Lee Strasberg has that unforgettable line in Godfather II about “small potatoes.” That’s what the Illinois corruption case is compared to the Fed’s hanky-panky with AIG.
Here are the details, in simple language, of how that scam worked. AIG had insured bond-like securities called CDOs against default. Default on a bond occurs when the issuer of the bond can’t make the promised interest payments. AIG, which is an insurance company, had collected insurance premiums from the buyers of these bonds for insuring them against the possible default of those bonds. That insurance it sold is called a "credit default swap," or CDS. The buyers of the insurance were banks like France’s Societe Generale, Germany’s Deutsche Bank, France’s Credit Agricole, and Merrill Lynch. The face value amounts were large, some $65 billion.
When the loans that were packaged into the CDOs began to go bad and fail to pay interest, these CDOs fell in price by half. That meant that AIG had to put up earnest money as a sign that they’d make good on their insurance. These are called collateral payments. AIG ran out of cash to make these payments. These kinds of payments are a common and legitimate business practice in financial matters in order to control risk. For example, in borrowing to buy stocks, the broker calls for more margin (money) if the stocks decline by a certain amount, in order to make sure that the borrower-buyer will be able to pay the purchase price.
Enter the Fed. The Fed formed a company with AIG called Maiden Lane (it’s a real street near Wall Street). The Fed then purchased the CDOs from these and other banks at their full insured value. The Fed became the insurer of last resort.
When the Fed buys Treasury bills, it gets something of value that is backed by the Treasury’s taxes. In the AIG case, the Fed has overpaid for the CDOs and given away its currency to the insured banks. The Fed has made good on bets made by a private company. It has the legal right to do this under the Federal Reserve Act, since it can accept the notes of a private corporation. This shows the Fed’s enormous power.
Who gains? Obviously, the banks that held the CDOs are the main gainers. The stockholders, bondholders, and depositors of these banks gain. The stock of Deutsche Bank was falling between September 10 and 17. It fell from $85.61 to $70.40. On September 18, the stock jumped to $83.86, a very unusual price increase. Deutsche Bank has been a large beneficiary of the Fed’s largesse. This is not the whole story, however. The results of the Fed’s action had more general effects. All or almost all banks showed similar price movements at these dates, even banks that probably would not be selling CDOs to the Fed. The Fed’s action had a systemic impact. For example, the regional bank index in the U.S. rallied from $35 to $41 on September 18. Despite the Fed’s actions, it appears that the impact has been temporary or that other events since September have dragged down bank stock values again. Deutsche Bank stock is now $36.75, and the regional bank index (KRE) has fallen from $41 to $28. Bank of America is now $16.69, down from $36.65 on September 19.
Who loses? Everyone who holds Federal Reserve notes loses. This Fed operation is like a company that gives away its stock to a select group of recipients. The rest of the stockholders discover that the stock has been, in effect, split. There are more shares outstanding but the firm’s assets haven’t changed. The result is that the share price falls. In this case, the value of the dollar falls.
Did the value of the dollar fall? Yes! The AIG takeover and Fed’s participation occurred around September 16—17, 2008. On September 17, the price of gold had an extraordinary price rise from about $770 to almost $860. The following day, it settled back to $825. (It is common in financial research to use a two-day window to evaluate the impact of an event.) Traders in markets are generally quick to evaluate and impound public information into speculative prices. This is an example. The traders attempt to assess the implications of events. If the Fed issued $65 billion of new currency as compared with its $832 billion at that time, the dilution would be 7.8 percent in the value of a dollar. At the $825 price, gold went up by 7.1 percent. We are in the ballpark of understanding why this jump in gold price occurred when it did and in the amount that it did. Mind you, traders would be attempting to evaluate not just this particular bailout but also future bailouts.
Suppose that the Fed’s holdings of CDOs work out to be even worse investments than expected. The Fed will then be writing off bad debts, and they will show up as reductions in its capital account. This will make the price of gold rise further. On the other hand, if these holdings turn out to provide better payoffs than expected, then gold may fall in reflection of that fact.
This analysis gives us some confidence in understanding the pricing of gold versus the dollar. The Fed has exploded its balance sheet. This means it has taken on a huge increase in loans. How good are those loans? That is what traders are evaluating. If these are bad loans or if traders get information that these loans are worse than they thought, then it means dilution of the currency. The result will be that gold’s price will rise. If these are good loans or if traders evaluate ongoing information as suggesting that these loans are better than they expected, then gold’s price will fall.
The existing price of gold reflects the market’s current consensus expectations about the strength of the loans that the Fed has made. The gold price will move up and down on any news about the quality of these loans and on any news that the Fed is making new loans. It will be evaluating the quality of any new loans. These considerations are by no means the only events that affect the price of gold against the dollar, but they are important ones as the reaction to the AIG bailout shows.