Bailout in Lieu of Bankruptcy: The Sad Saga of AIG

The Office of the Inspector General of the TARP released a tough report yesterday illuminating and criticizing the way the flawed design of the AIG bailout led to large transfers from taxpayers to AIG's counterparties.  You can read a good article by Mary Williams Walsh at The New York Times and another report from The Washington Post. 

I would take issue with one statement in the report and the associated discussion.  From the NYT article:

The Fed “refused to use its considerable leverage,” Neil M. Barofsky, the special inspector general for the Troubled Asset Relief Program, wrote in a report to be officially released on Tuesday, examining the much-criticized decision to make A.I.G.’s trading partners whole when people and businesses were taking painful losses in the financial markets.

The Fed should not have been using its leverage as the lender of last resort or as a regulator to drive a hard bargain with private financial institutions.  That, to me, is too much of a conflict of interest -- your regulator should not be compromising your financial position for the sake of some other institution.  That is government overreach in my book, and it only comes in because the government has already overstepped what it should be doing in offering bailout in lieu of bankruptcy.

If the Fed and Treasury were going to use some threat, it should have been that they that they would do nothing -- that they would allow AIG to go bankrupt -- to drive a hard bargain.  The Fed and Treasury should never have removed that option.  They could always have functioned as a lender of last resort to AIG's creditors when AIG entered bankruptcy.  Sure, it would be a messier set of transactions, but protecting the taxpayers' funds would have been worth it.

The idea that the Fed's leadership thought that the best course of action was to ask for voluntary concessions or draw on enormous sums of taxpayer money, rather than subjecting AIG and its creditors to a bankruptcy proceeding, is truly unbelievable.