dean-baker-plunder-and-blunder.thumbnail.jpg(Dean Baker is co-director of the Center for Economic and Policy Research and the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. Please welcome him in the comments — jh)

Dean Baker released a paper last week on AIG, written for the Center for Economic Policy and Research. The words "must read" get bandied about with way too much freedom, but they certainly apply here. (You can find it here, or download it on PDF).

Points he raises:

Did Geithner know about the AIG bonuses? Almost certainly:

This discussion is silly because Geithner almost certainly knew of the bonuses ever since the initial takeover on September 15th. He just didn’t think they were important.

Were AIG’s credit default swaps insurance, or just gambling? Meaning, were they purchased as insurance for assets held by a particular bank, or was the bank just betting on the failure of bonds they didn’t own? Dean rightly makes the point that there is a big difference, particularly with regard to the taxpayer’s need to pay them off:

If a bank had bought a CDS to protect itself against losses on a mortgage backed security, and the CDS was not honored, then it would be an unexpected blow to its balance sheet. On the other hand, if the bank was just gambling that a bond that it did not hold would go bad by buying a CDS issued against it, it is difficult to see how a failure to honor the CDS would impose a serious hardship.

Did the government have to pay off these insurance claims at 100% now, or could they have waited to see what happened? And what is the government’s policy about paying out credit default swaps?

The government, through AIG, paid an additional $30 billion to counterparties because it paid off CDSs at their notional value rather than their market value. In principle, AIG would have owed the notional value of the CDSs if the underlying bond had defaulted. In these cases, the bond had not defaulted. In effect, the government acted as though AIG had already lost its bet, at a time when it was still possible that the underlying bonds would not go bad.

Why did the government need to use AIG as an intermediary to pay off these banks?

When the government lent hundreds of billions of dollars to the banks through TARP, it got preferred shares of stock in return, in addition to placing conditions on the banks’ conduct. By contrast, the government received absolutely nothing for the tens of billions of dollars that it passed on to the banks through AIG. It may have been desirable to ensure that AIG’s defaults did not lead to the collapse of the major banks that were its counterparties, but this could have been accomplished by directly giving these banks capital through TARP or some equivalent mechanism. There is no obvious reason why it was necessary to give the money through AIG without getting anything in return.

I personally rely on Dean Baker to be a Rosetta Stone to the financial crisis. He speaks simply and clearly in a way that ordinary people can understand, and removes the cloak of confusion that is being used to hide a lot of misdeeds.

Please take the opportunity to ask him your questions in the comments, and remember that when it comes to the crisis in our financial system, everyone is confused, and there’s no such thing as a dumb question.