U.S. Treasury Secretary Timothy Geithner warned a congressional committee Wednesday that the U.S. economic crisis is not over, and defended the bailout of insurance giant AIG, arguing that not doing anything would have amplified the scale of the financial crisis.
Testifying before the House Oversight Committee on the government’s rescue of AIG, Geithner described the decision by Treasury and the Federal Reserve to step in as “exceptionally difficult and enormously consequential.”
The actions were necessary because the U.S. economy stood at the brink in the fall of 2008, with people rapidly losing confidence in the financial system and in the government’s ability to safeguard their economic future, he said in his prepared testimony.
“Action was required. The world was watching. And the government did not have the luxury of time,” Geithner told the panel. “We know that when confronting a severe economic crisis the government must respond with overwhelming force.”
Even more than a year after the upheaval in the financial system, “the economic crisis is not over,” the Treasury secretary said, noting that substantial challenges remain, including high unemployment, foreclosures, and the “significant” losses experienced by small banks.
But Geithner said that on the fateful weekend in September 2008 when officials gathered to contemplate AIG’s potentially “fatal” liquidity problems, the conclusion reached was that AIG’s failure would be catastrophic.
“AIG was much larger than Lehman, it was spread across more countries than Lehman, and while it posed many of the same basic risks as Lehman, they were actually greater because of AIG’s role as an insurance company,” he said.
AIG’s collapse, he added, would have directly threatened the savings of millions of Americans in ways that the Lehman bankruptcy did not.
And on a global level, Geithner said the stress, the failure of a large, global, highly-rated financial institution that had written hundreds of billion dollars of insurance on a range of financial instruments “would have dramatically amplified the crisis.”
If people thought the fallout from the Lehman bankruptcy was bad, he said, “The effects of the failure of AIG would have been much worse.”
Very few options were available to the government to contain this potential catastrophe, he said.
Amid the administration’s push for expanded resolution authority to resolve large failing financial institutions, Geithner said it was clear at the time there was no effective existing mechanism to limit the damage of an AIG failure.
“There was no legal tool available to handle the failure of AIG, comparable to the one available to the Federal Deposit Insurance Corporation for managing the orderly wind-down of a troubled bank,” he said.
The Federal Reserve and the Treasury determined that it was in the best interests of the United States to rescue AIG in order to slow the panic and prevent further damage to our economy, he said.
Geithner defended the role of the Federal Reserve, arguing that the choice of what to do about AIG fell to the central bank because Congress had given it unique responsibility and policy tools to protect the stability of the financial system.
“No one else could act in the same manner as the Federal Reserve,” he said. “Not to have used that authority at that time would have been deeply irresponsible.”
Shifting to the controversial issue of payments made to AIG counterparties, Geithner noted that policymakers were faced with the following options: let AIG default on these contracts; continue to lend AIG money so it could meet its obligations; or restructure these contracts to stop the hemorrhaging, and potentially recover value for the taxpayers in the future.
“If we had let AIG default, it would have gone into bankruptcy, triggering all the disastrous economic consequences we had feared since September,” he repeated.
The Fed faced constraints even after deciding to restructure contracts, he said, since the counterparties held insurance entitling them to full or par value of the contract.
“We could not risk a protracted negotiation. AIG’s financial position was deteriorating rapidly and the prospect of a downgrade was imminent,” Geithner said, nor was coercion of counterparties to accept less was not a viable option.
In the end, he argued, the prices paid for the securities were their fair market value. Geithner said because of the way the contracts worked, those prices were essentially equal to the difference between the par value of the CDOs and the payments that counterparties had already received.
Focusing on the present, Geithner said while AIG is in better shape today, the U.S. government is still exposed to substantial risk of losses on its investments in AIG, and is unlikely to fully recover the direct costs of Treasury’s capital investments in AIG.
But he added that if Congress adopts the Presidents proposed Financial Responsibility Fee, American taxpayers will not have to pay “one cent for the rescue of our financial system” in the event of a future crisis.
He stressed that the issue highlights the need for financial regulatory reform. If stronger supervision and regulation had been in place, the government could have acted sooner to avert the crisis, Geithner said.
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