Monday, March 2, 2009

Almost six months later, we still don’t know the extent of the damage.

From The Baseline Scenario:

"AIG in Review

with 13 comments

Well, it’s done. AIG is getting another bailout.

I have to admit I don’t fully understand the ongoing AIG bailout saga, so I thought I would do a little research to try to figure out what is going on. I thought I would just look up all the term sheets, but I found it’s harder to get that kind of information from the Federal Reserve web site than from the Treasury web site. For example, the original September 16 press release doesn’t say what the terms of the 79.9% equity interest are, and I still haven’t been able to figure that out. If you know the details, let me know and I’ll update this post. In any case, I think this is the best single-page overview you’ll find on the web.

September 16: The Federal Reserve gave AIG an $85 billion line of credit for 2 years at a very high interest rate - 3-month LIBOR (an interbank lending rate, which is generally pretty low) plus 8.5 percentage points on the full amount (whether or not it was drawn down). In exchange, the government (not sure which entity) got warrants on 79.9% of AIG stock - I don’t know what the price was, or if they were ever exercised.

October 8: By early October, AIG had already drawn down over $60 billion of its credit line. The Federal Reserve authorized the New York Fed to “borrow” up to $37.8 billion in illiquid securities from AIG and give it “cash collateral” (I think that means “cash”) in return. The problem was that AIG had lent some securities (call them A) to counterparties in exchange for cash or other collateral (call that B), and had then used B to buy some other securities (C) that had lost value. So when the counterparty wanted to return A and get B back, AIG couldn’t give them B back, because the money was tied up in C. So the New York Fed agreed to take C and give AIG cash so AIG could close out its trade - meaning the Fed effectively got stuck with the risk.

November 10: This time the Fed and Treasury got together.

  • Treasury invested $40 billion of TARP money in AIG for preferred stock paying a 10% dividend. Treasury also got warrants with an exercise price of $2.50 on 2% of AIG’s outstanding common stock (although I don’t know how this relates to the original warrants on 79.9% of the common stock.)
  • Some of that $40 billion was used to pay back the line of credit, which was reduced from $85 billion to $60 billion. The interest rate was reduced from LIBOR + 8.5 percentage points to LIBOR + 3 percentage points (a huge reduction), and the term was extended from 2 years to 5 years.
  • The New York Fed created a new entity called AIG RMBS LLC with $1 billion from AIG and a $19.8 billion loan from the Fed. That $20.8 billion was used to buy residential mortgage-backed securities from AIG. Those securities had a face value of $40 billion but a “fair value” of $20.8 billion, or 52 cents on the dollar. (I wonder what those RMBS were on the books at prior to the sale.) The purpose here was simply to relieve AIG of some toxic assets and minimize its losses on them. Interest on those securities and proceeds from sale will pay back the loan to the Fed, meaning that AIG will take the first $1 billion in losses and the Fed anything else. The $20.8 billion paid to AIG (to buy the securities) was paid back to the New York Fed to retire the lending/borrowing facility created on October 8.
  • The New York Fed created another entity called AIG CDO LLC with $5 billion from AIG and a loan of up to $30 billion from the Fed. The purpose of this entity was to buy CDOs from third parties who had purchased “insurance” (credit default swaps) from AIG. Since AIG’s biggest exposure was the possibility of having to pay out on this insurance, the idea was to buy up the assets (CDOs, in this case) that had been insured and require the third party to close the CDS contract. (Imagine AIG had underpriced insurance for houses on the Gulf Coast, and the government was buying the houses in order to cancel the insurance contracts.) According to the Fed web site, it looks like this entity has spent $20.1 billion to buy up CDOs with an aggregate face value of $53.5 billion - 38 cents on the dollar - but I’m not certain I’m reading that correctly. If those CDOs lose value, AIG bears the first $5 billion in losses, and the Fed bears the rest.

So as of November AIG had a $40 billion preferred stock injection and a $60 billion credit line. AIG had also put $6 billion into two new entities which could borrow up to $50 billion from the Fed and use the total funds to buy toxic assets: some from AIG (and I have no idea if we overpaid for those or not) and some from third parties.

