AIG: The Fed Is a Really Bad Trader

Now that the full details regarding the Fed's new plan for AIG have come to light, the only conclusion one could draw from this is that the Fed is a bad trader. Really bad.

When its statement regarding the AIG plan was released early Monday morning, the part which was most intriguing had to do with the Fed's intent to purchase multisector collateralized debt obligations (CDOs) backed by subprime loans, commercial-mortgage loans and other assets (from AIG's counterparties) on which AIG had written credit default swap (CDS) protection. The idea here was obviously to get AIG out of the CDS business because the insurance giant was incurring huge losses as the value of said CDOs plummeted.

Naturally, the Fed did not identify AIG's counterparties in its statement but you might have been able to take a wild guess that Goldman (GS), Merrill et. al. was involved. The Fed did say that the new facility it set up to purchase these assets (the aptly named Collateralized Debt Obligations Facility) was to be capitalized by the New York Fed with up to $30 billion, with an additional $5 billion to be provided by AIG itself.

The market values of these illiquid CDOs have declined sharply since the onset of the credit crisis in July 2007 as the values of the underlying assets plummeted, which has caused the banks to take billions in write downs. But as those values declined, the banks who bought CDS protection from AIG on these securities have been able to force the firm to post billions more in collateral--about $35 billion according to the WSJ. The real amount which had to be posted was probably a lot higher, given that AIG is into the government for $150 billion.

Now comes the part where the Fed makes a really bad trade for itself (and for the taxpayers) in its effort to bend over backwards to protect the banks. Under the terms being offered, the Fed will purchase these CDOs (which are worth who-knows-what on the dollar) at par value! And here's the kicker; according to the WSJ the banks get to keep the collateral AIG had to post, much of which came when the government made funds available to AIG in September!!

This is exactly as if after wrecking your car in an accident, someone were to come along and pay you full value for it “as is” while at the same time you were allowed to keep the payment that the insurance company made to you for your loss.

Talk about a bad trade by the Fed. How about if they would have gone to the banks holding these severely impaired "assets" 2 months ago and just offered to buy them outright for maybe 50 cents on the dollar, which would have been a generous offer considering that Merrill sold $30 billion worth of CDOs to an affiliate of Lone Star Funds for $6.7 billion (about 22 cents on the dollar) over the summer. The banks were probably so desperate to get all that junk off their books they likely would have jumped at the deal and torn up the CDS in the process. The Fed (and therefore, the taxpayers) would have stood to make a far better return than what they might now once the CDOs regain their value at some point in the future. And since the Fed can hold on to them forever anyway, "some point in the future" is meaningless. AIG would have been relieved of its CDS obligations in the process, likely saving its shareholders billions and a lot of stress for the overall stock market as well.

Granted that hindsight is 20-20, but this one seems pretty much like a no-brainer. The Fed has made a major gaffe here by not buying these troubled assets a lot earlier and it compounded its error with the deal it made on the CDOs. The banks should take no loss whatsoever on these assets? Where is the moral hazard? And what's worse is that the Fed has in effect created a terrible precedent for itself because if another situation like this comes down the road in the future (which is likely) why would an entity holding any toxic CDOs (which is likely to be Goldman, Merrill, et. al.) sell any of this junk to the Fed for anything less than par value now?

Comments

[chia:]

I can understand you wrote these but you are never or qualify as a government. YOU ARE ONLY LOOKING AT ONE ANGLE.

2008 Nov 13 05:24 AM

[Rigged:]

"Now comes the part where the Fed makes a really bad trade for itself (and for the taxpayers) in its effort to bend over backwards to protect the banks. Under the terms being offered, the Fed will purchase these CDOs (which are worth who-knows-what on the dollar) at par value! And here's the kicker; according to the WSJ the banks get to keep the collateral AIG had to post, much of which came when the government made funds available to AIG in September!!"

Could you have misinterpreted the information above? Maybe it should be "the banks get to keep the colleteral AIG had to post and with them getting 50 cents on the dollar they are made whole = par?" Otherwise, you seem to imply that the banks will get "par" plus collateral which would not make any sense at all.

2008 Nov 13 06:20 AM

[Tom Armistead:]

I listened to AIG's conference call and read the documents involved. The banks are made whole, and AIG takes the loss. The facility buys at the market price and holds for appreciation. AIG gets 1/3 of the salvage.

Judging from the conference call, some of the banks have been unwilling to close the deals on fair terms - they preferred to hold the collateral and continue to collect on the CDOs, most of which are performing just fine. The question comes up, does the insurance go with the bonds, or could the bonds be sold and the insurance retained? That sounds like something GS would do.

The Federal Reservie is doing the negotiating because they know how to talk to the banks, some of it may be offers they can't refuse.

2008 Nov 13 07:08 PM

[Zorian:]

"Let's just keep on trading" hum, that's an ingénues idea!

2008 Nov 13 08:49 PM

[monday1929:]

The FEd is doing exactly what it intended to do- help hide the bankrupt condition of JPM and Citbank. They are criminals, but not stupid.

2008 Nov 14 12:43 PM