Did Bush officials hide depth of AIG problems?

WASHINGTON — At the peak of the 2008 financial crisis, then-Treasury Secretary Henry Paulson and top Federal Reserve officials told the nation that there was an urgent need for the government to lend $85 billion to the American International Group so the giant insurer's temporary cash squeeze wouldn't trigger global financial chaos.

Nearly two years later, taxpayers are on the hook for twice that amount, and it now appears that Paulson and senior Federal Reserve officials either plunged ahead without understanding AIG's financial situation and the risks it posed to taxpayers — or were less than candid about one of the largest corporate bailouts in U.S. history.

AIG reported combined total losses of $110 billion in 2008 and 2009, erasing any doubt that the government stepped into a colossal mess.

AIG was at the epicenter of all the government bailouts of financial institutions in 2008, a company through which more than $90 billion in federal money flowed out the back door to some of the same Wall Street banks whose risky behavior fueled the crisis. Among the leading beneficiaries of the AIG bailout was investment banking giant Goldman Sachs, which Paulson headed until June 2006.

Explanations of the bailout from current and former top government officials have never fully jibed, fueling allegations that most of the money was always intended for Wall Street rather than Main Street.

Elizabeth Warren, the chairwoman of the Congressional Oversight Panel that's tracking the use of bailout money, said at a hearing in late May that the government "broke all the rules" with its rescue of AIG, which she labeled a "corporate Frankenstein" that defied regulatory oversight.

As the Fed wired billions of dollars to AIG in the fall of 2008, state and federal officials assured the public that the company's financial woes were limited largely to its parent, which had wagered $2 trillion on exotic financial instruments and incurred massive losses on housing-related investments. AIG's six dozen U.S.-based insurance companies, the regulators said, were all on solid footings.

A McClatchy analysis of the finances of 20 of AIG's larger insurance subsidiaries at the time has found a much bleaker picture, however: More than $200 billion in potential red ink was obscured by entanglements in which these subsidiaries bought stock in, reinsured or guaranteed debts of their sister companies.

Despite the regulators' public assurances and AIG's assertion that pooling arrangements among its subsidiaries made the liabilities look worse than they actually were, AIG has since propped up its insurance subsidiaries with $31 billion of taxpayers' dollars, and its total debt to taxpayers — once as much as $182 billion — still could reach $162.5 billion.

Now the company, nearly 80 percent owned by taxpayers, is reporting profits again and appears to have stabilized. Even before AIG's planned $35.5 billion sale of a prized Asian insurance subsidiary collapsed on June 1, however, government auditors projected that bailing it out will still cost taxpayers as much as $47 billion.

Most experts agree that shoring up the giant insurer was important to prevent a systemic financial breakdown, but critics question the government's handling of the bailout — from its misleading early portrayals of AIG's financial condition to failing to press Wall Street creditors such as Goldman to accept discounted payments from AIG.

Warren, whose panel is completing a critical report on the bailout, said, "The government invented a new process out of whole cloth."

In a normal restructuring, she said, AIG's shareholders "should have lost everything, and its creditors should have taken substantial losses."

Neil Barofsky, the special inspector general assigned to watch over hundreds of billions in federal bailout dollars, last fall also criticized the Fed's decision to pay Goldman and others 100 cents on the dollar to settle AIG's insurance-like bets, known as credit-default swaps, on offshore mortgage securities.

Instead, creditors such as Goldman were paid in full, and AIG shareholders' stock was diluted twentyfold, but not wiped out.

Now Barofsky is investigating whether New York Fed employees may have concealed information about the bailout and whether Wall Street firms might have defrauded taxpayers by concealing risks in seven offshore deals that AIG had insured. To settle AIG's positions, the New York Fed wound up buying mortgages in deals that appeared headed for default.

A central question is how much U.S. officials knew about the company's problems when they decided to bail it out.

Thomas Baxter, the general counsel of the Federal Reserve Bank of New York, acknowledged in phone interviews that the Fed's understanding of the insurer's financial condition "changed over time as we got to know AIG and its problems."

"That led us to come up with different solutions as we learned . . . that its problems were both liquidity (a cash squeeze) and capital (insufficient assets)," he said.

Robert Eisenbeis, a former research director for the Federal Reserve Bank of Atlanta, said that the AIG bailout "was painted as a liquidity problem, and it was a solvency problem. And it's still a solvency issue."

In making the massive loans to AIG, the Fed was wielding vast emergency powers that dated to the post-Depression era and were expanded by Congress in 1991.

Treasury Secretary Timothy Geithner, who headed the New York Fed in the fall of 2008, told Congress in late January that the central bank had the authority "to protect the financial system from broad-based runs," but could lend only to "firms that were solvent," able to pay their debts.

He made no mention of AIG's questionable solvency.

In his recently published book, "On the Brink," Paulson describes advising President George W. Bush at a White House meeting on Sept. 16, 2008, that AIG needed a large but temporary cash infusion.

