“What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup”

More about the Obama Administration’s team, whose motto seems to be “You cannot believe in Change.”  I recommend reading the full article.

What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup“, The Institutional Risk Analyst, 24 November 2008.  It’s worth reading in full.

Here is their conclusion:

By embracing Geithner {as Treasury Secretary}, President-elect Barack Obama is endorsing the ill-advised scheme to support AIG directed by Hank Paulson et al at Goldman Sachs and executed by Tim Geithner and Ben Bernanke. News reports have already documented the ties between GS and AIG, and the backroom machinations by Paulson to get the deal done. This scheme to stay AIG’s resolution cannot possibly work and when it does collapse, Barak Obama and his administration will wear the blame due through their endorsement of Tim Geithner.

Here is an excerpt from their article that explains how they got to this important and (in my opinion) essential conclusion:

The resolution of Downey illustrates both the best and the worst aspects of the government’s remediation efforts. On the one hand, we have argued that the government should be pushing bad banks into the arms of stronger banks to improve the overall condition of the system. The good people at the FDIC do that very well – when politics does not intervene.

In the case of {Downey Savings and Loan} and {PFF Bank and Trust}, it appears that the OTS {Office of Thrift Supervision} and FDIC projected forward from the current above-peer loss rates and concluded that a prompt resolution was required. Reasonable people can argue whether this is the right call. But when we see the equity and debt holders of DSL, Washington Mutual or Lehman Brothers taking a total loss, we have to ask a basic question: why is it that the debt holders of Bear Stearns and AIG are granted salvation by the Federal Reserve Board and the US Treasury, but other investors are not?

If the rule of driving money to the strong banks (see “View from the Top: A Prime Solution to the US Banking Crisis“) safety and soundness is to be effective, it must be applied to all. And now you know why we have questions about the nomination of Tim Geithner to be the next Treasury Secretary.

… a reasonable conclusion might be that the Paulson/Geithner model of political economy is rule by plutocrat. Facilitate a Fed bailout of the speculative elements of the financial world and their sponsors among the larger derivatives dealer banks, but leave the real economy to deal with the crisis via bankruptcy and liquidation. Thus Lehman, WaMu, Wachovia and Downey shareholders and creditors get the axe, but the bondholders and institutional counterparties of Bear and AIG do not.

Few observers outside Wall Street understand that the hundreds of billions of dollars pumped into AIG by the Fed of NY and Treasury, funds used to keep the creditors from a default, has been used to fund the payout at face value of credit default swap contracts (CDS) insurance written by AIG against senior traunches of collateralized debt obligations (CDO). The Paulson/Geithner model for dealing with troubled financial institutions such as AIG with net unfunded obligations to pay CDS contracts seems to be to simply provide the needed liquidity and hope for the best. Fed and AIG officials have even been attempting to purchase the CDOs insured by AIG in an attempt to tear up the CDS contracts. But these efforts only focus on a small part of AIG’s CDS book.

The Paulson/Geithner bailout model as manifest by the AIG situation is untenable and illustrates why President-elect Obama badly needs a new face at Treasury. A face with real financial credentials, somebody like Fannie Mae CEO Herb Allison. A banker with real world transactional experience, somebody who will know precisely how to deal with the last bubble that needs to be lanced – CDS.

Last Thursday, we gave a presentation to the New York Chapter of the Risk Management Association regarding the US banking sector and the long-term issues facing same. You can read a copy of the slides by clicking here.

As part of the presentation (Page 17-21), IRA co-founder Chris Whalen argued the case made by a reader of The IRA a week before (see “New Hope for Financial Economics: Interview with Bill Janeway“) that until we rid the markets of CDS, there will be no restoring investor confidence in financial institutions.

… AIG needs to be put into bankruptcy. As we wrote on TheBigPicture over the weekend, we’ll take our cue from NY State Insurance Commissioner Eric Dinalo and stipulate that we pay true hedge positions at face value, but the specs get pennies on the dollar of the face of CDS. And the specs should take the pennies gratefully and run before the crowd of angry citizens with the torches and pitchforks catch up to them.

President-elect Obama and the American people have a choice:

  1. embrace financial sanity and safety and soundness by deflating the last, biggest speculative bubble using the time-tested mechanism of insolvency, or
  2. we can muddle along for the next decade or more, using the Paulson/Geithner model of financial rescue for the AIG CDS Ponzi scheme and embrace the Japanese model of economic stagnation.

