AIG: Paulson's Folly

The Treasury is injecting another $27 billion into AIG and raising the taxpayers’ investment to $150 billon. Secretary Paulson appears more intent on helping his pals on Wall Street than protecting taxpayer interests.

AIG has solid businesses in industrial, commercial and life insurance, but like a lot of financial firms, was attracted to easy profits writing credit default swaps on mortgage backed bonds—so called collateralized debt obligations (CDOs).

AIG received fees to guarantee repayment of those mortgages, or the funds obtained through foreclosures when homeowners defaulted. Like most on Wall Street, AIG executives believed home prices would rise faster than household incomes forever, so these CDOs really bore little risk.

This credit default swap business was outside AIG’s highly-regulated, solid insurance businesses but was backed by the value of those businesses. Essentially, if the CDOs fell too much in value, AIG pledged the value of those businesses.

If an abnormal number of the mortgages failed, the held to maturity value of the CDOs would fall, and obligations would trigger for AIG to post collateral. When that happened in 2007, AIG deposited cash or other liquid assets with the investors holding the CDOs. With the housing market so depressed by the summer of 2007, AIG could not raise enough cash to meet all its obligations.

On September 16, the Federal Reserve provided $85 billion in loans to AIG in exchange for warrants—the right to buy common stock—equal to 79.9 percent of the company.

AIG was to pay 8.5 percent above Libor for the first $85 billion. AIG was to use the loans to honor obligations to holders of the credit default swaps, and AIG was to sell parts of its insurance businesses to repay the loans to the Federal Reserve. That loan proved inadequate, and the Fed advanced another $38 billion on October 9. 

The $123 billon was not enough to finance AIG’s short-term credit default swap obligations, and it cannot sell enough pieces of its good insurance businesses to pay back the Federal Reserve in the current environment.

Now, the Federal Reserve and Treasury are agreeing to restructure $60 billion of the original loan, lowering the interest rate to 3 percent above Libor and invest about another $27 billion in AIG.

The interest rates on the loans were lowered, in part, because large shareholders complained about heavy handed government action.  

The monies will be used to set up two special funds. The first will seek to buy up some of the CDOs that have declined in value for about 50 cents on the dollar, permitting AIG to recoup its collateral paid in cash. This fund will not buy up the most troubled CDOs, whose values are even lower than 50 cents on the dollar.

The second fund will be used to solve liquidity problems at AIG’s securities lending business. It rents securities to short sellers in the stock markets.

This is all folly.

The government assumes greater risks without getting benefits for the taxpayer. Many firms who purchased the original credit default swaps from AIG have used the collateral posted by AIG on the less risky CDOs for other purposes and may not want to sell AIG their CDOs. Also, many of the swaps have been resold to firms that don’t hold the CDOs, as part of complex derivatives transactions.

The short selling business is a whole new headache, and it should make taxpayers ask, what else is lying around at AIG. 

If the deal works out, AIG executives get to keep their jobs; but if the plan fails, the U.S. government may get stuck holding the bag on billions of dollars of false promises to pay from AIG. Its warrants may prove not worth very much as AIG’s obligations overwhelm the value of its businesses.

If AIG can’t make it on the money the taxpayers have already apparently squandered, then the Treasury should simply exercise its warrants, take control of AIG, and sell off AIG’s solid insurance businesses for what they are worth. The Treasury can buy back the CDOs for common shares in the company and reorganize the new AIG with more responsible management.

The executives at AIG certainly have not behaved well since the first bailout. They have enjoyed lavish golf retreats in California and luxurious hunting trips in Britain.

While the American taxpayers make monthly tax payment to Washington, AIG executives bang away at birds on the English countryside.

Disclosure: none

Comments

[IndyTB:]

"If AIG can’t make it on the money the taxpayers have already apparently squandered, then the Treasury should simply exercise its warrants, take control of AIG, and sell off AIG’s solid insurance businesses for what they are worth."

Well, this high on hubris, low on value suggestion gets repeated a lot. For those paying attention - AIG has been on board with selling most of their "solid busineses" since the first loan.

What makes you think that AIG is dragging their feet on asset sales?, or that Fed ownership will somehow magically create financing for would-be purchasers in this credit environment?

Finally - are we *really* still talking about those retreats? It has been covered extensively that they were non-AIG independent agents (you know, the very folks who will keep those "solid businesses" running for AIG and/or the Fed to sell). AIG may have been policitally tone-deaf on timing, but since their original Libor+850 loan was costing $1B/month -- I think they (and not the taxpayers) have more than covered it.

2008 Nov 10 01:01 PM

[jimmy46:]

worthless blog
tell us something new

2008 Nov 10 01:08 PM

[Jason Rines...:]

Liquidity creates bad habits in management at all levels, private and public sector. In a free for all deflation, best for mass bankruptcies to emerge and assets sold at pennies on the dollar and liabilities shed.

In AIG's case holding a large albatross of CDO's, all obligations should be restructured in banruptcy court.

