What would have happened if the government had let the giant fall? Former head counsel Ernie Patrikis explains.

Question: Would the situation have been better or worse if the bailout had gone to AIG counterparties rather than to AIG itself? (Tyler Cowen, Marginal Revolution)

Ernest Patrikis:  The bailout got to AIG counterparties.  Well, I guess they were bailed out.  I don’t know what that means.  Does that mean if AIG had failed?  I don’t fully understand the question.  Is it assumed that AIG failed and the failure of AIG would cause knock on failures of other firms would have to be bailed out if AIG were in a bankruptcy proceeding?  It would have been messy. 

I really saw the AIG problem in another light.  I think we saw, if I remember correctly, the beginning of some runs in Asia.  Life insurance in Asia is a savings product.  I think Asians will gamble on anything except their lives and there were some runs.  And that would have had a horrendous affect and countries where AIG was a major insurer, Taiwan, Thailand, Philippines, Hong Kong, huge problems there, plus the Narcon affects here of the major banking organizations who were the counterparties who needed the collateral.  So, I think it was a variety of issues. 

And if AIG had gone into bankruptcy, I think the subsidiaries would have had a harder time continuing in business.  At least, as I see it, Chartis, now of AIG Property and Casualty Subsidiary, is percolating along doing fairly well, it’s taken a beating with competitors.  The life insurance company in the states is doing fairly well; the companies outside the United States are doing fairly well, so it’s very interesting,

AIG had a flat organization chart with profit centers and with the exception of financial products and then those who needed financing, I mean the ILFC, the aircraft leasing company, has huge amounts of money to rollover.  Good company, well run, and the issue is certainly not credit worthiness, but financing.  And then AIG’s subprime lending sub.  I learned there are different kinds of subprime lending.  There’s the good subprime loans and the bad subprime loans and that subsidiary was doing fairly well the last time I talked to people.  So, what I see AIG is doing is just exacerbating a problem.  The Lehman shock to the system, the AIG shock enforces it.  And AIG has really become much more of a political issue because of the amount of the bailout. 

Question: How difficult would it have been if a non-bank resolution authority was in place to wind down AIG and transfer its obligations? (Dan Indiviglio, the Atlantic Business Channel)

Ernest Patrikis: Well, if we had something like the proposed legislation which would cover AIG because it has a federal savings bank, then AIG itself could have become part of a bridge bank.  In other words, the holding company in effect would be there and all its assets transferred, it would have adversely affected the shareholders and whatever creditors were not transferred over and continued in business.  This is the resolution that is being considered by Congress, which I think is helpful for institutions who live on liquidity and liquidity is very important to them. 

If that resolution authority hadn’t been in place, it would have been a lot easier to do it. Instead of this thing with the Fed lend some money and the Treasury lend some money and there’s a lot of opaqueness to that and one really has to drill down to understand it all.  But a bankruptcy from AIG would have affected all of the subsidiaries I think and it would have been in much worse shape than today. 

Question: How would you address the problem of regulatory capture? (Ryan Avent, The Economist)

Ernest Patrikis:  I really don’t see it.  I look at my own career of 30 years at the Fed where I did a lot of supervision.  I have a lot of friends in commercial investment banks.  That didn’t affect me when it came to doing remedial work.  I think the answer is, we got things done faster because we knew each other, we’ve dealt with each other over the years.  I really don’t see regulatory capture. 

And this goes go a whole other point that I’d like to get into if anyone hasn’t asked the question.  There is the structure of the Federal Reserve Banks.  Each Federal Reserve Bank has nine directors, three of them are appointed by the Board of Governors including the Chairman and Deputy Chairman of the Reserve Bank, and six are elected by shareholders.  One’s a big bank director, one’s a medium bank director, and one’s a small bank director, and the others are commerce industry, agriculture, labor.  They do not get into bank supervision at the Fed.  Where they help the fed is in terms of what they see in the economy, what people are telling them.  These are usually people who are leaders in their area, be it a union, or banking, or large business organization, global institution.  And provide a lot of insight into what’s going on in the economy.  Every two weeks, they meet and they vote on an interest rate, and then that goes down to the Board of Governors in Washington, along with a message which sums up the director’s feelings of up, down, or stay the same.  And that is not effective until approved by the Board of Governors. 

That system has worked so well over the years about giving intelligence to the Reserve Banks, the Board of Governors.  Again, these people do not get involved in bank supervision.  Some people want to change that.  And in effect want to make the Reserve Banks much closer to the Federal Government than they are today.  And I think that’s not going to happen.  I’ve asked myself why over the years at the Federal Reserve Bank in New York, where people in the community, so willing to tell us about things wrong. And I remember once an SEC Chairman saying, “Why is it they call you, and they don’t call me?”  And the answer is, I don’t think capture.  I think it’s trust, relationships over the years being in the market and that’s an issue that’s being pushed on and I just don’t think it’s right. 

Question: Should the size of large institutions be an area of concern for reasons of political influence and systemic risk? (Ryan Avent, The Economist)

Ernest Patrikis: I don’t think that size alone is an issue.  I mean, every institutions does the right thing, they’re reporting fully the amounts they spend on lobbying.  I know when I was at AIG we were scrupulous about it and we always wondered about whether other firms were as scrupulous as we were in terms of reporting what we did. 

I would go, not monthly, but periodically go and visit, not to lobby, but to let people on “The Hill” know where we were going, directions, issues, things like that.  I don’t know that large institutions – I didn’t hear large labor unions in that statement.  I didn’t hear about other organizations in that statement, and smaller institutions also have organizations, financial and otherwise.  There are the trade associations.  I don’t think it’s any more pervasive – but I’ve always thought in banking, no bank could get a law, they might be able to slow one down, but very, very difficult for a bank to say, here’s what we want, please enact it.  I just don’t see that kind of capture of “The Hill.” 

Question: What would the situation be today if Lehman had been rescued? (Steven Landsburg, The Big Questions)

Ernest Patrikis: I think it would have been different in the degree of severity.  We still would be going through this crisis.  I just think the shock to the system was too strong.  And if we didn’t show the resolve that we needed to, and then when it came to issues like the legislation, how poorly the bill was handled, the TARP Bill was handled, both in the administration and in Congress.  So the Narcon of the Lehman is equally as bad as the decision not to save Lehman. We’d still have all the problems with credit worthiness and those securitizations today, but I think the severity would have been tempered somewhat.

Recorded on November 9, 2009