When former Treasury secretary Henry (Hank) Paulson Jr. testified in a suit last month about the U.S. government takeover of American International Group, his words were — mostly — numbingly familiar. Explaining the “punitive” terms set for the September 2008 bailout, he referred again to the transaction’s “moral hazard” — a term of art Paulson has invoked to describe the notion that companies should not rely on Uncle Sam when they foul up. “I take moral hazard seriously,” he said.
In the deal, a hemorrhaging AIG got an $85 billion backstop that eventually ballooned to $182.3 billion in U.S. taxpayer funds, and Treasury got 79.9 percent of the insurer. “It did indeed punish the shareholders,” Paulson said. “That’s just the way our system is supposed to work, that when companies fail, the shareholders bear the losses.”
What makes Paulson’s testimony remarkable is a tale that can be pieced together through a court document, the Plaintiffs’ Corrected Proposed Findings of Fact, and the ex–Treasury secretary’s own foggy recollections. Despite talk of moral hazard, it turns out that at least one alternative to the taxpayer rescue was readily available. Specifically, China Investment Corp., the big sovereign wealth fund of the People’s Republic of China, approached the Treasury Department directly and was eager to make an AIG investment — an offer that one or more officials in Paulson’s office in September 2008 believed was sufficient to meet the insurer’s needs at the time.
According to the court document, Treasury officials, after consulting with Paulson, told CIC that its help was not wanted. The secretary did not return CIC’s phone call, as requested by the Chinese government. A Treasury colleague was dispatched to tell the fund, in effect, to go away. A seperate, indirect entreaty from CIC was rebuffed as well.
Paulson’s brush-off of CIC is proof, critics say, that at the very least there were unexplored rescue options for AIG. “There were other solutions that did not require taxpayers’ or anybody else’s money,” says longtime investor Jim Rogers, a former partner of Soros Fund Management and a critic of the AIG bailout. “In the end, somebody did pay, and I just wish it hadn’t been the American taxpayer.”
The disclosure prompts two gob-smacking questions: Was the taxpayer bailout of AIG, the biggest in U.S. history, really necessary? And what would have happened if the main sovereign wealth fund of America’s biggest geopolitical rival had rescued it instead?
Alas, we may never know, but the revelation bolsters the arguments of those who view the bailout as a giant payoff to banks that were on the hook for tens of billions of dollars if AIG went belly-up — including New York–based Goldman Sachs Group, where Paulson served as CEO from 1999 to 2006, before being appointed Treasury secretary.
“It’s sinister or cynical,” fumes James Cox, a professor at Duke Law School. “It’s protecting the big banks against the yellow peril.”
The suit, Starr International Co., Inc. v. United States of America, effectively pits Maurice (Hank) Greenberg, CEO of Starr, among the largest shareholders of AIG, against regulators including former Federal Reserve chairman Ben Bernanke and ex–New York Federal Reserve Bank president Timothy Geithner, who have also testified. Starr alleges the government violated its constitutional rights as well as those of other AIG investors by appropriating their property without just compensation. Filed in the U.S. Court of Federal Claims in Washington D.C., the suit also asserts that the terms of the bailout were unfair, citing in particular the interest rate of more than 14 percent on the credit line that was part of the deal.
Starr, based in Zug, Switzerland, is seeking more than $40 billion in damages. And in hiring David Boies of Boies, Schiller & Flexner, who represented former vice president Al Gore in Bush v. Gore and has worked on other noted cases, the 89-year-old Greenberg has lined up some high-gauge legal firepower. AIG itself is a nominal defendant in the suit, meaning it is included for technical reasons. The suit is ongoing, with a ruling not expected until next year. An AIG spokesman declined to comment.
As for Greenberg himself, he was forced out as CEO of AIG in 2005 amid fraud allegations by Eliot Spitzer that the former New York State Attorney General never proved. Greenberg maintained control of Starr, whose business was closely intertwined with that of AIG.
AIG wasn’t the only financial firm to run into trouble in September 2008 as credit markets froze and stock prices plunged. Fannie Mae and Freddie Mac, two government-sponsored mortgage companies, were placed in conservatorship on September 6, 2008, as the value of their loan portfolios collapsed. Merrill Lynch & Co., losses mounting, agreed on Sunday, September 14, to be acquired by Bank of America Corp. At 1:45 a.m. the following Monday, September 15, Lehman Brothers Holdings filed for bankruptcy, after a plan for London-based Barclays to buy it was nixed by the U.K.’s then-chancellor of the Exchequer Alistair Darling. That forced the venerable Reserve Primary Fund, a money market fund that held Lehman commercial paper, to “break the buck,” the value of its shares falling from $1 to 97 cents. Redemptions were suspended. Panic reigned.
