The Foundry

It’s official: U.S. taxpayers did not get a good deal when they bailed out AIG last year. That was the conclusion of a report released yesterday by Neil Barofsky, the federal government’s special inspector general for TARP. The conclusion is no surprise: no one holds up the $170 billion bailout of the insurance giant as an example of government at its best. But, the Inspector General’s report puts new teeth on the charge, and pins much of the blame on Timothy Geithner, then president of the New York Fed.

The report’s key charge against Geithner is essentially that he was a bad negotiator. Here’s what happened: AIG had sold massive amounts of so-called “credit default swaps,” pledging to compensate purchasers in the event of losses due to defaults on debts by other instruments. As part of the effort to shore up AIG last fall, the New York Fed bought out many of the purchasers of these contracts. The general idea was to prevent massive losses that would destablize the entire economy.

Whether or not the purchasers, or “counterparties” — which included huge institutions ranging from Goldman Sachs to France’s Societe Generale — needed protection can be debated. But, under agreements negotiated by Geithner and the New York Fed, counterparty losses weren’t cut in half, or by a third, or even by 10 percent. They suffered no losses at all. They received 100 percent of the value of their contracts, leaving taxpayers out by tens of billions.

The IG faulted Geithner’s negotiating strategy, saying the NY Fed could certainly have used its leverage to reduce payouts, limiting them to 70 or 80 percent on the dollar without jeopardizing the economy. In other words, as CBS News’ blog put it, “Geitner Gave Away the Farm.”

But is Geithner, currently the U.S. Treasury Secretary, really such a naif? If so, he shouldn’t be trusted to buy a car, never mind oversee the financial world. But the truth is really more complicated, as the Atlantic’s Megan McArdle points out. As it turns out, Geithner did try to talk counterparties into accepting lower payouts. But his negotiating power was crippled. Federal officials had already made it clear that they would under no circumstances let AIG fail, or send it into bankruptcy. Its as if they had walked into a used car lot with a wad of cash sticking out of their collective pockets, and declared: “We need a car today, now lets talk price.”

The IG argues that the NY Fed did have leverage, as the regulator of some of the counterparties. It could have threatened dire consequences if they didn’t take a discount. True enough, but Geithner should be praised, not condemned for declining to abuse his power. Geithner also insisted on treating all counterparties the same, something that hindered negotiating ability. That’s a closer call, but differential treatment could also raise legitimate concerns over possible abuse.

The basic problem, as it turns out, isn’t Geithner’s negotiating talent at all. It was his and other federal officials’ insistence from the start that AIG must be preserved, and that bankruptcy was off the table. Without failure as an option, there was no hope of a sucessful negotiation of terms.

All of this underscores the importance of the current congressional debate over “too big too fail” institutions. Most plans under debate would institutionalize “too big to fail,” virtually guaranteeing more AIGs in the future. This is the wrong road. Instead, policymakers must find a way to make orderly failure a realistic option. And this will involve finetuning the bankruptcy process so companies like AIG can go through that process without threatening the economy. That may not be a headline-friendly message. But if we don’t want to be giving away more farms in the future, its a critical one.