'Zombie' AIG a unique bailout case

If you got caught up last week in the noisy debate over whether AIG executive Jake DeSantis did or didn't deserve his $742,000 bonus, you might have missed an important point: At long last, the Obama administration laid out a new plan that would nip future DeSantises in the bud.

DeSantis' public letter of resignation capped weeks of growing fury over payments made by his former employer, American International Group Inc. - billions of dollars to other financial institutions such as Deutsche Bank AG and the Goldman Sachs Group Inc. and hundreds of thousands, sometimes millions, in bonuses to executives such as DeSantis.

DeSantis gave all the money to charity (denying that it was "a tax-deduction gimmick") and complained of an anti-AIG fever he said had swept up the innocent with the guilty. Regardless of whether or not you agree, one thing is clear. The bonus brouhaha obscured a key fact about his former employer, one that even DeSantis appears to have missed: He wasn't working for an ordinary bailed-out company.

In common understanding, there was one big financial bailout last fall, and AIG was a prime recipient. But AIG really was a separate case.

Financial experts and economists continue to debate whether some of the big bailed-out banks are truly recovering or are secretly insolvent and should be forced into receivership by the Federal Deposit Insurance Corp., or otherwise nationalized.

But for all intents and purposes, AIG was bankrupt on Sept. 16, the day the Federal Reserve stepped in with its first $85 billion emergency loan. The company could not meet its obligations.

The government just didn't have the tools to deal with it - a huge, multinational, nonbank financial institution with a trillion-dollar balance sheet that ostensibly backstopped $2 trillion in complex financial instruments and was about to pull back on some of its promises.

So the government kept AIG going as a zombie company, handpicked a new chief executive officer, and took an 80 percent equity stake for taxpayers. For the last six months, it has been trying to clean up AIG's mess.

The AIG takeover was totally ad hoc - the opening act of what may someday be known as the Panic of 2008. Former Treasury Secretary Henry M. Paulson Jr. named Edward M. Liddy as AIG's new chief executive. It wasn't until two days later that the AIG board rubber-stamped Paulson's choice.

One result of all this improvisation, as we learned recently, is that a zombie company still had characteristics of a business that was alive and well. Zombie AIG entered into new contracts and said it intended to honor old ones. Employees, understandably, expected it to keep its word.

That is just one small thing that would play out differently under the plan presented last week by Paulson's successor, Treasury Secretary Timothy Geithner.

Key elements of his proposal include new regulation of hedge funds and the complex financial instruments known as derivatives, such as the huge market in "credit default swaps" in which AIG was a prime player.

Had such regulations been in place six months ago, two other Geithner proposals would have dramatically changed the AIG story.

One is a new regulatory agency, or an old agency with a new role, charged with watching out for "systemic risk" - risk that a single company's bad bets could threaten a chain reaction of debilitating financial consequences.

The other is a new "resolution authority" - a legal structure for taking over a nonbank financial institution such as AIG, much as the Federal Deposit Insurance Corp. does when a bank failure threatens systemic risk.

With such authority, Geithner told Congress last week, the federal government could have intervened in an orderly fashion when it recognized that AIG was teetering.

Acting as a conservator or receiver, the new authority could have done what Liddy is trying to do with Zombie AIG: sell off assets to raise some cash, and seek to somehow preserve the company's solid, old-fashioned insurance operations.

But Geithner said the government also would have power that Liddy lacks - such as the authority to repudiate a company's contracts, "including with its employees," or at least force their renegotiation.

Geithner's call for "comprehensive reform" undoubtedly will face challenges.

David Skeel, a bankruptcy expert at the University of Pennsylvania's law school, questioned the need for a new resolution authority. He said bankruptcy courts could manage the restructuring of nonbank financial institutions - even those, such as AIG, considered "too big to fail" because of systemic risk.

Still, Skeel said he welcomed Geithner's proposals.

"This is the hard stuff - this is where we're not just throwing money at the problem," Skeel said. "This is what will or won't make it less likely that we'll see the same kind of disaster in the next five or 10 years."

To John Caskey, an economist and finance expert at Swarthmore College, the key change may be putting one agency in charge of guarding against systemic risk - the kind of authority that might have stopped AIG's huge bets on credit default swaps before they helped push the world economy to the brink.

The agency "could come in and say, 'Whoa, you're building up risks that are too big to handle, and we're going to stop you from doing that,' " Caskey said.