AIG Bailout 2: Why?

The WSJ has details of AIG Bailout II:

Under the terms being finalized on Sunday night, the government would replace its original $85 billion loan with a two-year duration with a $60 billion loan with a five-year duration. Interest on the loan would drop from 8.5% plus three-month Libor interest-rate benchmark to 3% plus Libor. (Libor, the London interbank offered rate, is a common short-term benchmark.)

In addition, the government would tap the $700 billion Troubled Asset Relief Program to inject $40 billion into AIG in return for preferred shares. Those shares would carry 10% annual interest payments.

Let's do a quick back-of-the-envelope calculation here. Libor is now at 2.29%, so $85 billion at Libor +850bp works out at $9.17 billion per year. Meanwhile, $60 billion at Libor +300bp works out at $3.17 billion per year, and the 10% coupon on $40 billion of preferred shares is of course $4 billion per year, for total interest payments under the new plan of $7.17 billion. That's a savings of $2 billion a year for AIG. Against that, AIG has to put $6 billion in cash into two new special-purpose vehicles, designed to help sort out many of the problems at the insurer's CDS and securities-lending business.

The article does shed some light on just how spectacularly incompetent AIG has been when it comes to securities lending:

A second vehicle would be set up to solve the liquidity problems in AIG's securities lending business. The business involves lending out securities to short sellers or others and investing the collateral for gains. The strategy for many has lately backfired as once-reliable credit investments have seized up...

Under the new plan, the government would inject about $20 billion into the securities lending vehicle and AIG would put in $1 billion. The vehicle would then buy the illiquid securities the AIG unit holds, known as residential mortgage-backed securities, for about 50 cents on the dollar.

Securities lending is meant to be a no-risk operation. In a repo operation, the long-term owner of a stock -- in this case, AIG -- will sell it to someone who wants to short it, and charge them interest. They then subsequently buy back the stock at the price they sold it for; the interest is pure profit.

AIG, however, seems to have gotten spectacularly greedy. It took the proceeds from the stock sales, and instead of putting it somewhere safe, invested it in RMBS. Which are now worth 50 cents on the dollar.

This is in a way worse than AIG's misadventures in the CDS market. When AIG Financial Products wrote credit protection, it thought the chances of default were minimal. But investing $42 billion of repo collateral in RMBS? There's no good reason to do that: It's not your money, you can't afford to lose it, so you put it somewhere safe.

The silliest bit of this plan, however, is the idea that AIG will be able to cancel out its CDS exposure by buying the underlying securities. The WSJ explains how improbable this scheme is:

The government may be betting that federal involvement will encourage the counterparties to sell the assets to the AIG vehicle.

Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted back the contracts...

However, the agreements may be difficult to work out. Some banks that face AIG in credit-default swaps don't actually hold the physical securities on which they purchased protection. Merrill Lynch & Co., for example, previously sold many mortgage CDOs it underwrote to European and Canadian banks. Through a complex set of transactions, Merrill took back the credit risk of some of those assets and hedged that risk by buying credit-default swaps from AIG. When the securities fell in value, the European and Canadian banks demanded collateral from Merrill which in turn demanded collateral from AIG.

None of this makes sense to me. If AIG wants to unwind its CDS exposure, all it needs to do is negotiate with its counterparties to pay them an up-front sum in return for their tearing up the contract. CDS are derivatives: You don't need to do anything with the underlying securities in order to cancel them out.

But of course if AIG simply made those kind of payments and took its losses, the government wouldn't end up with any assets, and wouldn't be able to tell the public that it was still possible that AIG might make a profit on the deal.

So this looks like an exercise in face-saving to me, rather than something with any real economic logic behind it. But at least the Troubled Asset Relief Program finally gets to buy itself some Troubled Assets, even if there isn't a reverse auction involved. Maybe that's why Treasury's going along with this plan; I can't think of any other reason. Here's how the WSJ parses the logic:

The revised structure is designed to improve both AIG's ability to sell assets for a decent price and the taxpayer's ability to recoup the money that has been pumped into the insurer. It also transfers to the government many of the risks once absorbed by AIG, potentially exposing the government to billions of dollars in future losses.

How does transferring billions of dollars of contingent liabilities from AIG to Treasury in any way help the taxpayer's ability to recoup the money that has been pumped into the insurer? I don't get it. And I don't see the systemic risk which this plan is meant to head off. Without that systemic risk, I see no reason why AIG should get any bailout at all.

Comments

[Smarty_Pants:]

Anyone want to guess how much of this bailout money finds its way to Goldman Sachs' pockets? That's the only reason I could think of off the top of my head.

