The New York Federal Reserve and Treasury Secretary Tim Geithner may soon testify once again before the House Committee on Oversight and Government Reform over their handling of the collapse of AIG.

Specifically, the Fed's decision to use taxpayer money to make 100% whole $62.1 billion worth of trades made by counterparties with American International Group, (AIG), including Goldman Sachs (GS), Societe Generale and Merrill Lynch.

But there are curious disclosures in government documents that you will likely hear Geithner use in his defense, a defense he's quietly made already without much ado in the media.

One disclosure: The government's definition of systemic risk took into account political fallout from not making whole foreign counterparties to AIG. In particular, France finance ministers had a heated reaction to not fully remunerating its companies, Societe Generale and Calyon.

The decision to force U.S. taxpayers to pay par for the AIG trades has met with a hailstorm of criticism, since the triple-A rated U.S. government was backing AIG at the time, right after the giant insurer was downgraded by the three main ratings agencies, and since the subprime loans underlying AIG's swaps had deteriorated—to the point where one of AIG's counterparties, UBS, had already agreed to a 2% haircut in price.

The Treasury Secretary and the New York Fed will also have to defend their decision to squelch disclosures about the bailout, including redacting documents and emails, and instructing the TARP inspector general to withhold confidential documents.

The Oversight and Government Reform Committee is moving to issue a subpoena for New York Fed records over the decision it made to fully reimburse AIG's trading partners.

France Says it Could Have Faced Criminal Sanctions

At the time of its AIG bailout, the New York Fed was negotiating with Commission Bancaire, the French bank regulator whose legal mandate is to protect depositors and act as a watchdog over the French financial system to ensure profitability and financial stability.

Commission Bancaire officials, overseeing the negotiations for Societe and Calyon, “forcefully asserted that, under French law, absent an AIG bankruptcy, the banks could not voluntarily agree to less than par value for the underlying securities in exchange for terminating the swap contracts,” says the TARP inspector general report on the AIG bailout. “Thus, the French banks claimed they were precluded by law from making concessions and could face potential criminalliability for failing to comply with their duties to shareholders.”

In France, it is a crime for a manager to use company assets in bad faith contrary to the interests of the company (essentially criminalizing a breach of fiduciary duties to shareholders).  

Fed's Failure to Disclose

Under its then chieftain, Geithner, the New York Fed had demanded the 100-cents on the dollar deal for AIG's counterparties, and it demanded that their identities be kept strictly confidential.

The counterparties got $27.1 billion to wipe out the securities underlying the swaps, and they also got to keep $35 billion in taxpayer-paid-for collateral that AIG had posted in exchange for tearing up their swap contracts, according to the TARP inspector general.

But the New York Fed, which oversaw the AIG bailout in September 2008, has said Geithner wasn't aware of the disclosure issues and was not involved in those discussions, despite the fact that Geithner was the president and chief executive of the New York Fed at the time, is notoriously detail obsessed, and was telling the media the central bank supports greater transparency.

AIG first received an $85 billion credit line from the New York Fed in the fall of 2008, a line later reduced to $60 billion. It also got a Treasury stake of $69.8 billion, and $52.5 billion more to buy mortgage-backed assets, bringing the bailout to about $182.3 billion. The Fed has since warehoused AIG assets, as well as Bear Stearns assets, in off-balance sheet entities that to date have earned a net $5.5 billion.

The way the bailout worked, taxpayer money was used to buy the securities underlying AIG's swaps from counterparties, including Goldman, Societe General and Merrill Lynch. Taxpayer money was also used to help AIG meet a cash drain in the form of collateral calls from the big banks that had bought AIG's credit default swaps to insure their asset-backed securities.

What Geithner Will Say

But here's what Geithner will say in his defense when he's called to testify.

He will say that the New York Fed felt there was little chance it could demand reductions from AIG's counterparties because it had no leverage over the negotiations.

The government could not use the threat of an AIG bankruptcy because it had stepped in quickly to avoid an AIG default.

Geithner will say a threat to withdraw the government's support from AIG may have triggered a more violent reaction from the credit rating agencies to AIG's credit rating.

