Bailout blunders

The AIG lawsuit by Maurice Greenberg attracts some scathing attention from Andrew Ross Sorkin in today’s Times. He’s right on the politics, but is he right on the law?

Sorkin has little sympathy for Greenberg, who is suing the government over its handling of the AIG takeover, writing that the insurance giant “stupidly insured big banks on large swaths of bad mortgage deals via credit-default swaps.”

As Sorkin recounts,

Mr. Greenberg, who sued on behalf of fellow shareholders and seeks more than $40 billion from the government, does not dispute that A.I.G. needed $192 billion to survive the financial crisis. It instead challenges the onerous nature of the rescue.

On Monday, his lawyer, David Boies, hammered Henry M. Paulson Jr., the former Treasury secretary, about why A.I.G.’s shareholders were nearly wiped out when the government took what eventually became a 92 percent stake in the firm and put the interest rate on the loans at a high 14 percent. The onerous terms were unlike the deals made for so many other institutions receiving bailouts in 2008, including Morgan Stanley, Citigroup and Bank of America.

In his complaint, Mr. Greenberg asserts that the terms amounted to a violation of the Fifth Amendment. “This is the only time in history when the government has taken without just compensation and/or illegally exacted the assets and equity of a company and its shareholders in connection with a loan, let alone a fully secured loan bearing an extortionate interest rate,” the suit says.

To Sorkin, this is a ridiculous argument. The AIG takeover was “punitive” and “confiscatory”, and “it was supposed to be”. Or, as Sorkin quotes,

On questioning, Mr. Paulson didn’t beat around the bush. ““It was important that the terms be harsh because I take moral hazard seriously,” he said, confirming that the deal was structured so as to be punitive to A.I.G. shareholders. “When companies fail, shareholders bear the losses,” he said, “It’s just the way our system is supposed to work.”…

So why was the government so tough on A.I.G. and so easy on the banks that bought the soured mortgage bundles in the first place?

In truth, because the government thought that such a deal wouldn’t destabilize A.I.G. — and a tougher deal for banks might undermine confidence in the financial system in the markets.

That’s the same reason the government didn’t push harder for A.I.G.’s counterparties — i.e. the banks — to take “haircuts,” or less than the money they were owed on the insured payouts. The government worried it would only make people more nervous about the strength of the banking system, undermining the confidence it was trying to sow.

Sorkin is right on the political optics of the case. If the Court of Federal Claims were to award any money to shareholders, it would be politically toxic for the legal system and at least two administrations.

But, as his reporting reveals, the government actually did seek to confiscate and use its force with AIG, and made it bear a burden not imposed on other financial players. This starts to sound like a regulatory taking, even if it were a politically justified one.

Now, even though this is a colorable taking case, I would be surprised if US courts sided with Greenberg. But this is because of the politics, not the law.

Indeed, as I wrote earlier in Greenberg’s lawsuit, he may have a better chance bringing his claim under the US’ investment treaty with Panama – which is where Greenberg’s holding company is domiciled.

I can see at least four reasons why a treaty based claim could yield more fruit than a domestic case.

My colleague Matt Porterfield has compared the domestic regulatory takings doctrine to the analogous international indirect expropriation doctrine. While the former is relatively pro-government, the latter is more deferential to investors. And in this case, the principals are on the record as saying they intended to punish and take shareholders’ property.

Second, if a US court failed to side with Greenberg despite the legal merits, he could claim additionally that the US judiciary contributed to the taking or to denial of justice.

Third, to my knowledge of the case law, Paulson’s moral hazard defense would not carry water – investment tribunals have been loath to give much weight to economics-rooted defenses. The government’s speculations that banks would be more able to bear the brunt of the burden would be just that. Greenberg could bring in many experts that will just say that the banks could have / should have failed. In treaty cases, experts tend to cancel each other out.

Finally, international arbitral tribunals do not face the same type of political pressures as US courts to side with the US government on a case that is “too big to lose”.