March 2 (updated 3/2 7:30 am): The announcements are out.

  • The $40 billion in preferred shares that Treasury got in November are being exchanged for $40 billion in preferred shares that are on better terms for AIG. There’s no way to get around this point. It’s the Series D to Series E conversion on the term sheet. The new preferred shares pay a “non-cumulative” dividend, which means they basically pay no dividend. More specifically, they only pay a dividend if AIG decides to pay the dividend. And they are non-cumulative, meaning that if AIG skips a dividend payment, they never have to pay it. (With a cumulative dividend, if you skip one payment, it gets added onto the next one.) The only condition is that if AIG skips the dividend for eight quarters in a row, Treasury can appoint some members of the board of directors.
  • In addition, Treasury is providing up to $30 billion more in cash in exchange for more preferred shares on yet different terms. That’s the Series F on the term sheet. I don’t see anything about dividends, so this is basically an interest-free five-year loan.
  • The terms on the credit line will be improved by reducing the floor on the interest rate (previously 6.5%). In addition, the credit line will be reduced by up to $34.5 billion, according to the two following provisions.
  • Two life insurance subsidiaries will be put into separate trusts. After AIG and the New York Fed agree on the valuations of those subsidiaries, the Fed will buy up to $26 billion in preferred stock in these trusts. That money will be used to pay down the credit line.
  • AIG will create new entities that own the rights to the cash flows from certain blocks of life insurance policies. The New York Fed will loan these entities $8.5 billion, which AIG will turn around and use to pay down the credit line. The $8.5 billion will be paid back (or not) by the new entities from the life insurance cash flows. (In other words, AIG is securitizing the life insurance policies and the Fed is buying the securities for $8.5 billion.)
  • AIG is issuing convertible preferred stock equivalent to a 77.9% ownership share to Treasury. This looks like Treasury is exercising the rights it got under the original loan agreement. The terms of the convertible preferred stock were not released as far as I can tell, but we can probably assume there are no dividends.

In summary: AIG gets better terms on the first $40 billion in preferred stock; AIG gets $30 billion more in cash in exchange for new preferred stock on even better terms; and the credit line gets reduced by giving Treasury some assets (that AIG was presumably unable to sell on the open market). The overall effect is to reduce AIG’s debt burden and shift more risk to the taxpayer. Whether the taxpayer got a good price for taking on that risk is far too complicated for anyone to figure out from just reading a term sheet, since it depends on the nature of the assets.

I know that AIG is different in many respects from the banks that everyone is worried about. In particular, AIG was a net seller of CDS protection, while most banks are (should have been?) net buyers of protection. But one thing still scares me. When the weekend of September 13-14 began, AIG said it needed $40 billion. After digging through the books, Goldman and JPMorgan put the price tag at $75 billion, and declined to put together a consortium to lend the money. The Fed lent $85 billion, thinking that would be enough. Almost six months later, we still don’t know the extent of the damage.

Update: I rewrote the March 2 section.

Update 2: Does anyone else find it strange that, less than one week after announcing that future capital will be given to banks in the form of convertible preferred shares with a 10% dividend, Treasury has already issued preferred stock on three different sets of terms (one to Citigroup and two to AIG), none of which are consistent with last week’s announcement? Also, with the AIG Series E and F, we have reached a new high (or low) of generosity, with a noncumulative dividend in one case and no dividend in the other. Of course, this is a company we already “own” - we control most of the equity, and we have implicitly guaranteed the debt - so maybe none of these terms really matter.

Written by James Kwak

March 1, 2009 at 11:11 pm"


From Nov. 10th:

“The Federal Reserve and the US Treasury now understand they are dealing with systemic risk rather than one company’s problems,” said Mr Liddy, a former chief executive of the insurer Allstate and board director of Goldman Sachs.

In an effort to defuse a possible political backlash over the use of yet more taxpayers’ funds to save a stricken financial institution, Mr Liddy said the government could make money out of the latest deal( NB Don ).