2008 Nov 10 03:14 PM

[JOEYG:]

i IMMAGINE HANK GREENBURG HAD EVERYTHING TO DO WITH THE PRESENT CALAMITY AT AIG BUT I HEAR NOT A WORD ABOUT HIM.i KEEP SEEING HIM ON t.V INTERVIEWS OFFERING TO BUY CERTAIN ACTIVITIES OF AIG BUT ISN'T HE THE ARCHITECT OF THEIR BALANCE SHEET?

2008 Nov 10 05:59 PM

[jadziasman:]

AIG is much like Lehman Bros, Merrill Lynch, Bear Stearns and Morgan Stanley. Each company made fundamental mistakes at a critical time from which each reached their point of no return. : - { The common mistake was the mismanagement of derivatives and asset backed securities (ABS).

Unwinding these derivatives and ABS' with the help of people like BlackRock's Larry Fink will take time but with the unlimited resources of the US and other central banks it will eventually get sorted out. Will it be "painful"? Does anyone doubt that the answer is yes?

I believe it's safe to say that the vast majority of US citizens have benefited from credit securitization and derivatives despite the drawbacks. And, since it is not practical or even possible for a Luddite solution for another fine mess they've gotten us into, we've all got to do our part to keep the good ship Liberty upright lest she capsize and we all drown like rats.

2008 Nov 10 06:18 PM

[Tom Armistead:]

I listened to the conference call, there were a number of questions about how much the vehicle formed to buy the CDOs would be paying. Answers were evasive, the Federal Reserve is going to be doing the negotiating as it has more standing with the sellers than AIG does. There is something people are not talking about - maybe some of those who have the 30 billion of collateral would just as soon hang on to the money.

There is the possibility that much of the mark to market losses on the CDOs will revert over time as many of the underlying assets are still performing. AIG would get approximately 1/3 of the salvage, the Federal Reserve would get the rest.

The way I understand the transaction, AIG will be booking the entire mark to market loss, the special purpose facility will pay approximately market price because AIG will have taken the loss. Then if the CDOs are worth more, AIG gets 1/3 and the government gets 2/3.

The payoff for AIG is they can stop posting more and more collateral every time the market for the CDOs goes down further. Per Liddy, "we need to stop it, we need to stop it now."

The vehicle for the RMBS from the securities lending operation will hold the assets until values recover. AIG will get 1/6 of any salvage, the government will keep the rest. Again it appears the facility will be paying market prices, and AIG's motivation is to cap the losses and move on.

The usurious rates of interest and short term of the bridge loan were onerous and would have forced AIG to sell valuable assets at fire sale prices. The revised bailout will avoid fire sales and as such will promote market stability.

2008 Nov 10 07:39 PM

[User 265729:]

QUICK FELIX!!!

Buy! Buy! Buy! AIG

How could you go wrong with Pelosi and Paulson behind the plan?

LOL!

If you really want to see something funny, look at this link from Bloomberg... Seems Paulson, et.al. don't think that its important to let us know who they lent $2 TRILLION to...

What a SCAM!

No investment is safe in this country until there is real transparency. Then, and MAYBE then, will confidence return to the markets.

2008 Nov 10 10:43 PM

[User 265729:]

Soory Felix, I forgot to post the link to the Bloomberg $2 Trillion story:

www.bloomberg.com/apps...

2008 Nov 10 10:44 PM

[Stimpy:]

It doesn't make sense to you because you don't really understand it, Felix.

What if, JUST HYPOTHETICALLY YOU UNDERSTAND, AIG is able to DEMAND physical delivery on illiquid CDO tranches from counterparties long protection in the same way Delphi was handled?

Why can't AIG refuse cash settlement on a bespoke CDO reference where there is no cheapest to deliver?

If AIG had bought back collateral in the 50's (marked using indexes that may overstate the actual damage) and cornered all or most of the market, owners of "naked" protection might well be out of luck in a litigation that is SURE to make things a PR nightmare for those looking to collect at the expense of taxpayers.

As for the idea that the securities lending operation is worse than the CDS at AIG, again you demostrate a FUNDAMENTAL misunderstanding of the true nature of the problem.

Both are really the same thing, Felix.

In both cases, the problem (in reality--not theory) is the msimanagement of re-hypothicated collateral (or assets) that results in a classic "bank-run" when the counterparties get cold feet.

Res Ipsa,

2008 Nov 11 10:28 AM

[Augustus:]

As others have commented, AID is having to post collateral based upon a Mark to Market valuation of securities which no one is actually selling. The securities may not have suffered defaults, but they have been marked as if they will. Calling their bluff and having them turn over the bonds will cause there to be at least some market. Any appreciation and the current payments will accrue to AIG. The coupons may be reasonably current. Taking the 6% bonds in at 50% will give AIG a current yield of 12 and retire the debt to Treasury. I like the idea but more needs to be known about the particular bonds being called in by AIG.

2008 Nov 11 02:27 PM