Geithner will say that the government could not use its position as a top regulator of the U.S. counterparties as leverage in the negotiations because the government had become a creditor of AIG.

He'll say the New York Fed was “uncomfortable with violating the principle of sanctity of contract,” despite the fact that the government would soon tear up all sorts of contracts, notably with creditors in the bailouts of the automakers.

And Geithner will say that the French banks refused to negotiate concessions, throwing a wrench in the process. He will say that the Fed considers one of its “core values” the idea that it treats all parties equally, and thus would not want to be perceived as cutting a more favorable deal with the French banks than with U.S. companies.

Citing the Federal Reserve Act

Moreover, to that end, Geithner will cite section 4 of the Federal Reserve act, which required the Federal Reserve to treat member banks and banks equally, and the principles of national treatment and equality of competitive opportunity in the International Banking Act.

Geithner will also say that the Fed had no legal mechanism in place to selectively impose losses on counterparties.

The Fed's big problem was that the government played its cards too soon. “It bailed out AIG, and then tried to say, ‘come on guys, take a haircut,' when the time to negotiate haircuts is beforeyou pledge the money, not after.  Once you pledge the money, you have no leverage,” says Fox News analyst James Farrell.

Why Did Goldman's AIG Trades Pose Systemic Risk?

What was the systemic risk of not fully remunerating Goldman Sachs?

Didn't Goldman have enough collateral to protect itself in the event of an AIG default, as it often boasts of its huge cash reserves on hand?

A question worth asking: did Goldman Sachs lowball the value of its securities underlying its AIG swaps in order to get more taxpayer bailout money out of AIG? 

Goldman had about $22.1 billion worth of swaps with AIG, $20 billion of which covered its CDOs. Goldman refused to take a haircut because it didn't want to book a loss on the deals, and got $14 billion back on its trades with AIG ($5.6 billion from Maiden Lane III, and $8.4 billion in collateral payments).

According to reports, Goldman is known for aggressive, conservative approach to asset marks, in keeping with comments from its chief executive, Lloyd Blankfein, as supporting fair value accounting. That means Goldman posted low quotes on its asset values, in turn forcing AIG to post higher collateral.

According to another report, Goldman was pricing its asset-backed securities in keeping with an illiquid market. One Wall Street blog, Economics of Contempt, says Merrill Lynch was quoting an ABS deal called Independence V at 90, while Goldman had it down at 67.5.

Geithner Says AIG Collapse Would Hurt the Little Guy

Geithner has also testified about systemic risk in AIG's traditional insurance lines of business. "If AIG had defaulted, you would have seen a downgrade leading to the liquidation and failure of a set of insurance contracts that touched Americans across this country and, of course, savers around the world," he said.

The Special Inspector General for TARP, Neil Barofsky, has already issued a report noting that the Fed and the U.S. Treasury were worried about a potential $88 billion in AIG investor and debt-holder losses swallowed by state and local governments ($10 billion), 401(k) accounts ($40 billion), and other retirement plans ($38 billion).

And Treasury and the Fed were concerned that an AIG default would hit money market funds with losses, too, as they held $20 billion in commercial paper issued by AIG.

An AIG default coming fast on the heels of the Lehman collapse likely would have caused more money funds to drop below $1 per share in net asset value, called “breaking the buck,” and would have triggered a panicky run on the fund industry, which backs the commercial paper market (the Federal Reserve moved swiftly to provide a new backstop this market after Lehman failed).

TARP Inspector General Not Having It

Barofsky assailed the Fed's moves to stop disclosures about the AIG bailout in a November 17, 2009, audit report about AIG:

"Notwithstanding the Federal Reserve's warnings, the sky did not fall; there is no indication that AIG's disclosure undermined the stability of AIG or the market or damaged legitimate interests of the counterparties. The lesson that should be learned one that has been made apparent time after time in the government's response to the financial crisis is that the default position, whenever government funds are deployed in a crisis to support markets or institutions, should be that the public is entitled to know what is being done with government funds."