New York–based AIG’s financial situation had been deteriorating for months. The company was bleeding cash, largely because of the rising cost of insurance it had written on $62.1 billion of toxic collateralized debt obligations (CDOs). On September 15, the same day Lehman filed for Chapter 11, major rating agencies downgraded AIG’s long-term credit outlook, triggering further collateral calls by its bank counterparties. The downgrades would almost certainly have bankrupted the insurance giant.
We know what happened next. As part of the bailout, the New York Fed, on behalf of the U.S. government, took control of AIG’s management and directed it to pay off the banks that had bought insurance on the CDOs — despite the fact that these counterparties, including Goldman Sachs, Frankfurt-based Deutsche Bank, Merrill Lynch and Société Générale of Paris, had largely underwritten or managed these cratering securities themselves. The public was outraged.
A key point of contention was the New York Fed’s insistence that AIG pay the banks 100 cents on the dollar for the insurance, which was in the form of credit default swaps, even though AIG had been negotiating discounts on the insurance. That made Goldman Sachs, Paulson’s alma mater, whole on its $14 billion in CDO protection and the other banks whole on theirs. The CDOs were shunted into a special-purpose vehicle called Maiden Lane III, named after the street where the New York Fed keeps a back door through which it can sneak people without undue attention. (Perhaps that’s another reason to call the rescue a backdoor bailout.) A spokeswoman for the New York Fed declined to comment, while the Treasury Department did not respond to phone calls.
The suit speaks to the changes in sovereign wealth funds themselves since the crisis — a period in which the state-owned investors have mushroomed, hitting an estimated $5.3 trillion in assets under management in 2014, up from just $2.4 trillion in 2007, according to Institutional Investor’s Sovereign Wealth Center.
The funds have evolved, becoming more sophisticated stewards of their nations’ wealth and less likely to serve as bottomless sources of liquidity in times of trouble. Before and during the financial crisis, they were pouring money into foundering U.S. and European banks with abandon.
Among the biggest deals, according to Sovereign Wealth Center data, was GIC’s $6.9 billion investment in New York–based Citigroup in January 2008 and a $10.3 billion deal with Zurich-based UBS that May. In November 2007 the Abu Dhabi Investment Authority had sunk $7.5 billion into Citigroup. Korea Investment Corp. and the Kuwait Investment Authority each plowed $2 billion into Merrill Lynch in January 2008 following Temasek Holding’s $4.4 billion investment in the firm the previous month. Temasek took an additional $3.4 billion slug in July 2008, just months before Merrill’s disastrous acquisition by Charlotte, North Carolina–based Bank of America, which was completed, under U.S. government pressure, on January 1, 2009. The Qatar Investment Authority ponied up a total of $7.7 billion for two 2008 investments in Barclays. The fund also sank a total of $4.4 billion into two deals with Zurich-based Credit Suisse. The list goes on.
“There were multiple motivations back then,” says Rachel Ziemba, director of emerging markets at Roubini Global Economics in London. “One was to gain access to assets at a discount, two was trying to leverage their own financial institutions and partner with the firms they were investing in, and three was some feeling they would be thanked — there was a desire to build up political capital.” Some of the sovereign funds would come to regret their munificence.
“The investments of 2007–’08 were largely interpreted as sovereign wealth funds coming to the rescue of the Western financial system,” says Sven Behrendt, founder of Geneva-based consulting firm GeoEconomica. “There was an implicit understanding of a political quid pro quo based on financial engagement for broader nondiscriminatory market access.”
Don’t count on a repeat in the next crisis. “Many sovereign wealth funds, in particular those that were created in the past ten years, today take more-measured decisions,” Behrendt says. “They make their risk-return calculations and see if any future investment fits into their asset allocations. The times of personality-driven investment decisions are gone.”
