The actions taken to prevent the collapse of American International Group commenced nine years ago this month. The government’s response to AIG was one of the most controversial chapters of the global financial crisis, even though the intervening years have shown that stabilizing AIG, as distasteful at it was, marked an important milestone in stemming a rapidly developing systemic crisis. But reforms put in place since then — many of which were established by the Dodd-Frank Act — offer essential protections against similar catastrophes occurring in the future.
If attempts to repeal those protections are successful, it will be a big step backward.
To be clear, AIG would have failed had not the federal government intervened, leaving our economy even more exposed to a systemic collapse. Then-Treasury Secretary Henry Paulson and the Federal Reserve Board acted because they feared an AIG bankruptcy — at that time and in those circumstances — could bring down our financial system. Initially, the Fed provided an $85 billion loan in return for preferred shares in the company. Later, Treasury provided additional funds through the Troubled Asset Relief Program, and the Fed provided over $50 billion in additional credit.
The activities that brought AIG to its knees and that required the unfathomable $182 billion the government committed to keep the company afloat made AIG the poster child for the most unsavory aspects of the global financial crisis.
Calamity turned to farce when the former chairman of AIG, Maurice Greenberg, sued Treasury and the Fed. He audaciously claimed that their actions were without legal authority and were an unconstitutional “taking” from the shareholders, despite the fact that the company would have gone bankrupt, completely wiping out shareholders, without government intervention.
Fortunately, the story got better over time.
The federal government ultimately recovered all of the money committed to AIG and then some. The government sold its final AIG shares in 2012, ending up with a total profit of $23 billion. The late Robert Benmosche, who became the company’s CEO in 2009 and committed the company to repaying the government in full, deserves special mention for making that happen.
Greenberg eventually lost in court. The trial court agreed with Mr. Greenberg that the government didn’t have the right to do what it did, but declined to award damages. But last spring, the court of appeals overruled the trial court, threw out the lawsuit and ordered Greenberg to pay the government’s costs.
Even though the government recouped its money, the AIG debacle remains a terrible episode in the history of our financial markets. The company’s collapse during the financial crisis revealed significant deficiencies in our financial system and the government’s response capability. While Dodd Frank addressed many issues and can surely be improved on in several areas — its effects on smaller banks come to mind — repeal of the reforms that addressed the AIG fiasco would be a mistake.
AIG was largely undone by excessive risk taken on by swap traders in London not subject to oversight. The U.S. and other governments have subsequently reformed the over-the-counter swaps markets. Today, most swaps are subject to margin and capital requirements, and must be traded on regulated platforms and cleared through central clearinghouses.
The government also has new tools to make sure the failure of a nonbank financial institution doesn’t cause massive damage to our financial system.
The calls to repeal Dodd-Frank cast doubt over the survival of these reforms, even as the lessons of AIG show how we have benefited from them. The principles now governing swaps markets are similar to those that govern the futures market, which operated smoothly through the crisis. The financial industry has generally accepted these reforms, which may need some fine-tuning, but they should not be repealed. Steps such as harmonizing international trading rules (as has been done with margin and certain clearinghouse rules) would help, and the supplementary leverage ratio that applies to banks should be modified so that they aren’t penalized for posting cash margin with clearinghouses.
The Orderly Liquidation Authority mandated by Dodd-Frank gives the government the ability to resolve and wind down a large financial services firm like AIG whose failure would otherwise threaten the system. Those calling for repeal of this authority, which imposes losses on shareholders and creditors rather than taxpayers, believe it contributes to moral hazard and suggest that the bankruptcy process can be tweaked to handle financial institutions. But systemic institutions may require something more, depending on the circumstances. In a situation where a financial panic is feared, the government must be able to act quickly to prevent bank runs and restore market stability.
Some proponents of repealing crisis-era regulatory reforms argue that higher capital levels offer better protection, in part because regulators cannot predict what will be the source of the next crisis. More capital is good, but it alone won’t solve every problem, and our inability to predict the future compels us to learn from the past. Does anybody really want to risk having another AIG that can threaten the collapse of our financial system?