Who Should Be Bailed Out?

CAMBRIDGE – As governments around the world develop policies to deal with failing financial institutions, they should be sure to pick their beneficiaries wisely. In particular, they should study and avoid the mistakes made in the AIG bailout in late 2008.

A United States Special Inspector General recently issued a report criticizing the US government for failing to insist that AIG’s counterparties in the market for financial derivatives bear some of the costs of bailing out the company. Indeed, bailouts of failed institutions should never extend the government’s safety net to such counterparties.

The AIG bailout was one of the largest in history, with the US government injecting more than $100 billion into the company. The bailout was brought about by AIG’s large losses on derivative transactions with financial institutions, mostly sophisticated players such as Goldman Sachs and Spain’s Banco Santander.

After the government’s infusion of funds in September 2008, AIG’s losses continued to mount, so the government provided substantial amounts of additional capital two months later. At this point, the government asked AIG’s derivative counterparties to take a voluntary “haircut” – that is, accept a discount on the amount owed to them. When some of these parties refused, the government backed down and financed AIG’s payment of all of its derivative obligations in full.