Since last September, the government's case for bailing out AIG has rested on the notion that the company was too big to fail. If AIG hadn't been rescued, the argument goes, its credit default swap (CDS) obligations would have caused huge losses to its counterparties--and thus provoked a financial collapse.
Last week's news that this was not in fact the motive for AIG's rescue has implications that go well beyond the Obama administration's efforts to regulate CDSs and other derivatives. It's one more example that the administration may be using the financial crisis as a pretext to extend Washington's control of the financial sector.
The truth about the credit default swaps came out last week in a report by TARP Special Inspector General Neil Barofsky. It says that Treasury Secretary Tim Geithner, then president of the New York Federal Reserve Bank, did not believe that the financial condition of AIG's credit default swap counterparties was "a relevant factor" in the decision to bail out the company. This contradicts the conventional assumption, never denied by the Federal Reserve or the Treasury, that AIG's failure would have had a devastating effect.
So why did the government rescue AIG? This has never been clear.
The Obama administration has consistently argued that the "interconnections" among financial companies made it necessary to save AIG and Bear Stearns. Focusing on interconnections implies that the failure of one large financial firm will cause debilitating losses at others, and eventually a systemic breakdown. Apparently this was not true in the case of AIG and its credit default swaps--which leaves open the question of why the Fed, with the support of the Treasury, poured $180 billion into AIG.
The broader question is whether the entire regulatory regime proposed by the administration, and now being pushed through Congress by Rep. Barney Frank and Sen. Chris Dodd, is based on a faulty premise. The administration has consistently used the term "large, complex and interconnected" to describe the nonbank financial institutions it wants to regulate. The prospect that the failure of one of these firms might pose a systemic risk is the foundation of the administration's comprehensive regulatory regime for the financial industry.
Up to now, very few pundits or reporters have questioned this logic. They have apparently been satisfied with the explanation that the "interconnectedness" created by those mysterious credit default swaps was the culprit.
But the New York Fed is the regulatory body most familiar with the CDS market. If that agency did not believe AIG's failure would have actually brought down its counterparties--and ultimately the financial system itself--it raises serious questions about the administration's credibility, and about the need for its regulatory proposals. If "interconnections" among financial institutions are indeed the source of the financial crisis, the administration should be far more forthcoming than it has been about exactly what these interconnections are, and how exactly a broad new system of regulation and resolution would eliminate or reduce them.
The administration's unwillingness or inability to clearly define the problem of interconnectedness is not the only weakness in its rationale for imposing a whole new regulatory regime on the financial system. Another example is the claim--made by Mr. Geithner and President Obama himself--that predatory lending by mortgage brokers was one of the causes of the financial crisis.
No doubt some deceptive practices occurred in mortgage origination. But the facts suggest that the government's own housing policies--and not weak regulation--were the source of these bad loans.
At the end of 2008, there were about 26 million subprime and other nonprime mortgages in our financial system. Two-thirds of these mortgages were on the balance sheets of the Federal Housing Administration, Fannie Mae and Freddie Mac, and the four largest U.S. banks. The banks were required to make these loans in order to gain approval from the Fed and other regulators for mergers and expansions.
The fact that the government itself either bought these bad loans or required them to be made shows that the most plausible explanation for the large number of subprime loans in our economy is not a lack of regulation at the mortgage origination level, but government-created demand for these loans.
Finally, although there may be a good policy argument for a new consumer protection agency for financial services and products, the scope of what the administration has proposed goes far beyond lending, or even deposit-taking. In the administration's proposed legislation, the Consumer Financial Protection Agency would cover any business that provides consumer credit of any kind, including the common layaway plans and Christmas clubs that small retailers offer their customers.
Under the guise of addressing the causes of a global financial crisis, the Obama administration's bill would have regulated credit counseling, educational courses on finance, financial-data processing, money transmission and custodial services, and dozens more small businesses that could not possibly cause a financial crisis. Even Chairmen Frank and Dodd balked at this overreach. Their bills exempt retailers if their financial activity is incidental to their other business. Still, many vestiges of this excess remain in the legislation that is now being pushed toward a vote.
The lack of candor about credit default swaps, the effort to blame lack of regulation for the subprime crisis and the excessive reach of the proposed consumer protection agency are all of a piece. The administration seems to be using the specter of another financial crisis to bring more and more of the economy under Washington's control.
With the help of large Democratic majorities in Congress, this train has had considerable momentum. But perhaps--with the disclosure about credit default swaps and the AIG crisis--the wheels are finally coming off.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy at AEI.