Why the AIG Bailout Worked

Taxpayers may get all their money back after all.

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American International Group building in Tokyo.

Just two years ago, it looked as if U.S. taxpayers might never recoup the billions spent to save insurance giant AIG.

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A detailed report by the Congressionally-appointed panel overseeing the Wall Street bailouts warned in June 2010 that taxpayers "remain at risk for severe losses" from the AIG bailout. It predicted that the U.S. government, which had pumped about $132 billion into the firm at the time and owned 80 percent of it, would remain a significant shareholder long after 2012.

Congress piled on, criticizing the Federal Reserve and the U.S. Treasury—which co-orchestrated the AIG bailout—of wasting Main Street dollars on bailouts for bankers and CEOs. When Fed chairman Ben Bernanke said he believed AIG would pay taxpayers back, critics slammed him as a hapless shill for Wall Street.

Now it looks like Bernanke was right. The U.S. Treasury recently announced plans to sell $18 billion worth of AIG stock, which would cut the government's ownership stake, now at 53 percent, to less than 20 percent. The Treasury has been selling AIG stock and reducing its ownership stake since early 2011, and this latest sale would make Washington a minority shareholder for the first time since 2008, when it effectively nationalized the world's biggest insurer. If the sale goes smoothly, it would bode well for a complete divesture--plus, a profit for taxpayers.

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Meanwhile, the Federal Reserve has also cleared AIG off of its books. As part of the complex rescue back in 2008, the Fed bought a huge batch of AIG securities that had plunged in value and eventually sadded AIG with the losses that threatened its implosion. Those securities weren't worthless. But they had become highly risky, because they were linked to subprime lending and exotic derivatives that suddenly nobody would touch. The Fed bought them at a discount in 2008, then resold them to investors in auctions earlier this year, earning an overall $18 billion profit that went into government coffers.

The federal government can make bailouts such as the AIG deal work because it has one advantage most other investors don't have: time. The Fed, for example, could have held those AIG assets as long as necessary in order to break even, which it knew when it bought them. The Treasury can do the same thing with the shares it holds in AIG and other bailed-out firms, such as General Motors and Ally Financial. The government's stake in AIG, meanwhile, has given the firm the time it needs to shore up its business units, restructure itself, sell assets at fair market prices and return to profitability.

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There can be powerful political reasons, of course, for the government to sell its stake in private-sector companies, or avoid taking a stake in the first place. The bailouts turned out to be deeply unpopular, and it's certainly in President Obama's interest to reduce the government's stake in private-sector firms as much as possible before the November elections. His Republican opponent, Mitt Romney, has stoked the controversy by saying he'd promptly sell the government's $26 billion stake in GM, even if taxpayers would lose money.

But financially, most of the bailouts executed during the financial crisis have turned out to be successful. Most of the firms that received a bailout have paid it back with interest, with the government actually earning $87 billion on $319 billion of money that has been repaid, according to ProPublica, which has tracked all the spending.

There are a few big exceptions. Fannie Mae and Freddie Mac, the moribund housing agencies, have sopped up nearly $190 billion worth of taxpayer funds, and there may be little hope of the government getting that money back. The Treasury Dept. still owns about one-third of GM and 74 percent of Ally Financial (formerly GMAC). And it's about $3 billion in the hole on Chrysler, remnants of which are still being liquidated.

What made the 2008 and 2009 bailouts seem truly odious, however, weren't the stock or asset purchases, but the bonuses paid to executives of bailed-out firms. AIG, for instance, paid "retention bonuses" totaling $165 million to executives at the unit that made most of the deals that sunk the firm, which was one of the most politically explosive developments of the entire financial meltdown.

AIG argued that it was vital to keep those people on board, since they supposedly had the knowledge necessary to unwind the firm's most dangerous contracts. But to mostly everybody else, it seemed like a group of financial engineers was holding U.S. taxpayers hostage. If there's ever another AIG-style bailout, expect taxpayers to have a lot more say over who gets paid what.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.