The View from the Ivory Tower

Paul Krugman disagrees with my “legal argument” on the AIG counterparties issue because, according to Krugman, “Wall Street doesn't work like that, and never has.” Oh Paul, won’t you please tell us more about how Wall Street works? Seriously though, I’m flattered that Krugman, who’s practically a hero of mine, actually read my post. Unfortunately, his vast Wall Street experience fails him.

The AIG counterparty negotiations were completely different from the LTCM rescue, because when the banks were negotiating the LTCM rescue, the Fed hadn’t already signaled that it wasn’t willing to let LTCM fail. When the NY Fed was negotiating with the AIG counterparties, it had already bailed AIG out, and had told the entire world that it wasn’t willing to let AIG fail. With LTCM, the Fed could use the threat of bankruptcy to force the banks to agree to a rescue. That simply wasn’t the case with the AIG counterparty negotiations, because the Fed couldn’t credibly commit to putting AIG in bankruptcy. That’s a fundamental, elephant-in-the-room -like difference.

Another huge difference is that the AIG counterparty negotiations weren’t about saving the system from meltdown. They were purely distributional—this was about justice, not the stability of the financial system. In all of Krugman’s examples, the Wall Street firms were better off if they cooperated to save the system. In the AIG situation, there was absolutely no benefit to collective action. None.

Finally, Krugman points to TED’s speech as proof that the NY Fed could have negotiated haircuts. While TED’s speech was admittedly inspiring, and had me reaching for my checkbook, there’s one glaring problem: the speech was predicated on the NY Fed having the support of the French regulators, which, as the SIGTARP report makes clear, was not the case. From the SIGTARP report:

The Commission Bancaire spoke again with FRBNY and forcefully asserted that, under French law, absent an AIG bankruptcy, [SocGen and Calyon] could not voluntarily agree to less than par value for the underlying securities in exchange for terminating the swap contracts.

SocGen and Calyon, by the way, held over a third of the $62bn CDS book that AIG was trying to terminate. With SocGen and Calyon explicitly prohibited from agreeing to haircuts, the NY Fed’s negotiations were DOA.