In September 2008, though, CIC was still a yearling. By early 2006, China had surpassed Japan to become the biggest holder of foreign exchange reserves — more than $1 trillion — and the State Administration of Foreign Exchange (SAFE) was worried that it was overly exposed to the dollar, which had tumbled steeply against industrialized nations’ currencies, according to a history of CIC on the Sovereign Wealth Center. SAFE had already set up Central Huijin Investment to support domestic banks, a fund that was eventually rolled into CIC, which was formally launched in September 2007 and, after much foot-dragging by the People’s Bank of China and SAFE, capitalized with more than $200 billion.
Critics lambasted the fund’s early management: CIC’s first investments were classic clunkers. Through Huijin, for example, it bought a 9.9 percent nonvoting stake in New York–based Blackstone Group’s initial public offering in June 2007 at a discounted price of $29 a share versus $31 for other investors. Shares briefly spiked and then fell below $5 in the 2008–’09 meltdown. In December 2007, CIC paid $5.6 billion for a 9.9 percent stake in Morgan Stanley, also of New York, through a convertible position yielding 9 percent. In February 2008, CIC teamed with New York–based private equity firm J.C. Flowers & Co. to form a fund to invest in distressed financial stocks, providing 80 percent of the $3.2 billion in capital.
The state-owned fund also held $5.4 billion of its cash in the Reserve Primary Fund, the ill-fated money market fund. CIC managed to withdraw before the fund froze redemptions. In June 2014, China’s National Audit Office disclosed it had found evidence of mismanagement at CIC and inadequate due diligence in 12 overseas investments. CIC now has $652.7 billion in assets, according to the Sovereign Wealth Center.
What would a 2008 CIC takeover or big investment in AIG have meant? It’s certainly likely that CIC would have insisted that the insurer drive a harder bargain on the swaps, costing Goldman and the other banks big bucks. “AIG should have pushed back — they should have clawed back the collateral,” says Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. “Those CDOs were fraudulent.”
At least one other insurer had obtained a steep discount on swap payments it owed to a bank. Critically, as part of the rescue terms, AIG surrendered the right to sue the bank counterparties. That likely wouldn’t have happened if CIC were backstopping the firm. The New York Fed directed AIG to redact the names of bank counterparties and the identities of CDOs in a key Securities and Exchange Commission filing — wrapping the whole affair in a cloak of secrecy that has fed conspiracy theories.
What exactly was going on in the days before and after September 16, 2008, the day AIG’s board agreed to the punitive, and nonnegotiable, terms set by the New York Fed? That’s where the court document (the plaintiffs’ findings of fact) comes in. It cites snippets of depositions from key players at the time: Treasury Department officials, bankers and AIG executives.
The document cites John Studzinski, a partner in Blackstone’s advisory team working with AIG, who described investor interest from sovereign funds, including two of the biggest: CIC and Singapore’s GIC. The sovereign wealth funds had sufficient dry powder. At year-end 2008, CIC had $297.5 billion in assets and GIC an estimated $198 billion, according to the Sovereign Wealth Center. Through a Blackstone spokesman, Studzinski declined to comment.
The U.S. government discouraged China from helping AIG, the document says. A key sentence refers to the CIC offer. “At 12:25 p.m. on September 16, 2008, Taiya Smith, Paulson’s deputy chief of staff and executive secretary, informed Paulson’s chief of staff and Under Secretary for International Affairs David McCormick that the CIC was ‘prepared to make a big investment in AIG, but would need Hank to call [Chinese Vice Premier] Wang Qishan.’” The document says Smith added that “the Chinese ‘were actually willing to put in a little more than the total amount of money required for AIG.’” Based on the original bailout terms, that might have been more than $85 billion.
That day, the findings say, McCormick talked to Paulson about the Chinese interest in investing in AIG. “McCormick then told Smith that Treasury ‘did not want the Chinese coming in at this point in time on AIG,’” the document says. It was then left up to Smith to explain to the Chinese that the Treasury Department did not want them to invest. She spent as long as two hours doing so, at a previously planned trade and commerce meeting in Yorba Linda, California. “All [the Chinese officials] wanted to talk about was AIG,” she is quoted as saying.
Through a spokeswoman, McCormick, now president of Westport, Connecticut–based hedge fund firm Bridgewater Associates, declined to comment. Smith is a managing partner at Garnet Strategies, a China-focused advisory firm in Boston, Virginia, and a senior adviser at the Paulson Institute, an independent center founded by the ex-Treasury secretary at the University of Chicago that promotes economic growth and clean energy in the U.S. and China. Efforts to contact Smith were not successful.