And, yes, we can put AIG and the other providers of protection through a bankruptcy and force the CDS market into a quick and final extinction. Remember, when AIG goes bankrupt the insurance units are taken over by NY, WI and put into statutory receiverships. Only the rancid CDS positions and financial engineering unit of AIG end up in bankruptcy. And fortunately we have a fine example of just how to do it in the bankruptcy of Lehman Brothers.

Our friends at Katten Muchin Rosenman in Chicago wrote last week in their excellent Client Advisory {Lehman Seeks to Establish Expedited Procedures for Assumption, Assignment and Termination of Derivative Contracts, 17 November 2008}:

On November 13, 2008, Lehman Brothers Holdings Inc. and its U.S. affiliates in bankruptcy, including Lehman Brothers Special Financing and Lehman Brothers Commercial Paper (collectively, “Lehman”) filed a motion asking that certain expedited procedures be put in place to allow Lehman to assume, assign or terminate the thousands of executory derivative contracts to which they are a party. If Lehman’s motion is granted, counterparties to transactions that have not been terminated will have very little time to react and will likely find themselves with new counterparties and no further recourse to Lehman because, by assigning contracts to third parties, Lehman will effectively receive, by normal operation of the Bankruptcy Code, a novation.

The bankruptcy court process also allows for parties to terminate or “rip up” CDS contracts, something that has also been fully enabled by the DTCC. The bankruptcy can dispose and the DTCC will confirm.

… The only way to deal with this ridiculous Ponzi scheme is bankruptcy. The way to start that healing process, in our view, is by the Fed emulating the FDIC’s treatment of DSL, withdrawing financial support for AIG and pushing the company into the arms of the bankruptcy court. The eager buyers for the AIG insurance units, cleansed of liability via a receivership, will stretch around the block.

By embracing Geithner, President-elect Barack Obama is endorsing the ill-advised scheme to support AIG directed by Hank Paulson et al at Goldman Sachs and executed by Tim Geithner and Ben Bernanke. News reports have already documented the ties between GS and AIG, and the backroom machinations by Paulson to get the deal done. This scheme to stay AIG’s resolution cannot possibly work and when it does collapse, Barak Obama and his administration will wear the blame due through their endorsement of Tim Geithner.

Afterword

If you are new to this site, please glance at the archives below.  You may find answers to your questions in these.

Please share your comments by posting below.  Per the FM site’s Comment Policy, please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp relevance to this topic:

Analysis of our government’s solutions to date:

  1. Treasury Secretary Paulson leads us across the Rubicon, 9 September 2008
  2. Say good-bye to the old America. Welcome to our new socialist paradise!, 17 September 2008
  3. Another voice warning about the nationalization of AIG, 18 September 2008
  4. What do we know about the financial crisis? What are the key questions?, 20 September 2008
  5. Slowly a few voices are raised about the pending theft of taxpayer money, 20 September 2008
  6. A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
  7. The Paulson Plan will buy assets cheap, just as all good cons offer easy money to the marks, 30 September 2008 
  8. Miscelaneous news and thoughts about the financial crisis, 16 October 2008
  9. A reminder – the TARP program is just theft, 24 November 2008

10 thoughts on ““What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup”

  1. I just skimmed the article, but the following quote jumped out to my eyes:

    Of note, nobody in the audience argued.

    1) Start with the $50 trillion or so in extant CDS.

    2) Assume that as default rates for all types of collateral rise over next 24-36 months, 40% of the $50 trillion in CDS goes into the money. That is $20 trillion gross notional of CDS which must be funded.

    3) Now assume a 25% recovery rate against that portion of all CDS that goes into the money.

    4) That leaves you with a $15 trillion net amount that must be paid by providers of protection in CDS. And remember, a 40% in the money assumption for CDS is VERY conservative. The rise in loss rates for all type of collateral over the next 24 months could easily make the portion of CDS in the money grow to more like 60-70%. That is $40 plus trillion in notional payments vs. a recovery rate in single digits.

    These are the sorts of statistics that cause one to consider becoming a hermit in the wilderness as a career move.
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    Fabius Maximus replies: These are just financial events. Markets are virtual things, connected to but distinct from the real world. These events on “Wall Street” are nothing compared to the recession that is just now hitting “Main Street.” That is what deserves attention.

  2. I understand the reasoning behind the article but I don’t agree with it.

    My guess is that Geithner was chosen primarily to calm the markets and offer some continuity from the market’s perspective. I believe that others, Larry Summers for example, will actually be calling the shots.

