Bailout watchdog: AIG was 'Frankenstein'

NEW YORK (CNNMoney.com) -- An overseer of the $700 billion financial sector bailout said Wednesday that insurer AIG lacked regulation, leading to a taxpayer-funded rescue that "broke all the rules."

"The company was a corporate Frankenstein, a conglomeration of banking and insurance and investment interests that defied regulatory oversight," said Congressional Oversight Panel Chairwoman Elizabeth Warren at a hearing about AIG's bailout.

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Congressional Oversight Panel Chairwoman Elizabeth Warren said Wednesday that AIG's bailout "broke all the rules."

Warren said the government's lack of oversight of AIG (AIG, Fortune 500) and the insurer's monstrous nature explain why the company got a $182 billion government bailout rather than a traditional bankruptcy proceeding. But she questioned why government regulators didn't act sooner to try to find a less costly solution for taxpayers.

At the hearing, representatives from the Fed testified that the extraordinary events of mid-September 2008 required it to rescue AIG with a government-funded bailout. They said that the collapse of Lehman Brothers on Sept. 15 ruined any chance of a possible private-sector bailout, and the government needed to step in quickly to avoid another giant, systemically significant financial institution from collapsing.

"The Federal Reserve became 'Plan B,'" said Tom Baxter, the Fed's chief lawyer. "We had a matter of hours to deal with decision."

Baxter said that the Fed's chief decision makers only became aware of AIG's inevitable collapse on Sept. 12, four days before the insurers bailout. Sarah Dahlgren, the Fed's chief AIG monitor, said that prior to Sept. 12, the Fed did not even consider AIG to be one of the "top 10 exposures."

Whether the government could have and should have acted sooner on AIG was a subject of intense debate at the hearing. The Fed insisted that it could not have predicted that AIG would have taken a sharp and sudden turn for the worse in September 2008, because it is in essence a "trading group" that lives or dies on the ability to make its next trade.

But others testified that the government knew of AIG's crisis much earlier.

Former AIG CEO Robert Willumstad testified that AIG made the Fed aware of its severe problems in July 2008. Michael Finn, OTS' Northeast Regional Director, said that the regulator became aware of AIG's capital problems in December 2007 and liquidity concerns in the summer of 2008. Finn said OTS met with the Fed about AIG's issues in August.

AIG CEO Robert Benmosche spoke about how the company is faring, saying that AIG is "on a clear path" to repaying the government. But he also noted that the insurer not close to paying back the loan in full.

Benmosche said the company has become less reliant on government aid in recent months, and he said he doesn't anticipate needing to borrow any more from the Treasury.

Benmosche also called to attention the fact that the company's insurance businesses are profitable and growing stronger, even in spite of large catastrophe losses from the Chilean earthquake and the Gulf Coast oil crisis. He predicted that AIG will be able to earn between $6 billion and $8 billion after taxes next year.

AIG's CEO also said that the risk to taxpayers from its derivatives portfolio is about $4 billion, down from about $22 billion at the beginning of 2009. He said the company was no longer "too big to fail," and a viable company without government support.

AIG is in the process of selling two large foreign life insurance businesses, AIA and Alico, the proceeds of which will be used to pay down $51 billion of AIG's debt to the taxpayers. That will almost completely pay off AIG's loan from the Federal Reserve Bank of New York, but still has to pay back the nearly $50 billion it has borrowed from Treasury's Troubled Asset Relief Program.

"We are working hard to complete the sales of AIA and Alico by the end of this year, to increase profits at our remaining businesses, and to improve operating returns," said Benmosche. "Then we can begin to examine the alternatives we have to address the Treasury's TARP investment."