks when our bond matures or when our loan payment is due. Banks issue our money by monetizing our debts. Our debts are assets to banks because we owe the money “to” the banks. Our money is the banking system’s liability, and our debt is the banking system’s asset. Banks and non-banks are monetary mirror images of each other.

      I know MMT puts government on the money issuing side, and banks along with the rest of the private sector on the money using side, but the straightforward way to understand our money system is to see that non-banks issue debt and banks issue money to purchase that debt. Banks are in the business of earning interest income on the money they create, which is why our interest bearing debts are the banking system’s assets.

      If a bank suffers systemic loan defaults, and if the bank is made to “realize” loan losses by accounting for them on its current year profit/loss statement and balance sheet, and if the bank is becoming illiquid due to insufficient interest income coming in and too many costs being paid out, then the bank may be taken into receivership by banking regulators. If receivers determine that liquidation (sale) of the bank’s assets would not generate enough money to pay out the bank’s obligations, the bank may be declared insolvent and put up for sale.

      Aside from the bank’s physical assets (all its bank branches, etc, which may be of little interest to a competing bank already operating in the same markets), the main value of a bank to a potential buyer is the interest income and other income that might be earned from its customer base and asset portfolio. But the buyer of an insolvent bank will want to buy those assets at a discount. So if a failed bank has a total of $1 billion of loan principal outstanding on its asset portfolio, the buying bank may offer the receiver $800 million. If this deal goes through then the buying bank books the $800 million as its new asset, and the regulators write off the $200 million of loan principal loss.

      So that leaves $200 million of money in the economy that will NEVER be extinguished in a loan repayment, because the people who have the money are not the people who owe it as a debt. The $200 million of unpaid debt was defaulted and the debt was ultimately written off, but the “money” that was created by that debt has not been written off or otherwise extinguished. A lot of the money banks create as deposits, and that borrowers spend into the economy, does not return to the banking system as deposits. There is a large financial economy and shadow banking system that holds money outside of bank accounts. So the banking system balance sheet imbalance that arises from leaving the $200 million of unpaid loan principal out in the economy does not pose a serious balance sheet accounting problem.

  5. John Q. Public

    Ha ha ha, good one. When I’m at work tomorrow and told for the fifth time I’m not moving fast enough and producing enough (which mens I’ll be kicking rocks tomorrow if I don’t run faster than the next guy), I will console my son of a dead beat with stories of American Pride and Success. Go Team Paulson!

  6. Socialism for the rich and capitalism for the poor.

    Or putting it in popular jargon ” Its the rich wot gets the gravy, its the poor wot gets the blame.

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