Paulson also wrote that he persuaded presidential candidates Barack Obama and John McCain not to call the AIG rescue a "bailout," and they obliged.

He recalled that he told Bush that AIG, unlike the investment bank Lehman Brothers, which had gone bankrupt two days earlier, didn't have a shortage of assets — "at least we didn't think so at the time."

However, Paulson also recalled learning within weeks that AIG was "in dreadful shape . . . a badly wounded company" on the verge of collapse, unable even to make the interest payments on its government loans. On Nov. 5, 2008, the day after the presidential election, Paulson advised Bush that the Treasury Department would pay $40 billion to buy preferred stock in the insurer to keep it alive.

Paulson wrote that Bush asked his Treasury Department aide, Jim Lambright: "Will we ever get the money back?"

"I don't know, sir," Lambright replied.

A spokeswoman for Paulson referred a reporter to his book and declined further comment.

The GAO found last year that Paulson and the New York Fed initiated the rescue without consulting the Office of Thrift Supervision, a Treasury Department agency that regulated AIG's consolidated operations because the insurer owned a savings bank, but which never policed the company effectively.

The OTS had sent AIG a scathing, confidential letter in March 2008 citing its failure to write off losses from its swaps dealings properly and downgrading the insurer's regulatory rating.

However, the officials at the New York Fed who were watching over AIG knew so little about its financial troubles that the insurer wasn't among the "top 10 exposures" they were monitoring until days before the bailout, Sarah Dahlgren, an executive vice president at the powerful regional bank, told Warren's panel.

Insurers such as AIG seldom make much of their money from policy premiums, which they must set aside to pay future claims. To generate big profits, they need investment bonanzas.

AIG's gambles instead racked up colossal losses.

One AIG investment company, AIG Securities Lending, borrowed as much as $94 billion in high-grade bonds from domestic life insurers and loaned $76 billion of the bonds to U.S. banks in return for cash. It then invested the short-term money in long-term mortgage securities backed by loans to homebuyers with marginal credit.

Douglas Slape, the chief financial analyst for the Texas Department of Insurance, said that Texas regulators discovered, during a routine exam in 2007 just as the housing market began to stutter, that AIG had "overinvested in one sector — the housing market."

State regulators pressed AIG to unravel the program, but it had divested only about a quarter of its risky securities by the third quarter of 2008, when the crisis hit.

The banks' demanded their short-term money back in return for the bonds, which escalated AIG's cash drain.

After the taxpayer bailout, McClatchy found, AIG distributed $20 billion in securities lending losses among its insurance subsidiaries, and then offset the red ink by booking similarly sized capital contributions that only could have come from taxpayers. That lifeline kept seven life insurers in the black, according to their regulatory filings.

However, AIG then assessed several of the insurers $7 billion, cobbling that together with government cash and loans to finance a $43.7 billion settlement that returned the bonds to the insurers and left taxpayers holding risky mortgage securities.

W.O. Myrick, a retired Louisiana chief insurance examiner who's studied AIG, criticized state regulators for allowing the insurers to "falsify" their balance sheets by continuing to list the bonds as assets while they were loaned to banks.

"Had something been done back then," Myrick said, "there would have been people that would have been speaking up to avoid long prison terms," perhaps leading to action that could have prevented the massive securities lending losses.

Many of the company's troubles have been blamed on its colorful former chairman, Maurice "Hank" Greenberg. While he presided for 37 years over its growth into a trillion-dollar goliath with operations in more than 130 countries, the firm also ran afoul of the law.

Beginning in 2004, the SEC obtained three court injunctions barring AIG from illegal practices including bid rigging and accounting fraud, including concealment of liabilities in offshore companies that it secretly controlled. In 2004 and again in early 2006, the Justice Department and AIG signed agreements that deferred criminal prosecution.

The worst shenanigans didn't occur until after Greenberg's 2005 departure, however. The firm's London subsidiary, AIG Financial Products, issued $500 billion in insurance-like contracts, known as credit-default swaps, which amounted to bets on the performance of securities.

From 2004 to 2006, AIG wrote swaps for Goldman and other banks covering $70 billion in mortgage securities, most of them backed by home loans to shaky borrowers.

When the housing market crash sank the securities' value, the banks clamored for the cash AIG had posted as collateral on these swaps.

AIG wound up settling most of its bad bets by effectively buying the underlying securities from U.S. and European banks, most of them for their full face value of $62 billion, including $15.6 billion to Goldman, a firm that had a decades-long relationship with the insurer and former executives perched in senior Bush administration jobs.

AIG then used the securities as collateral for a $24.3 billion loan from the Federal Reserve Bank of New York.

Some critics allege that in buying those securities, the New York Fed illegally accepted as loan security the same kinds of toxic assets that firms such as Goldman were desperate to dump.

Unlike President Franklin Roosevelt in the Depression era, neither Bush nor Obama stood up to the major financial institutions by refusing to bail out those with "bad assets," said Michael Aguirre, a San Diego lawyer who's fighting in an appeals court for the right to sue AIG for allegedly defrauding policyholders.

