The Bailout Bluff that Saved Wall Street

Eric Schillinger, Editing Chair, ESchillinger@albanylaw.edu

In the wake of September’s now infamous banking collapse, New York State Governor David Paterson played an instrumental role in saving the world’s largest insurance company from bankruptcy and staving off a total collapse of the market. New York based American International Group (A.I.G.) nearly filed bankruptcy on September 15 after the declaration of bankruptcy by Lehman Brothers, and sale of Merrill Lynch to Bank of America for a price roughly half its estimated value twelve months ago. (1)  The market began dropping at a rate frightening to the average investor and high stakes financial planner alike. (2)  Paterson intervened, restoring a modicum of stability in the economy, and freezing the market before its downward spiral went out of control. (3)

Amazingly the bailout Paterson proposed was a bluff, halting the collapse, but not actually bailing out anything. Paterson’s “subsidiary restructuring” plan simply steadied the market’s invisible hand, buying time for A.I.G., while he devised a broad strategy to combat the harsh realities of a market suffocated by foreclosure. The bailout plan Governor Paterson proposed for A.I.G., would have allowed the insurance giant to collateralize its subsidiary holdings, in an effort to obtain needed loans and stave off bankruptcy. (4)  All in all, the deal would have unlocked over twenty billion dollars in capital for the insurance company, presently held by A.I.G. subsidiaries; essentially the governor suggested the state would allow A.I.G. to raid its subsidiaries for cash. (5)  Funds not previously available to A.I.G. would have been liquidized for use as collateral, putting A.I.G. subsidiaries on the line, but allowing the huge corporation to stay afloat. (6)

The substance of the plan was less important then the fact that a plan existed. By placing the state in the center of the collapse, the governor helped to slow down the downward spiral sparked by the collapse of Lehman Brothers. Patterson’s plan restored trust in the market, showing that, while the government might let the situation get bad, it would not stay uninvolved in the face of system-wide collapse. This action bought Paterson time, and with total disaster staved off for the moment, to move past his initial plan and draw the Federal Reserve into the mix. (7)  With the collapse at least on pause, the governor sent New York State Insurance Department Superintendent Eric Dinallo to negotiate with the Federal Reserve. Dinallo secured a Federal loan for A.I.G. totaling more than eighty billion dollars. ( 8 )  That loan would never have happened without the state first stabilizing the market. Just like private investors, the federal government was unwilling to throw money at a terminally ill market. (9)  Paterson put the market in stable but critical condition, and showed the Federal Reserve a capital injection would likely restore the market to relatively good health.

Amazingly, Paterson’s authority to “bailout” A.I.G under the proposed plan violated the State’s Insurance Law. (9)  The state bailout system presented by Paterson and Dinallo emphasized the fact that no tax payer money was going to A.I.G. (11)  Under the Paterson plan, capital would have been generated by A.I.G. restructuring itself to produce liquid funds. In effect, the state offered to allow A.I.G. to loot its own subsidiaries to stave off bankruptcy, in blatant violation of New York State Insurance Law § 1608. That section of the code states in part that:

The business operations, corporate proceedings and fiscal and accounting records of subsidiaries organized or acquired pursuant to this article shall be conducted or maintained so as to assure the separate legal and operating identities of the parent and subsidiary . . . . (12)

The bailout plan that Paterson proposed would have allowed A.I.G. to pull capital out of its subsidiaries solely for the purposes of generating collateral to borrow more money and keep the company running. Doing so would have obliterated the separate operating identities of the companies, as A.I.G. would have been reliant solely on its subsidiaries as a source of operating capital. With all the money mixed, the critical but sometimes fine line between parent corporation and subsidiary would have evaporated. However, the legal validity of the plan was of no consequence. Implementation took a back seat to involvement – by showing that the state was not going to let the market collapse without a fight, investors developed a restored sense of stability. With stability restored, Paterson had time to figure out another means of bailing out A.I.G. that was both legal and effective. The initial plan bought him time, and with that time he enabled the Federal Reserve’s involvement, eventually securing over eighty billion dollars in bailout money for the injured insurance giant. (13)

Essentially, the governor stalled the market’s collapse for one critical day by merely proposing a state-based regulatory bailout of A.I.G. With the market stabilized, Paterson bought enough time for Eric Dinallo to seek and secure federal aid. When eighty five billon dollars in aid from the Federal Reserve came down the pipeline, Paterson’s proposed plan became unnecessary. The legal issues surrounding it were mooted – A.I.G. never actually restructured its subsidiaries, instead they took a high interest loan directly from the federal government.

Paterson’s plan was successful because it was never implemented. The governor over-reached his authority in offering to allow A.I.G. to restructure itself and draw capital out of its subsidiaries, but in an amazingly frail market, a functional sounding but potentially illegal legal bailout plan saved the day. By demonstrating New York’s willingness to help prevent enormous corporate collapses, Paterson generated enough trust to create market stability when no other factors encouraged it. With the collapse frozen, Paterson had the time he needed to secure a functional and legal bailout of A.I.G. from the Federal Reserve. In effect, he offered a bluff of a bailout, holding the market at bay just long enough to get the federal government involved to save the day.

Robert Magee, _____________ editors.

____________________________________________________________________________________

1 – Andrew R. Sorkin, Bids to Halt Financial Crisis Reshape Landscape of Wall St., N.Y. TIMES, Sept. 15, 2008, at A1.

2 – Id.

3 – Posting of Irene J. Liu to Capital Confidential, http://blogs.timesunion.com/capitol/archives/8720 (Sept. 15, 2008, 12:48 EST).

4 – Id.

5 – Id.

6 – Id.

7 – Press Release, Boards of Governors of the Federal Reserve System, Federal Reserve Board, with full support of the Treasury Department, authorizes the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) (Sept. 16, 2008 ) (stating that the Federal Reserve was providing an $85 billion dollar bailout to A.I.G.) available at http://www.federalreserve.gov/newsevents/press/other/20080916a.htm.

8 – Michael Gromley, N.Y. Gov. Paterson Praises Insurance Chief Dinallo on A.I.G. Rescue, INSURANCE JOURNAL, Sept. 18, 2008 available at http://www.insurancejournal.com/news/east/2008/09/18/93807.htm.

9 – Liu, supra note 4.

10 – N.Y. INS. LAW § 1608 (2008 ).

11 – Liu, supra note 4.

12 – N.Y. INS. LAW § 1608 (a) (2008); see generally Counties of Warren & Wash. Indus. Dev. Agency v. Adirondack Res. Recovery Assocs., 283 A.D.2d 846, 849 (N.Y. App. Div. 3d Dep’t 2001) (discussing separate identities of corporate parents and subsidiaries).

13 – Federal Reserve Board, supra note 7.

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