What does Paulson have to say about the CIC offer? A spokeswoman for the former Treasury secretary sent an e-mail attachment with an excerpt of his court testimony.
On October 6, under examination by Boies, Paulson testified repeatedly that he could not remember any offer from CIC at that point. “I have no recollection of that, but I would say this,” Paulson said. “There’s no way I would have encouraged them to come in because I was certain that they would not have done a deal of the size that it took to save AIG without a government guarantee, and I couldn’t — couldn’t provide one, and the government couldn’t provide that assurance.” That seems on the surface at odds with the statement by Smith about CIC’s eagerness to invest. The court document makes no mention of a request by CIC for a government guarantee.
The former Treasury secretary testified that he did, in fact, recollect talking to then-president George W. Bush about CIC making an additional investment in Morgan Stanley, also in the midst of a liquidity crisis and in which the sovereign wealth fund had already sunk $5.6 billion the previous year. CIC ultimately did not invest more capital in Morgan Stanley in 2008. The fund did invest an additional $1.2 billion in the bank the following year.
While maintaining that he didn’t recall any CIC offer on or before September 16, Paulson said that in retrospect he wouldn’t have wanted to sow panic given AIG’s precarious state. “I sure wouldn’t have wanted to spook the Chinese knowing what I know now,” Paulson testified. “And I’ll tell you, I can only imagine how they would have reacted if I had to air the dirty linen and tell them what we were dealing with at that point in time.”
Bailout critics call this obfuscation. “This was the epitome of crony capitalism,” consultant Tavakoli says. “What happened was egregious, and the public doesn’t get how egregious it was, and Congress doesn’t understand how egregious it was.”
To be sure, by September 16, after the downgrades of the previous day, AIG’s money was running out. The government was readying the term sheet for the takeover. Paulson might have viewed a CIC approach as a distraction. “I’m skeptical it was a real option,” says Damon Silvers, former deputy chairman of the Congressional Oversight Panel, which investigated the AIG bailout. “It was the 16th. Time’s up. The cash had to be in hand.”
Paulson said as much in his testimony. “If the CEO of AIG on the 13th or 14th when we were talking with him or on the 15th had said, ‘We are in discussions with CIC and we’re negotiating to make an investment, would you say something to them, I would have said, ‘You betcha,’” Paulson testified. His redacted Treasury Department phone logs for the 13th and 14th of September, which were released under a Freedom of Information Act request [from the New York Times], are blank because he was at a New York Fed meeting, staying at the Waldorf Astoria hotel.
One obvious question is whether September 16 was too late in the game for a CIC-assisted rescue. It was certainly a busy day: Those same phone logs showed Paulson made or received about 60 calls on the 16th, including conversations with former president Bush, Geithner, Bernanke, Berkshire Hathaway CEO Warren Buffett and presidential candidates John McCain and Barack Obama. But the court document does not say specifically that September 16 was the date the Chinese offer was broached; it only says that Smith informed undersecretary McCormick on that date. Because Paulson says he can recall so little about the situation, we may never know the specifics.
However — and this may be crucial — September 16 was only the day that AIG’s board signed the term sheet authorizing the government takeover. Term sheets, by their nature, are nonbinding agreements. “It’s a bid,” says Duke professor Cox, referring to the legal documents in general. “It’s important to remember that a term sheet is not the deal.”
The definitive agreement, laden with onerous terms, including those that protected the banks from possible AIG suits, was not announced until September 23. By that time Paulson had already fired AIG CEO Robert Willumstad. He was replaced with ex–Allstate Corp. CEO Edward Liddy, a Goldman Sachs board member and chairman of its audit committee, who was put in charge of liquidating the company.
Regardless, the Chinese fund remained persistent. The trial transcript shows that former Goldman Sachs president John Thornton, a professor at Tsinghua University in Beijing with close China ties, had approached Paulson about CIC buying or investing in AIG but that the former Treasury secretary again could not recall when that happened. “I suspect it was after the 16th,” Paulson testified about the approach. “And as I’ve thought about it, I thought it was probably coming from a man named Gao, who ran CIC, which reported up to, you know, the State Council, but I don’t remember when, when John approached me, but I do remember that.” He was referring, presumably, to CIC’s president at the time, Gao Xiqing. CIC did not return an e-mail seeking comment, nor did a spokeswoman for GIC.