"AIG went to always higher levels of fraud, higher levels of risk, and finally this whole thing blew up," but the insurer still got bailed out, Aguirre said.

Fed officials say the loans were legal, and that the securities, the best slices of packages marketed offshore, have recouped so much value that taxpayers are ahead $6 billion to $7 billion.

A newly released October 2008 draft analysis by Blackrock, Inc., a financial services firm assisting the New York Fed with the bailout, concluded that the securities were essentially safe bets all along. Even in a catastrophic scenario, Blackrock found, there was little risk of more than a partial loss of interest payments on those mortgage-backed securities.

Sylvain Raynes, an expert in structured securities who's followed the subprime mortgage meltdown, said that if Blackrock's analysis is accurate, Goldman and others had few grounds to demand more cash from AIG, and "no bailout was needed."

The New York Fed's Baxter said the rescue of AIG "wasn't about Wall Street," but about calming panic and unfreezing credit markets.

AIG's creditors "came in all shapes and sizes, and I'm not fighting that some were large financial institutions," Baxter said. "But that's not why we did what we did. It was the rest of America, really: Pensions, 401K holders, municipalities."

Thomas Gober, a former Mississippi chief insurance examiner, however, fears that AIG's problems run so deep that taxpayers and insurance policyholders will be left holding the bag.

Gober, who said he's been paid as a plaintiff's expert witness in suits against the company, alleged that until it was rescued, AIG's parent followed a business model that he said resembled a Ponzi scheme.

The parent company, he charged, drained billions of dollars in dividends from its subsidiaries, deceived regulators by shifting liabilities to affiliates or offshore companies and lured consumers to make lump sum investments in a bid to keep pace with spiraling obligations.

AIG denies such allegations.

Gober said state regulators couldn't keep up with the schemes because they never coordinated a simultaneous financial audit of all of AIG's 71 domestic insurers, 18 of which have now been sold, so he attempted one himself last year.

He now predicts $300 billion in additional losses to taxpayers and policyholders — possibly double or triple that — "based on AIG's pattern of false accounting schemes and persistent overstating of assets and understating of liabilities."

"I'm expecting it to be a significant insolvency when all the propping up stops," said Myrick, the Louisiana examiner who's spent hundreds of unpaid hours studying AIG subsidiaries' regulatory filings and examination reports. He warned that policyholders, such as those who bought retirement products guaranteeing monthly fixed-income payments, could be at risk.

Robert Benmosche, AIG's chief executive, dismisses such talk. In a phone interview, he said that, "the policyholders are completely protected . . . in every country we do business in."

Scott Harrington, a professor at the University of Pennsylvania's Wharton School of Business who specializes in insurance, agrees that U.S. policyholders won't get hurt. He said he finds it "fundamentally implausible" that policyholders will be left short "now that the U.S. government is standing behind any and all claims against AIG."

Benmosche acknowledged that the company "would not be here as it is today if it were not for government support."

He predicted, however, that the firm's recovering core operations and steady selloff of assets will propel the repayment of its $132.3 billion in outstanding taxpayer loans ahead of a 2013 deadline.

In testimony to Warren's panel in late May, Benmosche said he thought the company could generate $6 billion to $8 billion in net profits by 2011.

"If he can get it to $8 billion (in) after-tax earnings," said James Millstein, the Treasury Department's chief restructuring officer, "we're gonna be repaid in full."

In recent weeks, Benmosche and AIG have trumpeted an upgrade of its credit ratings and the potential for a huge financial boost by selling two plum Asian insurance companies, American International Assurance, or AIA, and the American Life Insurance Co., known as Alico, for $51 billion by year's end.

However, London-based Prudential PLC pulled out of the AIA purchase after British regulators questioned whether the company could carry the extra debt load and its shareholders protested.

"AIG is in the best shape it's been in two years," Benmosche said in a letter to employees after the deal fell through, "and our goals remain the same: to honor all of our obligations, divest certain assets to repay the U.S. government and ensure that our remaining businesses thrive."

AIG is expected to make good on its $83 billion debt to the New York Fed, but the Government Accountability Office predicted in April that the company will draw down the remaining $22 billion available on a nearly $30 billion credit line from the Treasury Department.

The most recent forecasts from the Congressional Budget Office and the Treasury Department project taxpayer losses of $36 billion to $47 billion on Treasury loans to AIG totaling nearly $70 billion.

Moreover, while nearly every major bailed-out bank has arranged to repay its emergency government loans, American taxpayers still own a 79.8 percent stake in AIG, a company with a labyrinth of internal financial relationships and such a history of law breaking that a Delaware judge last year likened it to "a criminal organization."

MORE FROM MCCLATCHY

McClatchy's Pulitzer-finalist coverage of the financial crisis

McClatchy's investigation of Goldman Sachs

McClatchy's coverage of the Gulf oil spill

Check out McClatchy's politics blog: Planet Washington