Paulson's Bad Aig Deal

You can't really blame the AIG stuff on the Democrats. Paulson and Co. decided to be deliberately nontransparent, which led inexorably to where we are. No one in DC seemed to understand who exactly they were bailing out and why. It's overwhelmingly the counterparties and it's the debt-holders of these institutions--those who would take haircuts if these financial institutions were airlines or telephone companies or railroads or any other company that went into bankruptcy. It is only to a modest degree the shareholders, who'd get entirely wiped out if they were owners of an airline, telephone company, railroad, etc. It is also, of course, the employees--which is why one is right to be indignant about employees taking cash out of these companies until the government gets paid back, whether you call it a bonus or any raise beyond what people were making before.

Only when the taxpayers get involved are the creditors of all these bailed-out institutions able to recover amounts at face value. To see where the creditors would wind up if any of these failed, check out the very public estimates of Lehman recovery values. It is true that avoiding bankruptcy of financial institutions (as opposed to airlines, etc) has some benefits--the avoidance of cascading liquidations that could ripple through the economy. But just because it would be bad to allow financial institution debt-holders and counterparties to suffer a full scale evaporation of their positions (Lehman again) -- especially when your overriding public policy objective is to salvage the financial system -- does not mean they should get paid back at 100 cents on the dollar with the taxpayer at risk. Does one really suppose anyone would've said no to (say) a 15% discount on their AIG CDS contracts when the alternative of bankruptcy might mean a discount of 50% or more? There, I just saved the government $25 billion, enough to bail out the entire car industry. For the life of me, I will never understand why the sophisticated deal people on Paulson's team did not as a condition for throwing all this money at AIG consider some mechanism like this -- if not when they were immersed in the first panicky flush of $80 billion, then during the subsequent bailout tranches.