There is no call to or from Thornton listed for the 15th or 16th on Paulson’s Treasury Department phone log. There is a ten-minute call from Thornton, from 7:40 a.m. to 7:50 a.m., on September 19th, four days before AIG announced the definitive bailout agreement.
Thornton joined the first International Advisory Council of CIC in 2009. He is also chairman of Toronto-based Barrick Gold Corp. and co-chairman of the Brookings Institution, a Washington-based think tank. Thornton did not respond to a phone call and e-mail seeking comment left with a spokeswoman at Brookings.
Silvers contends that a major investment by CIC in AIG would have been a dangerous undertaking for China’s leadership — potentially, a disastrous one if the insurer had gone belly-up. “They would be taking an enormous risk,” he says. “They would have been risking the overthrow of the government.” (Ironically, after piling on extra financing, the U.S. government ultimately made a profit of $22.7 billion from the AIG bailout, according to a December 2012 press release from the Treasury Department. That figure has been disputed.)
One factor goading on CIC may have been AIG’s large book of business in China. “AIG sold enormous amounts of insurance in China,” says Silvers, who is now director of strategy and special counsel for the AFL-CIO labor union in Washington. “They may have considered what kind of impact a bankruptcy by AIG would have domestically.” Also, AIG is intimately intertwined with Chinese history: Its predecessor firm was founded in a two-room office by Cornelius Vander Starr in Shanghai’s Bund district in 1919 before branching out across Asia in the years leading up to World War II.
That fact that CIC’s offer has never been has made public is as startling as the news itself. It bolsters accusations of a cover-up.
For the record, Paulson’s own book on the subject, On the Brink — copies of which were handed out during Paulson’s October 6 testimony — made no mention of the CIC offer. Nor did Andrew Ross Sorkin’s seminal Too Big to Fail or the Financial Crisis Inquiry Report, the official report by the Financial Crisis Inquiry Commission.
More egregious, perhaps, numerous government investigations that drilled down into the AIG takeover and the subsequent swap payments to the banks made no mention of the CIC offer. One of the first, by the Office of the Special Inspector General for the Troubled Asset Relief Program, in November 2009, did not refer to any sovereign wealth fund offers. A SIGTARP spokesman declined to comment on whether the office knew of the CIC offer or others at the time. A person familiar with the audit process said that if the information had been made available to SIGTARP, it would have been included in its November 2009 report.
The Congressional Oversight Panel’s June Oversight Report in 2010 referenced discussions between AIG and sovereign wealth funds but did not mention specific funds or any offers to invest. “We interviewed numerous Fed and Treasury officials, and none of them mentioned this matter,” former deputy chairman Silvers says. Similarly, a September 2011 report by the U.S. Government Accountability Office referred to talks between AIG and a group of private equity firms, sovereign wealth funds, investment banks and others regarding financial assistance but made no mention of specific offers from CIC or GIC to the Treasury Department. A GAO spokesman e-mailed a copy of the report declining further comment.
“That would be one elephant-size omission,” says Michael Smallberg, an investigator at the Project on Government Oversight, a watchdog group in Washington. “All taxpayers have a legitimate interest in this. I’d be fascinated to know the reasons for why Hank Paulson didn’t engage.”
Duke professor Cox says Paulson likely would not have been psychologically inclined to hand over such an enormous financial institution to a foreign power. “Given his personality and DNA, he likes to be in charge,” Cox explains. “If you let somebody else into the deal, you are no longer in charge.” And, obviously, elements of the term sheet might have been challenged — such as the 100 percent payoffs on the swaps and the requirement not to seek redress against the bank counterparties.
Silvers, for all his skepticism regarding the viability of the CIC offer, is certain that Paulson would never have approved it under most any circumstance. “The day that China buys out a systemically important company because the U.S. government can’t is the day the U.S. loses its preeminence,” he says. “Paulson is too macho to have ever let such a thing happen on his watch.”
For Tavakoli, who worked briefly in the 1980s as a mortgage expert at Goldman Sachs, it all boils down to the former Treasury secretary’s ties to his former employer. “Paulson is saying, ‘I saved the banking system, and I did it the right way,’” she says. “He did it in a way that benefited Goldman Sachs.”
Ultimately, the geopolitics of the situation may have proved overwhelming for Paulson. “The savior of the financial system would have been a communist, totalitarian country,” says Cox. “The irony of the Chinese saving Wall Street would have been too much.”