    The bigger question in my mind is what will the shots be aimed at? Are we looking at a strictly Keynesian approach of massive government intervention or are we looking at something more creative?

    Jim Jubak points out that the Asians are beginning to view buying US T-Bills as an exercise in stupidity and a massive stimulus package that is funded primarily by printing money could cause more long-term damage than the benefit we would derive from it.

    I’m beginning to wonder if the government’s two obvious options; (Keynesian economics or doing nothing) are really a choice between a long, slow, painful decline and a swift, excruciating one.

  3. Fabius Maximus replies:

    These are just financial events. Markets are virtual things, connected to but distinct from the real world. These events on “Wall Street” are nothing compared to the recession that is just now hitting “Main Street.” That is what deserves attention.

    A while back you laid into me for stressing that the big problem here is not ‘housing’ but derivatives. This article above clearly spells out how most of what is going on has been (and continues to be) about these same infamous thingumajigs which, although as you accurately point out are essentially fictive, nevertheless threaten to bring down the ‘real’ economy. Why? My suspicion is simply because they both use the same underlying measure of value, aka currency it is now impossible to separate the ‘real’ from the ‘fictive’. I have felt from the beginning of this (back in 2005-6) that the only way was to nullify these contracts, and last year as your article recommends to let them go into bankruptcy.

    But the article also points out that really what is going on is an effort to maintain an unelected and unofficial ruling ‘plutocracy’. This gets into the political, moral, financial and cultural meat of the matter. In short, our society is not what it says it is and this current financial meltdown is simply a quantifiable symptom of underlying societal/systemic distortions now imploding.

    It is a mistake to get into ‘good’ versus ‘evil’ thinking on this, however. The current ‘ruling elites’ for the most part, even if they are selfish pricks, believe deeply in what they are doing. It is to be expected that they continue to try to preserve the status quo. And to echo FM’s assertion that it’s all fictive stuff anyway, so are the bailout trillions currently in play. Whether they go to effective or ineffective initiatives is irrelevant. They have to try and Obama has to let them. He has no choice.

    However, if ‘reality’ shows that they have failed, well and truly, after being given every opportunity to succeed, then and only then (along with much suffering on the part of ordinary people of course) can we begin to consider dismantling the current plutocracy and hopefully putting together something whose foundation is based on sanity and reality versus delusions.
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    Fabius Maximus replies: Neither housing nor derivatives are the primary or fundamental source of our problems. It is excess private sector debt. The resulting stress — like torque applied to a complex and large machine — depresses asset prices (e.g., housing, stocks, commodities) and snaps weak links in our economy (e.g., hedge funds, derivatives).

    That is, the primary problem creates secondary problems, which are also quite serious. A medical analogy is syphilis. The secondary problems can also be very serious (with syphilis, dementia).

  4. I recall supporting the bailout with the following reasoning: the Free Market depends on gov’t for two things: 1) defining property rights, and 2) enforcing contracts.
    All bankruptcy is part of the correct gov’t job of enforcing contracts.

    My support of the bailout was to avoid bankruptcy. The failure of the $700 bil. bailout to avoid bankruptcy means the bailout has been a failure.
    As I learned more about the CDS insurance on senior (AAA rated) CDO derivatives, it’s clear to me now that pre-packaged / special bankruptcy would have been and still is better than bailouts.
    “The bankruptcy court process also allows for parties to terminate or “rip up” CDS contracts, something that has also been fully enabled by the DTCC. The bankruptcy can dispose and the DTCC will confirm.

    Not all CDS contracts can be fulfilled. The CDS system is broken. The gov’t plutocrats should NOT be allowed to choose winners and losers; shutting down the CDS market seems the most fair (among all unfair) system.
    Maybe around 10% of face value?

    Yes, AIG goes bankrupt: we pay true hedge positions at face value, but the specs get pennies on the dollar of the face of CDS. And the specs should take the pennies gratefully and run before the crowd of angry citizens with the torches and pitchforks catch up to them.

    The risk paper doesn’t yet solve the housing unfinished crash, nor does it quite deal with the reality of too many bankers. It’s easy to see that when there are too many houses, and house building stops, some 500 000 folks loose their jobs.
    There should probably be more than 500 000 folks losing their finance jobs.
    Starting at AIG, Fannie Mae, CITI, Lehman (oh, already started, I guess!).

