Hank Greenberg's AIG Lawsuit Could Crush 'Too Big To Fail'

The trial challenging the government's rescue of American International Group is in full swing this week. Ben Bernanke, Hank Paulson, and Tim Geithner are making appearances. AIG's former CEO-through his charitable foundation, which is a large AIG shareholder-has sued the government for its allegedly punitive bailout of AIG during the financial crisis. The government officials who bailed out the company may find it hard to run from their prior statements.

Over the same weekend that Lehman failed, AIG was also on the precipice of failure. Not only were collateral demands from counter parties of its notorious Financial Products division draining the company's liquid assets, but its securities lending operations were also emptying company coffers and threatening the viability of some of the company's insurance subsidiaries.

The company and its regulators concocted a number of plans for non-governmental rescues, but each of these fell through. A consortium of big banks took a deep look at AIG and concluded that it wasn't worth saving. Forthcoming demands for cash from the company exceeded the value of the company's assets, so there was no point in pouring good money in after bad. As insurance expert David Merkel puts it, "AIG was broke."

The government, not deterred by the thought that it might be rescuing an insolvent company, jumped right in with an $85 billion loan. AIG was in such bad shape that the initial loan was followed by more government money and a loosening of the loan terms. Wrapped in the government's protective mantle, AIG survived.

Now Hank Greenberg, AIG's long-time CEO, is challenging the tough terms under which the government rescued his former company from trouble that probably would not have happened under his watch. His lawsuit alleges that the federal government withheld help from AIG, such as discount window access and loan guarantees, that it extended to other companies. When the government finally coughed up assistance for AIG, the lawsuit alleges, "the terms demanded by the Government were grossly disproportionate to the Government's interest in protecting the interests of taxpayers." In addition to securing the loan with all of the company's assets, the government took a 79.9 percent equity stake in the company-an unconstitutional taking of private property according to Greenberg's suit.

The government could credibly argue that AIG was in so much trouble that even such a large stake in the company was not of any value. That is what the private sector would-be lenders concluded. AIG's problems ran through the company and were not just isolated to its Financial Products unit. But that sort of defense would raise new questions about why the government rescued AIG at all. The government is not supposed to loan money to insolvent companies, but only those that have good collateral to secure the loan.

Accordingly, in defending the rescue in the past, government officials have argued that AIG-in contrast to Lehman-was very valuable when it was rescued. Former Federal Reserve Chairman Ben Bernanke, for example, insisted that AIG "had lots and lots of perfectly good assets. And as a result, it had collateral which it could offer to the Fed to allow us to make a loan to provide the liquidity needed to stay afloat." Statements like that make it awfully hard to argue in the context of this lawsuit that actually AIG was not chock full of good collateral, but was so desperate for help that the government was justified in taking a big equity stake.

Bolstered by the government's own insistence that AIG was a really valuable company with a temporary liquidity problem, Greenberg might succeed in convincing the court that the government took private property without just compensation. Although not the right result, at least it would strike a blow to too-big-to-fail by adding to the bailout calculus the specter of subsequent courtroom payouts to allegedly aggrieved shareholders.