Watchdog’s critique of NY Fed actions on AIG raises question of regulatory authority

Exclusive analysis for FinReg21 by Darrell Delamaide

The watchdog for the bank bailout suggested in a report this week that the New York Federal Reserve Bank placed an unnecessary burden on taxpayers by paying AIG’s counterparties the full value of their credit default swaps instead of getting them to take partial payment.

An audit of the payments by Neil Barofsky, special inspector general for the Troubled Asset Relief Program (SIGTARP), concluded that the Fed should have used its authority as a regulator to extract concessions from the banks, raising a question about the limits of regulatory authority.

The criticism led to some defensive posturing by the then-president of the New York Fed, who now happens to be the secretary of the Treasury. Timothy Geithner took the “you had to be there” line of defense.

“It’s a great strength of our country, that you’re going to have the chance for a range of people to look back at every decision made in every stage in this crisis, and look at the quality of judgments made and evaluate them with the benefit of hindsight,” Geithner said at a press conference after the audit came out. “Now, you’re going to see a lot of conviction in this, a lot of strong views – a lot of it untainted by experience,” he said.

There’s a certain amount of disdain in the use of the words “hindsight” and “untainted by experience” that seems to allow little room for learning from mistakes, well-intentioned or not, or even conceding that one can make mistakes in the heat of the battle. By definition, Geithner seems to be saying, the decisions were the right ones because they were the ones we made.

In its written response to the audit, the Fed, represented by lawyers for both the New York Fed and the Federal Reserve Board, merely re-asserted that it had acted appropriately, had respected contracts and had treated everybody equally.

But Barofsky – a prosecutor “untainted by experience” in Geithner’s words – thought the Fed should have used its authority as a regulator to demand that the counterparties take a haircut on the payments.

He acknowledged that such a use of the authority could be subject to abuse and should be exercised carefully, but also pointed out that the Fed did not hesitate to bully Bank of America into acquiring Merrill Lynch and the government was willing to jawbone creditors of the auto makers into accepting concessions in those rescues.

The banks had sound reasons for not “voluntarily” accepting a haircut. The biggest was that AIG was not in danger of going bankrupt once the government intervened to prop it up. So, Barofsky is suggesting, what is wrong with the government using its regulatory authority to sidestep this Catch-22?

The efforts made by New York Fed officials to gain concessions seem particularly half-hearted as described in the audit, consisting largely, it seems, of a single phone call. The banks said “no,” and the officials threw up their hands and said “guess we have to pay them the full amount.”

What lends the whole controversy some piquancy is that one of the biggest beneficiaries of these counterparty payments was Goldman Sachs, whose former chairman and current board member, Stephen Friedman, was chairman of the New York Fed during this critical period, and who was buying more stock in the bank in the belief the share price would rise.

Geithner was notably timid about throwing around his weight as a regulator when he was president of the New York Fed. Though he realized that the burgeoning market in credit default swaps could pose some risks, the only jawboning he did with the banks was to have them clean up their paperwork.

In congressional testimony for his nomination to head the Treasury Department, Geithner even said at one point he had never been a regulator, even though that is part of the job description for the New York Fed president.

So the Treasury secretary has something of a credibility problem when he goes before Congress to push the administration’s program for regulatory reform.

“We need to move on the reform agenda when the memory of the crisis is still acute,” Geithner said during an appearance this week before the Senate Foreign Relations Committee, urging Congress not to drop the ball on regulatory reform.

In testimony later in the week before the Joint Economic Committee, he said the reform package must be passed in order for us to meet “our obligation to the next generation.”

The centerpiece of the reform is the resolution authority for non-bank financial institutions. This is Geithner’s preferred solution for any future AIG dilemma, and was cited by the Fed lawyers in their written response to the SIGTARP audit as the appropriate lesson to be drawn from the AIG experience.

But it will be difficult to debate the merits of this proposal or regulatory reform in general if the Treasury secretary wants to exclude the benefit of hindsight or limit the discussion to those who were indeed tainted by experience.

Meanwhile, the political fallout from the SIGTARP report has already started. Former Republican congressman Rob Simmons, who is challenging Sen. Chris Dodd (D-Conn.) in next year’s election, called on Geithner to resign after the report came out. “America can no longer afford Geithner’s failed prescriptions and mismanagement,” Simmons said in a statement on his campaign site.