ankruptcy For AIG?
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0 WASHINGTON, D.C.–Earlier this week, Texas Republican Jeb Hensarling and California Democrat Brad Sherman–who rarely find themselves on the same side of an issue–both suggested putting failed and shamed insurer American International Group into a “receivership,” a process that the government uses to unwind failed banks.

Sherman says that he’s floated the idea to Treasury Secretary Timothy Geithner. (A Treasury spokesman did not respond to a request for comment.) Wednesday, Federal Deposit Insurance Corp. Chairman Sheila Bair, all but echoed these suggestions, telling a Senate panel that for companies that are too big to fail, there should be “a legal mechanism for the orderly resolution of these institutions similar to that which exists for FDIC insured banks.” In other words, a receivership.

Given the $170 billion into AIG , and the explosion of anger over the company’s payout of $165 million in bonuses, it’s no shock the idea is being explored as a way of washing the public’s hands of the messy and troublesome firm. Could it work? Yes, but there are risks.

The FDIC acts as a “receiver” for failed banks all the time, taking them over and selling assets to satisfy creditors’ claims. There’s currently no mechanism for placing a non-bank holding company like AIG into a receivership, so Congress would have to create this authority.

The problem is AIG’s debt. In a receivership, debt contracts are usually kept in place. Without restructuring those contracts, taxpayer money would still be on the line to make sure they’re paid–meaning that that the government actually might not save money under such a scenario.

What, then, about regular old bankruptcy? Because AIG is a massive holding company with a reach far beyond the insurance business, the firm could file for restructuring under normal Chapter 11 proceedings. A bankruptcy judge would put a freeze on all assets and determine which subsidiaries need to be restructured and which don’t (like its healthy insurance businesses). Shareholder equity would be wiped out and the company would settle up on its liabilities, paying a percentage of the debts owed.

Sounds simple enough, but there’s a problem here too: counterparties. If AIG can’t pay banks to which it owes money, there could be a further drag on the financial system. Also, when a bank holding company or non-bank financial holding company files for Chapter 11, certain financial securities aren’t subject to a freeze on creditor claims, as Bair points out in her testimony (though she wasn’t talking about AIG specifically). The result can be a run on the bank.

This puts the government in a Catch-22 position: keep dumping money into a failing institution and face the wrath of constituents, or run the risk of pulling down the economy even further if customers flee the world’s biggest insurer en masse.

So far, the Federal Reserve and the Treasury Department have chosen the former option, but such worries about extensive damage to the financial system might be overblown. According to University of Pennsylvania law professor David Skeel, the U.S. government can simply step in and guarantee the key trades among counterparties.

“I think the claim that the sky will fall if the company winds up in Chapter 11 is generally unfounded,” he says. So far no one’s ready to take that bet–yet.