Originally posted on FT Alphaville by Paul Murphy:
The AIG CDS story has been smoldering for so long now that most ordinary mortals are left either confused or bemused, or both.
But then, out of the blue, along comes a development that is easy to understand, that is sitting there in black and white, available for the public to read.
And it says “Yes, there was a cover up. The authorities didn’t want the public to know how handsomely Wall Street was being bailed out with their money.”
That’s easy for everyone to understand. Whether it was understandable at the time – in the latter months of 2008, when the US authorities were quite literally working to save the financial system – is a debate that still has to reach a conclusion.
The disclosure on Thursday, on Bloomberg and the NYT’s Dealbook, of documents suggesting that the Federal Bank of New York actively (and successfully) sought to prevent AIG from disclosing full details of the payments it was making to the likes of Goldman Sachs and Deutsche Bank, will hurry that debate along.
It might also encourage the departure of Tim Geithner, now US treasury secretary, who happened to be running the NY Fed at the time.
If so, the shot that finally pierced Mr Geithner’s skin will be attributed to Republican congressman Darrell Issa, who used his position on the House Oversight and Government Reform Committee to get copies of the smoking documents.
This is all redolent of that congressional testimony offered up by the Peterson Institute economist (and UK MPC member) Adam Posen back in February last year, when he argued that the only way to end a banking crisis was to sack all those in charge at the time – including the supervisors and regulators.
In the mid-1980s in the United States and most of the 1990s in Japan, bank supervisors engaged in regulatory forbearance, meaning they held off intervening in or closing banks with insufficient capital in the hope that time would restore asset values and heal the wounds. One can easily imagine the incentives for the bank supervisors, well documented in historical cases and the economic data, not to have a prominent bank fail on their watch. The problem, also evident in these historical cases and in the economic data, is that top management and shareholders of banks know that supervisors have this interest, and respond accordingly. The managers and shareholders do everything they can to avoid outright failing, which fits their own personal incentives…
That self-preservation, not profit-maximization, strategy by the banks usually entails calling in or selling off good loans, so as to get cash for what is liquid, while rolling over loans to bad risks or holding on to impaired assets, so as to avoid taking obvious losses, and gambling that they will return to value. The result of this dynamic is to create the credit crunch of the sort we are seeing today, and this only adds to the eventual losses of the banks when these losses are finally recognized.2 The economy as a whole, and nonfinancial small businesses in particular, suffer in order to spare the positions of current bank shareholders and top management (and, on the firing line, bank supervisors).
In the US and elsewhere, a few more scalps are required before we can declare this crisis over.