Dialectics of Finance: A Letter to Mr. Baxter

Dear Mr. Baxter,

I just read your testimony before the House committee investigating the financial crisis. You delivered a long, carefully prepared text to defend the Fed's bailout of AIG. As the executive VP and general counsel of the New York Fed, nothing less was expected from you.

Did I get your approach, your strategy, right?

Your strategy, I think, was to deliver a one-two punch wrapped around a coma-inducing narrative. One, you talked at length about the threat of a looming, apocalyptic crisis, which made the bailout necessary, almost a patriotic duty. Two, you said that it was all for the benefit of taxpayers. You used the word “taxpayer” 16 times, as in the Fed “protecting taxpayer interest”, or the Fed “securing both downside protection and upside participation for the U.S. taxpayer”.

Now, the Fed creating funds electronically from thin air and transmitting them here and there has nothing to do with taxpayers. But I am not writing to criticize you for using catch words that you thought would score a point with your audience. That would be missing the point, like criticizing a B-movie director for including too many sex and car chase scenes.

As for the length of the speech, may I say it was a benumbing case of too much transparecny and “putting everything on the table”, where you omitted what was necessary but included everything else, as in this gem:

The first 8-K was filed by AIG on December 2, 2008, after Maiden Lane III purchased the first group of CDOs. On December 18 and 22, 2008, Maiden Lane III purchased a second group of CDOs. Also, an agreement struck in November in conjunction with the original transaction, known as the Shortfall Agreement between Maiden Lane III and AIG FP, was amended as of December 18th. These events required the filing of a second 8-K on December 24, 2008.

Good performance. My compliments.

And, yet, sir, talking too much was an error. When you talk too much, even deliberately, you reveal things that you did not intend. If you want to de-emphasize something, or skip over it – if you want to hide something, in short – the less said the better. Ask any mobster or petty criminal who would tell you that unsaid favors you.

So what did you reveal?

On the question of the authority of the Federal Reserve to rescue AIG, nothing. You said not one word on the subject. And that was the revelation. I will return to that intriguing point in the next post because it goes to the heart of a matter that is dear to me. But before then, allow me to make a few comments on what you said about the Fed forcing AIG counterparts to accept less than par for their credit default swaps (CDSs). You said:

The Federal Reserve has been criticized by some for not using its regulatory power to force the counterparties to accept less money for the CDOs. The critics overlook a number of key factors.

First, there was little time, and substantial execution risk and attendant harm of not getting the deal done by the deadline of November 10th.

Second, the Federal Reserve had little or no bargaining power given the circumstances. This restructuring negotiation was taking place in November of 2008, less than two months after the decision to rescue AIG from insolvency and the infusion of tens of billions of dollars.

Finally, even if we had had bargaining power, the rating agencies, as discussed above, were closely examining AIG for signs that it would not be able to address its financial situation. If they saw the Federal Reserve take any action that seemed to suggest a lack of full support, in particular a bankruptcy threat, it might well have led to an immediate downgrade and the irreversible destruction of AIG, with the attendant consequences on the financial stability of our economy.

Some have said that, in the absence of other bargaining power, the Federal Reserve should have used its regulatory power ... to make regulated counterparties give up or compromise their contractual rights. We see that as an abuse of regulatory power.

Dear Tom,

In consideration of your first and second points – no time left for action and the Fed having no bargaining power – may I suggest that you refrain from playing poker in the future. When you voluntarily tip your hand, you will, of course have no bluffing/bargaining power.

The time to have forced a deal with AIG CDS counterparties was on the morning of September 15, when Lehman filed for bankruptcy. I will return to this point in a moment.

Regarding the final point, about the rating agencies closely examining AIG, come now, Tom. The purpose of the Fed’s intervention, as per your testimony, was to annul the CDS contracts. That is what the rating agencies were looking for. They would not have cared whether you paid 60 cents on a dollar to annul them, or full dollar, which you did. “Full support” does not, and did not, mean full payment.

Then, there is the question of authority. You brought up the issue the abuse of authority, which I found funny. I don’t mean ha ha funny but funny in the sense that you mentioned it in a hearing convened to examine the question of the Fed’s abuse of its authority to give $180 billion to AIG. But I know you did not realize it. (There was a ha ha funny part, though: a presentation by the boys in BlackRock where they told you that AIG counterparties would not acccept anything less than par. When I read about it, I actually laughed. Whose idea was that one, and what was the subject/title/agenda of the presentation?)

I will return to the question of authority in the next post. Let me now tell you when the Fed would have had tremendous bargaining power over all AIG counterparts without restoring to threat of abuse.

On Monday, September 15, 2008, Lehman filed for bankruptcy. That is when, according to you, hell broke loose. Le Monde said it was the day that Capitalism stopped functioning.

On that day, a meeting was held between Mr. Blankfein in his capacity as the CEO of Goldman Sachs and Mr. Timothy Geithner is his capacity as the president of the Federal Reserve Bank of New York.