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AIG Bailout: Did the Government Overpay?

It is possible that the government might have overpaid a number of banks during its initial rescue attempt of American International Group (AIG). The company was in such big trouble that the Federal Reserve Bank of New York – previously headed by Treasury Secretary Tim Geithner – that the US government had to wind down its relationships with business partners.

The Federal Reserve Bank had paid the full face value of securities so that these businesses would cancel the insurance handed out by AIG. This was an attempt to relax the AIG’s liquidity trouble. However, reports leaked that at least one company had offered to cancel the contract at less than its face value. According to Neil Barofsky, the Special Inspector General, what it means is that the government might have paid billions more than what was necessary to cancel debt insurance contracts.

Why Was AIG Bailed Out at Any Cost?

Despite these findings, some analyst cannot blame the actions of the Fed during the crisis. AIG is too interconnected with other financial and non-financial firms that its failure could push the global banking system over the edge. As it neared collapse, officials decided to step up and bailout the company with billions of dollars and government guarantee to prevent a deepening of the crisis.

Whether the bailout is good for the long-term future of AIG and the government remains to be seen. This is because after several bailout attempts, the company now holds up to $180 billion in government commitments. The Treasury Department owns about 80 percent of AIG.

The Government Still Getting Some Criticisms

Critics though aren’t content with the government’s actions. They note that AIG’s trading partners knew full well what risks they are taking when they got insurance for credit-default-swaps. These partners showed willingness to take risks based on these actions. They should have been forced to take than 100 percent value of their contracts.

Neil Barofsky said that taxpayers are unlikely to recover the money infused into AIG.

CIT Failure Will Have Far-Reaching Impact

If big banks like Citigroup Inc, Bank of America, JPMorgan Chase, and Goldman Sachs were “too big to fail”, does this mean that less dominant banks should be allowed to fail because they are “too small?” The government seems to think so. The share price of the CIT Group Inc. (CIT) plunged as the company announced that there was very little likelihood that they will receive fresh cash infusion from the government over the near term.

Representatives of the bank scrambled to get a minimum of $2 billion in rescue funding from its current debt holders. As was revealed by CIT representatives to stockholders, there is a high probability that bank might need to file for bankruptcy if it does not receive help. If this happens, the financial market will be tested on its strength and sustainability in financing small and business enterprises (SMEs).

What It Means to the Average Joe Entrepreneur

Individual small business around the country might be “small enough” to fail, but the issue is if they do, they will not go down alone. For example, even small businessmen who are not associated with CIT directly will feel the effects of the bank’s demise if it fails. This is because if their clients, suppliers, and probably even shareholders are drawing credit from CIT, this source of funding will be cut off. There won’t be enough money to pay their partners or buy new products and services.

It is believed that the effects of the bank’s failure will be widespread among small and medium scale businesses. There are around a million small businesses that rely on specialty finance to support their operations. In a 2003 research from the Fed, it was discovered that nonbank lenders account for 28.9 percent of equipment financing, 22 percent of lease financing, and 13 percent of small business credit line.

If companies like CIT cease to exist, small business operations in the United States (accounting for half of the nation’s GDP) is expected to suffer from a bad credit crunch at the time when it is needed the most. The US needs these enterprises to produce, sell goods and services, and hire people to get the country out of recession.

Banks Pay Back TARP

The Treasury has finally allowed 10 big backs to repay some part of the TARP money they received during the height of the financial turmoil. Though the Treasury did not specifically identify these banks, allowing them to make the announcement on their own, the banks have been identified as JPMorgan Chase, Goldman Sachs, US Bancorp, BB&T Corporation, Capital One Financial, American Express, State Street Corporation, and the Bank of New York and Mellon.

Two of these banks namely JPMorgan Chase and Goldman Sachs are deemed financially strong enough to leave the TARP program. It is expected that the 10 big banks will return an estimated $68.3 billion back to the government. The latest estimate is dramatically more than the original repayment estimate of $25 billion. Other financial institutions specifically Morgan Stanley and Northern Trust are expected to repay the government as well. Previously, Morgan Stanley was asked to raise $1.8 billion after “failing” the stress test.

The $68.3 billion to be repaid this year is around a quarter of the TARP bailout fund. 22 community banks have already paid back $1.9 billion to the Treasury. While these developments are certainly good news for the Obama administration, the public, and even the bank themselves, these institutions are not yet totally out of government oversight. As condition to receiving the bailout fund, the banks agreed to “warrants” or stock options that give the government a share in profits once stock values rise.

In addition, the public won’t benefit as much as initially believed. This is because five of the repaying banks have little to do with consumer lending. Goldman Sachs and Morgan Stanley are mainly investment institutions while State Street, Northern Trust, and Bank of New York Mellon are asset management firms. With the exception of JPMorgan, none of these banks are big-time consumer lenders. The biggest lenders – Bank of America, Citigroup Inc., and Wells Fargo – don’t look like they’ll be in the position of repaying the government anytime soon.

Whatever the case, the repayment plan is certainly a welcome development in today’s grim economic times. Within several days, majority of the financial institutions mentioned above will wire the repayment to the Treasury Department.

Banks to Undergo Management Review

Over the past few weeks, news has been buzzing that nine of the country’s largest banks that failed the stress test are undergoing capital-raising initiatives to meet the government’s criteria. Monday is scheduled to be deadline for federal bank regulators’ approval for these plans. This long-awaited moment can be outshined by a less known deadline though: management review of these banks.

Banks including Citigroup Inc. and Bank of America will assess their top executives to ensure that the banks have sufficient leadership capability that will take them through the tough times. According to regulators, this process is necessary to find out if the current management has the “ability to manage the risks presented by the current economic environment”.

For many, this management review seems confusing, if not unnecessary. This is because the rules of the management review remain unclear. And individual regulators are providing contradictory guidance which further confuses the process. Whatever way they call it, it is clear that federal regulators are simply pressuring banks to get more people with commercial banking expertise.

Bank of America has already bowed to the pressure by replacing one senior executive and several directors. For its part, Citigroup is beefing up its board by adding new directors. It remains unclear if federal regulators will approve the management review on its deadline, which is on Monday.

Even as “weaker” banks prepare to wait for government approval for their capital raising initiatives and management review approval; “stronger” banks like JPMorgan Chase & Co and Goldman Sachs Group are preparing to repay the government. If their repayment scheme is approved, this will spell a dramatic milestone in today’s chaotic financial market.

It is expected that the government will accept the repayment of these banks. The Fed previously announced that it will allow repayment if the banks can prove they can raise capital from outside investors and lend to borrowers without relying on federal support.

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