  5. Pluto, any Asians not wanting to buy T-bills are welcome to try … CDS or CDOs!
    Or to loan to businesses, in the US or elsewhere.
    Or to stop selling junk to Americans (and see how their own unemployment goes up). I read in Strategy Page that China is having a crisis of increasing bankruptcies and unemployment due to a drop in exports — maybe the Chinese should send a huge ‘tax rebate’ to its own poor, inland farmers so that they can buy more Chinese stuff (and even improve their own lives).

    For this crisis, maybe only this one, America will avoid the world ‘punishment’ it might deserve because just about everywhere else provides no better high yield-low risk investments. As long as the Chinese gov’t wants to support exports (and Chinese employment) by funding US import consumption, they’ll have to keep making loans to US buyers. They do NOT get the export market without making the loans; altho maybe they need to accept that the loans might be more like gifts, which might mean the Chinese are not getting such a sweet deal as they expected.

    I saw that the UK is dropping the claim that China has taken Tibet (?Strategy Page? They Sold Tibet). When the US owes China $600 bil., … China has a problem.

  6. Erasmus’ comment points to the high ground in this discussion. The existing financial system will do what it thinks will maintain the system in the short run, whether it is just or effective or not, and we can’t really expect them to do otherwise. FM may be right in calling this the end of the post WW II economic order, but there is no lobby or intellectual concensus on how to replace it, so the current order will stumble forward as best it can.

    So far, European countries seem to have been more creative in their responses to the crisis, illustrating perhaps that smaller entities are always nimbler.

    Erasmus’ comment that Geithner’s appointment was made to “calm the markets” makes me think of a further motive — the stock markets are the most visible public barometer of the health of the economy, and the one place aside from their job, where most people are affected. Keeping the stock market from a monumental collapse may have been an equally important motive as “restoring liquidity”, etc.

  7. Market depends on gov’t for two things: 1) defining property rights, and 2) enforcing contracts.
    All bankruptcy is part of the correct gov’t job of enforcing contracts.

    One possible way out – ultimately and theoretically – would be something like the surrender and regrant policy the Tudors pursued in 16th Century Ireland.

    Prior to that time, Irish property and other rested upon its traditional Brehon laws, which differed from British common law and other jurisprudence.

    The linked article characterizes the surrender and regrant policy as a failure. This is true in the sense that, in the short term, it was associated with a series of bloody and expensive Irish uprisings and, in the long term, it was associated with both Swift’s “Modest Proposal” as well as the potato famine. However, it is false in the sense that these policies prevented the Spanish from using Ireland as a launching pad to invade Elizabethan England and, in the long term, the Tudor conquest of Ireland would be the first step toward establishing the British Empire.

    Some sort of contemporary surrender and regrant policy would likewise involve surrendering current property and contract rights in return for others that we find to be more just and/or more pragmatic.

  8. It seems to be an inherent conundrum that anyone with any experience in this realm is already somewhat tainted and discredited by the circumstances such people would be assigned to solve. Besides this insiderness problem, it may be that there are inherent limitations associated with these organisms… corporations… when they scale up to a certain size.

    Metaphors abound in the natural world… beyond a certain size, human beings have problems… dinosaurs… plants that get stalky and topple. If one assumes that complexity is vulnerability, and that things generally get more complex as they get larger, one may be forced to conclude that many of our problems result from exceeding optimal limits of scaling things up. This is more obvious when one considers that the larger anything is, the more ‘expensive’ it is to grow in one way or another… and that compulsion in turn, to grow or die, which is now more difficult, leads to diversification… which increases complexity and diminishes focus.

    So what we are seeing in the financial world (without even indulging in the complexity of derivatives, and of the system itself across corporate and governmental limits) may be symptomatic of what, let us ponder, may be behind what is going wrong with newspapers, the music industry, television… all the areas in which there is a widely perceived diminution of quality that is associated with, if not caused by, the growth in the size of corporations.

    This leads to the shocking, simple, but perhaps effective notion that what society may need to do as a form of regulation is start to impose size limits on corporate entities and systems. When it gets too big, it has to split up… exactly how long have amoebas been around?

  9. Greg: elegant and interesting comment! The concept applies in many areas, as you suggest. Not only corporations should be broken up, but perhaps governing bodies and nations too. Democracy is really a meaningless concept in a country of 300 million people. At that size, government can only be authoritarian. Truth is sacrificed to propaganda.

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