That of course would upset a lot of nations. But that is part of investing, you can win and you can lose. Why should the American citizenship subsidize the failures for the entire globe? How about all of those investors return there profits, those at the top of the giant pyramid scheme? No? Then all investors take there losses globally and the globe isolates those that hatched the pyramid scheme and if nothing else make sure these people never have a job in the financial sector - EVER.

The citizenship will take matters into there own hands at some point regardless of government being retroactive in dealing with this. If the American government must pick winners and losers, perhaps it is better to start deciding that the American citizenship is in the winners camp.

2008 Nov 10 03:54 PM

[Rigged:]

You missed the point completely.

The way the first "bailout" was structured, it was so onerous that AIG continued to face downgrades and further downgrade. The FEDs charged too high an interest and took 80% without any capital investment (since all the money was provided as a loan). The rating agency saw through the terms of the first bailout and all agreed that it is not good for AIG (i.e. how can AIG get enough revenue to pay the ongoing interest and thus AIG has no leverage in selling assets). Thus they continued to downgrade AIG and thus causing more collaterals to be required which then caused more downgrades...etc...

With the new deal, AIG financials (operating cash flow, cash on hand, etc.) have been upgraded. The agency will now be able to say that the new terms gives AIG a reasonable chance to continue to operate and pay the interests to the FEDs from its ongoing revenue. AIG will also be able to pay the FED back the principals when it has asset sales. This will mean that the rating agencies will be less inclined to downgrade AIG further.

Now that the new term is 5 years, AIG will have leverage in dealing with 3rd parties when it sell its assets. With the FED owning 80% of AIG, this would benefit the FED also.

2008 Nov 10 04:41 PM

[User 265729:]

Here seems to be ANOTHER folly of Paulson... Apparently he doesn't want to tell the American people where $2 TRILLION of our taxpayer money went.

www.bloomberg.com/apps...

Maybe he had it sewn into Nancy Pelosi's mattress.

They need to put an END to this!

Between Congress, the Fed and Treasury, they will ruin our economy to the degree unknown in history.

2008 Nov 10 10:19 PM

[countrybanker:]

The analysis that is really missing in the AIG discussion is who is really benefiting from the AIG bailout. I think that AIG is just an indirect bailout of the big banks and investment banks. Can someone trace the money pumped inyo AIG to who the big counterparties are that are getting the benefit. ??

2008 Nov 10 10:48 PM

[Bill Jencks:]

If you consider Paulson's actions in a wider context i.e. in terms of Wall Street's Investment Banks against the ordinary Mainstreet Banks (that's where American citizens put their life savings), then can anyone - off the top of their heads - think of any mainstreet US Banks that have been "saved" by Paulson's TARP fund. It seems to me this ratio is horrendously unfair.

What no one seems to mention here is the real reason that AIG was saved was because it sold, and was responsible for, about $800 billion in US Treasury debt to China. So if Paulson had let AIG fall - then China would have lost about $1 trillion dollars from her reserve. The Chinese Dragon, in anger, would have reared up and sold all her dollar reserves(currently standing at $2 trillion) as a result - and what would that do for the US economy ?

Good indicators for the collapse of the dollar and US economy are:

1.) If the derivative market implodes(CDS against CDO's) because of defaults.

2.)If GM, Ford or Chrysler go bankrupt.

3.)If the Dow/Gold ratio plummets even more than it has.

2008 Nov 11 04:32 AM

[monday1929:]

AIG is just a conduit to pump money into JPM and other failed banks. Paulson will let AIG twist in the wind after it serves its whoreish purpose, with apologies to whores who at least are honest about what profession they belong to. Paulson lobbied to remove the regulations which might have prevented this problem from exponentially growing over the past 5 years. Pailson needs to be prosecuted for aiding this looting of the American Economy.

2008 Nov 12 08:52 AM

[countrybanker:]

Monday 1929. Exactly my point from two posts earlier. Can you name names, or just JP Morgan. Agree, just a "zombie" conduit to get money to big banks. These banks have been broke for years and will continue to be broke (insolvent). Wait til ya see the final tally on how much "bailout" money , both direct and indirect, they receive.

2008 Nov 12 09:15 AM

[anarchist:]

We, the punters will never see the final bailout bill as the books will be cooked like about every Government financial statistic put out these days..

2008 Nov 14 10:56 AM

[monday1929:]

Just saw your question. I've heard that GS and Merrill are/were big beneficiaries, but the Fed won't reveal names. My belief is that, since JPM/Jamie Dimon supposedly saw some of the risks ahead of the doomed banks, and he's got a chip on his shoulder, he bet BIG against Citi, AIG, and others. His counter-parties are now busted so he can't collect on those bets, and any hedges he made against those bets were big losers to boot. This is all just conjecture, but who else would the Fed be so interested in saving at any cost? And who else was able to bet hundreds of billions?


On Nov 12 09:15 AM countrybanker wrote:

> Monday 1929. Exactly my point from two posts earlier. Can you name
> names, or just JP Morgan. Agree, just a "zombie" conduit to get money
> to big banks. These banks have been broke for years and will continue
> to be broke (insolvent). Wait til ya see the final tally on how much
> "bailout" money , both direct and indirect, they receive.

Mar 08 06:07 PM