A report released today calls into question the actions taken by the New York Fed during the time that AIG was being bailed out by the government.  The Special Inspector General (SIG) of the TARP was asked by Congress to look into what the actions of the government with regard to AIG.  Specifically, Congress requested that the decision making process be examined, a determination be made as to why AIG's counterparties were paid at par, and what exposure to credit default swaps remains on AIG's books.

As you know, and as the report says, in the fall of 2008, AIG was facing a liquidity crisis.  Attempts to find financing from the private sector were unsuccessful, and in the end, the New York Fed and Treasury decided to provide financial support to AIG instead of letting it file for chapter 11.  There was concern that if AIG failed, "key sectors" of the financial system, "such as retirement accounts and the credit market," would be harmed.

Initially, the government injected capital into AIG, which came with a high interest rate.  However, when it became clear that AIG's liquidity problem would not be solved by the injection of capital and another downgrade to the company's credit rating was imminent, the government decided to step in and buy the underlying assets on which AIG had sold credit default swaps.  By purchasing the underlying assets, the government effectively wiped out any liability AIG had to its counterparties, because now the only counterparty was the government.

According to the SIG, the government made "limited efforts" to negotiate concessions.  However, when the government encountered resistance, it decided to pay the counterparties at par.  The government felt that its ability to negotiate would be hampered by a number of factors.  One of the biggest was that since the threat of bankruptcy had been eliminated by the government's rescue action, government negotiators felt they had lost leverage.

The SIG concluded that the government made several decisions that "severely limited" its ability to extract concessions.  First, it decided that it would treat all the counterparties the same and that foreign banks would not be treated differently than domestic banks.  This made it next to impossible to get concessions, as the French government refused to allow two of its banks to accept concessions.  Second, this gave effective veto power to any one of the counterparties.

The government also let AIG's counterparties know that participation in the negotiations was voluntary.  As a regulator of the entities that held AIG's credit default swaps, the government did not want to be seen as using a heavy hand.

In the end, the decisions of the government potentially resulted in significantly more being paid to AIG's counterparties than necessary.  Members of the government who were involved in the decision defended their actions.  Treasury secretary Timothy Geithner, who was the president of the New York Fed at the time when the bailout of AIG was taking place, said "you're going to see a lot of conviction in this, a lot of strong views -- a lot of it untainted by experience."

However, all is not lost.  AIG owes the government $19.3 billion for the underlying assets that were taken off the hands of its counterparties.  The current market value of those underlying assets is $23.5 billion.

So, despite what happened, it is possible that the government may make money on the AIG bailout.  Nevertheless, the government needs to learn from this incident and not make the same mistake if something like this happens again.