Government Prepares Defense in AIG Bailout Trial

David Boies spent much of the past month interrogating the architects of the 2008 Wall Street bailout, making the case that the U.S. cheated American International Group Inc. shareholders of at least $25 billion partly for the benefit of an elite bankers club.

This week, the government is set for its turn to respond to claims by Boies and his client, former AIG Chairman Maurice “Hank” Greenberg, describing the lawsuit as the ultimate case of biting the hand that feeds you.

Boies, the attorney for Greenberg’s Starr International Co. in the trial challenging the government’s demand for AIG equity in consideration for an initial $85 billion loan, has framed the rescue as a series of deals rigged by regulators in favor of Goldman Sachs Group Inc. and other investment banks at the insurer’s expense.

Those called to the witness stand included former Federal Reserve Chairman Ben Bernanke, Goldman Sachs chief turned U.S. Treasury Secretary Henry Paulson and Timothy Geithner, then head of the Federal Reserve Bank of New York and later Paulson’s successor at the Treasury Department. All three testified about why AIG was treated more harshly than banks shored up by government money.

“It is human nature to favor individuals and institutions who we know or for whom we feel responsible,” Boies said in his opening statement on Sept. 29. Bernanke, Geithner and Paulson knew and felt responsible for investment banks and trampled AIG shareholder rights as a result, according to Boies.

Goldman Sachs, Morgan Stanley and other banks borrowed tens of billions of dollars at rates of no more than 4 percent, while New York-based AIG was saddled with a 14 percent interest rate and was forced to surrender 80 percent of its equity, Starr alleges.

‘Backdoor Bailout’

After getting the stock, the government controlled the insurer to enable a “backdoor bailout” of banks and other financial institutions, according to Zug, Switzerland-based Starr, which was AIG’s biggest shareholder when the financial crisis struck.

The U.S. used its control of the company to orchestrate a reverse stock split that circumvented a shareholder vote against increasing the number of authorized shares of AIG common stock, Starr contends.

The government argues that it insulated itself from direct involvement in AIG by putting its shares in a trust.

The bailout loan was legal, voluntarily accepted by AIG’s board and couldn’t have harmed shareholders because their alternative was bankruptcy, according to the U.S. lawyers.

Uncomfortable ‘Lifeboats’

Starr’s attitude is “you brought the lifeboats, but they weren’t comfortable enough,” Kenneth Dintzer, a Justice Department lawyer, said in the government’s opening statement.

Boies is set to conclude his presentation of testimony and evidence by Oct. 29, shifting the spotlight to Dintzer and other Justice Department lawyers for the government’s defense. The nonjury trial before U.S. Court of Federal Claims Judge Thomas Wheeler in Washington is expected to continue for about two more weeks.

Possible government witnesses include the 89-year-old Greenberg, who was AIG’s chief executive officer for almost four decades before leaving in 2005, and Robert Willumstad, who was AIG’s CEO in September 2008 and whose resignation was a condition of the bailout.

Starr’s final witnesses will include experts on the Fed’s use of emergency powers in a financial crisis and damages for investors.

Independence Questioned

Boies spent part of the past week trying to show the lack of independence of two of three overseers of the trust for AIG shares.

One of them, Chester Feldberg, testified he worked at the New York Fed for 36 years and had been a supervisor of Sarah Dahlgren, a bank vice president who was assigned to monitor AIG after the bailout.

A second trustee, Douglas Foshee, told Wheeler that he was chairman of the Houston branch of the Federal Reserve Bank of Dallas when he was asked to help oversee the trust by Thomas Baxter, the general counsel of the New York Fed.

Boies suggested that trustees might have a conflict of interest in following advice from the New York Fed in the trust agreement. The guidance was that “maximizing potential value for all stockholders of the company will require managing the company so as to maximize its ability to repay” the bailout loan, he said, reading from the agreement.

Foshee rejected the notion of a conflict.

Taxpayer Interest

“I can’t imagine a scenario under which the long-term best interests of the U.S. taxpayer would be different from maximizing the long-term value of the stock we held in the trust,” Foshee said under cross-examination by J.J. Todor, a Justice Department lawyer.

Boies opened his case by calling Scott Alvarez, the Fed’s top lawyer, to inquire about a core component of the Starr suit: whether the central bank had the authority to demand stock as a condition for a loan.

Alvarez told Boies he believed the Fed, while lacking power to hold shares for a long period, could acquire and hold them on an interim basis.

Boies repeatedly portrayed the investment banks as a pampered clique.

He sought to show that Goldman Sachs officials or alumni picked a new CEO for AIG, Edward Liddy, a member of the New York-based bank’s board, after the government forced out Willumstad.

Liddy’s Appointment

“Did you think that there was anything unusual or strange about having the chairman of the investment banking division of Goldman Sachs be the first person to call you, to ask you if you would become CEO of AIG?,” Boies asked.

No, Liddy replied, because he assumed the call from Christopher Cole was made on behalf of Paulson, then the Treasury Secretary and a former Goldman Sachs CEO.

Liddy oversaw full payments to counterparties including Goldman Sachs, instead of negotiating concessions, according to documents and testimony. Liddy, who had left the bank’s board, testified that he didn’t participate in AIG decisions involving Goldman Sachs.

Morgan Stanley owed more money to the Fed than AIG did, yet was granted bank holding company status, requiring a central bank finding that it was “well capitalized and well managed,” according to documents introduced into evidence by Boies.

Catastrophic Damage

Bernanke, Geithner and Paulson testified that they intervened only to prevent further, catastrophic damage to the economy because AIG, once the world’s largest insurer, was enmeshed in so many parts of the financial system. The value of the AIG bailout ultimately grew to $182 billion.

All three said that even as they threw the company a lifeline, they worried about moral hazard, using the economics term for consequence-free risk taking.

If the government steps in, “there’s the danger that the market participants won’t continue to be as vigilant and you’ll lose market discipline,” Paulson testified.

Geithner told the court he was responsible for setting the loan’s interest rate, which Boies called extortionate.

The costly rate and other stiff terms “were designed to avoid creating an undue windfall for the existing shareholders,” Geithner testified.

Bernanke may have aided Boies’s argument that there was no legal authority for demanding stock for a loan. He testified that “rate” didn’t include equity when used to describe compensation for extending emergency credit.

“Did that term, ‘rate,’ include equity?” Boies asked.

“I normally think of rates as interest rates,” Bernanke replied.

Paulson Rationale

Paulson offered the court a rationale for treating AIG more harshly than investment banks.

The government avoided punitive terms for the banks because it feared doing so would encourage shortsellers to attack them or other financial institutions, further destabilizing the economy, Paulson told the court.

There was no similar risk of a domino effect in the insurance market, according to Paulson. “I didn’t see another insurance company that was vulnerable” and posed a risk to the entire economy as AIG did, he said.

Paulson said he advocated “fairness to the extent you can have fairness,” but “to me, stability trumped moral hazard.”

–With assistance from Christie Smythe in federal court in Brooklyn, New York,.