He pointed to the 10 per cent interest payable by AIG on the $40bn-worth of preferred shares to be acquired by the government as well as the interest on a $60bn loan from the authorities, which is set at 3 per cent over the London interbank borrowing rate.

Mr Liddy also said that most of the gains from a rise in the value of AIG’s toxic assets over the next few years would be retained by the Fed, not the company. A special vehicle is being set up to take over the billions of dollars in illiquid credit default swaps and mortgage-backed assets owned by AIG.

“The taxpayer is going to do very well out of this deal,” Mr Liddy said. ( NB Don )

The debt securities which triggered AIG‘s collapse continued to plague the company in the third quarter. Included in its net loss was a pre-tax charge of around $7bn related to AIG Financial Products’ credit default swap portfolio, as well as a pre-tax impairment charge of $18.3bn from the group’s investment portfolio.

Mr Liddy said that in the frantic moments that preceded the first rescue of AIG, regulators had not paid enough attention to the cash drain on the company’s resources caused by the toxic assets.

Since the Fed did not regulate insurers, it had initially overlooked the pitfalls of the previous bail-out, he added.

Despite receiving an $85bn government loan in mid-September, AIG was in danger of running out of money due to the high interest rate charged by the government and the need to put up capital as its assets continued to depreciate. ( NB Don )

Mr Liddy said that with the new plan, the authorities wanted to avoid a repeat of the credit markets paralysis that followed the collapse of investment bank Lehman Brothers, which went bankrupt just before the first rescue of AIG.

“The collapse of Lehman caused the credit markets to freeze up. Had AIG gone, it would have been even more significant,” Mr Liddy said.

Mr Liddy pledged to press on with a wide-ranging programme of asset sales aimed at raising funds to repay the $100bn in capital injected by the government. (NB Don )

He said the extension of the duration of the main government loan from two to five years and the cutting of the loan’s value from $85bn to $60bn would ensure AIG did not have to dispose of businesses at fire-sale prices.( NB Don )

“We have more capital so we don’t have to sell good assets in bad markets,” ( NB Don ) he said. AIG has not announced a single major disposal so far, partly because potential buyers have not been able to get funding.

Mr Liddy has said he wants to sell most of AIG’s life assurance operations, and close its troubled financial services unit, to create a smaller company focused on its general insurance business around the world.

However, he reiterated that he wanted to keep a majority interest in its Asian life assurance and savings business – one of the jewels in AIG’s crown.”

Asian businesses are like Banamex for Citi. It’s pretty clear that this plan is failing. However, I’ve yet to get a clear picture of why it’s failing. Theoretically, we’ve given AIG enough money to get through this downturn. It could be:
1) No one wants to buy anything from AIG
2) AIG is asking too much money for the assets
3) The assets are turning out to be worth less and less
4) AIG is still losing money on current investments

From Bloomberg:

“AIG’s ability to repay “every single penny” owed to taxpayers, as Liddy vowed in December, is doubted by investors who drove the company’s stock about 80 percent lower since he took over in September. AIG may post a fourth-quarter loss of about $60 billion next week, said the people, who declined to be identified because talks with the government are private.

“There isn’t a great deal of confidence we can take AIG’s word at face value,” said Bill Bergman, analyst at Morningstar Inc. “AIG shares trading this close to zero suggest there are real losses out there, and if there’s no value for shareholders, taxpayers may be taking some very significant losses.” AIG gained 10 cents to 56 cents in New York Stock Exchange composite trading at $10.47 a.m….”


“Government help “allows unhealthy insurers to grab more market share in the short term at levels that are unsustainable in the long term,” said David Sampson, head of the Property Casualty Insurers Association of America, an industry group, in a statement this week.”

In other words, AIG is the problem. The brand is the problem.Buyers believe that the losses are real. They will not appreciate. If they are correct, this could be an enormous loss to the taxpayers. It never occurs to people that, if foreign investors or any other investors thought that AIG was sound, they could invest in it or buy the assets at their asking price. Either investors in AIG take the losses, or the US taxpayer will. Which will it be? What am I missing? A miracle?

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