AIG has attracted a lot of ridicule and anger with the announcement that it might join Ace Greenberg’s suit contesting the Constitutionality of the firm’s bailout in 2008. The prevailing theme is that AIG is being extremely ungrateful. If the Feds hadn’t bailed it out, it would have gone bankrupt, and its shareholders would have gotten nothing.
Well, Greenberg’s point is that its shareholders did get nothing, and gave up something valuable in return. That the government exploited AIG in its hour of distress.
I realize that the suit has a snowball’s chance in hell, and that there is a rather tragicomic aspect to it. But, contrarian that I am, I feel obliged to offer up a couple of counterpoints to the conventional wisdom.
Most notably, bankruptcy law incorporates several provisions intended to protect the claimants of financially distressed firms from the depredations of would-be saviors. Preference and fraudulent conveyance provisions of the bankruptcy code permit other creditors to claw back money from a “savior” that buys assets from a distressed firm at bargain prices.
AIG didn’t declare bankruptcy, so this isn’t a legal issue. Moreover, it would be a remedy available to creditors, not shareholders. But the basic principle is pretty clear: you can’t take advantage of a firm’s financial distress to extract unduly favorable loan terms, or to buy the firm’s assets at unduly favorable prices.
That’s the gravamen of Greenberg’s claim. That the Fed and Treasury obtained control of AIG at a fraction of its true value because the firm had no alternative but to accept these terms. ”The firm was going to fail if it didn’t accept my terms” doesn’t fly in bankruptcy court. Given the implicit principle in that, why shouldn’t the same argument apply to the US government? I would actually suggest that the question should be: why shouldn’t that argument apply with special force to the US government, given its disproportionate power, especially during such extraordinary times? Bankruptcy law is structured to protect the creditors of desperate firms from the the predations of those who exploit that desperation. An efficiency-driven economic story can be told to justify that structure. That story applies when the potential exploiter is the government.
Interestingly, at the time of the crisis, Bernanke testified before Congress that due to the liquidity crisis, market prices of assets were far below their fair values based on discounted expected cash flows. He did so, in part, to justify Fed assistance to everyone from banks to money markets: “It’s a liquidity problem, not a solvency problem, so we’ll get paid back. It’s not really a bailout.” Given the evaporation of liquidity and the implosion of asset markets at this time, it is pretty clear that conditions were extraordinary, and those with money to spare-like the Fed and the Treasury-wielded the whip hand. The liquid were in a dominant position to extract wealth from the illiquid.
And that in a nutshell is what Greenberg is claiming that the Fed did: the Fed exploited AIG’s illiquidity (which reflected the general implosion of liquidity) in order to get assets for a song. So Greenberg’s claims should not be dismissed out of hand. Indeed, Bernanke’s Fire Sale Chat provides considerable validation for his claims.
That said, there are other considerations. Moral hazard, for instance. Bagehot’s dictum for the lender of last resort-lend against good collateral, at penalty rates-reflects a balance between liquidity and moral hazard considerations: the penalty rate provides a disincentive to court trouble. Pour encourager les autres, it was appropriate to pay below fair value for AIG’s assets/equity, lest others take excessive risks in the comfort that a Fed put would protect them from the worst.
But how much below? That’s a harder question. But it’s by no means obvious that 100 percent below is the right answer. Those responding to Greenberg and AIG in such high dudgeon believe it is the right answer. Contrarian that I am, I wouldn’t be so sure.