The Washington Post (from Bloomberg News) "With Fed's Help, AIG Unloads $16 Billion in Credit Default Swaps" reports that American International Group (NYSE:AIG) retired another $16B face value of credit default swaps for $6.7B by purchasing the underlying securities and canceling the contracts. The insured (counterparties) were able to keep the more than $9B in collateral that AIG posted. The counterparties were taken out at par. So far, the Fed’s Maiden Lane III special purchase fund has purchased $62.1B face value of CDOs from AIG’s counterparties. The Fed has committed to purchase up to $70B face value of CDOs from AIG’s counterparties at roughly 50% of par. Each time the Fed is allowing the counterparties to keep all collateral.
Why has the Fed completely removed the risk of AIG as a counterparty in CDS transactions? Perhaps the Fed views moral hazard as a foreword looking constraint and AIG is just trying to unwind past regrettable activities. More likely the Fed is viewing AIG as a conduit to funnel capital into favored financial institutions. By forcing counterparties to sell the underlying CDO securities in order to receive full recovery, the Fed is liquidating toxic assets and preventing pure speculators from participating. But by paying close to par, when posted collateral is included, the benefit of price discovery is missing.
AIG told shareholders that the Fed would negotiate the CDO purchases on AIG’s behalf and AIG’s participation in any price appreciation would be limited. The implication was that the Fed would use its strength to be an advocate for AIG. Quite the opposite turned out to be true. Instead the Fed used its strength to force a weakened AIG to make whole its stronger counter parties.
Let’s compare AIG’s “loss mitigation” on credit insurance with the monolines. Ambac (ABK), MBIA (NYSE:MBI) and others have commuted some of the worst CDS and continue to negotiate the remainder. The transactions were always under par and the counterparties always retained the underlying CDOs. Collateral posted was always included as part of the price. The monolines still retained the right to recover their losses from the mortgage originators. The key difference is that negotiations led by New York Insurance Superintendent Eric R. Dinallo always held out the monolines’ solvency and the possibility of rehabilitation (receivership) as a risk. Counterparties had to consider that some payment was better than no payment.
The New York Insurance Superintendent clearly strengthened Ambac and MBIA in the negotiations to commute CDO policies, while the Fed’s efforts on AIG’s behalf are questionable. If the Fed had AIG’s best interest at heart, they would have simply reinsured AIG for a fee. Instead, the Fed is contriving one way after another to profit from and execute policy objectives through AIG. AIG has become the Fed’s Fannie Mae (FNM) and Freddie Mac (FRE). The Fed keeps pushing AIG to the brink. If they go too far, the Fed will lose their 79.9% investment, and might not even get paid back.
As pure speculation, I think that the government’s relationship with AIG will change under President Obama. The Fed and Treasury created a multitude of opaque programs which on the surface appear to follow the free market mantra of President Bush. In January, true agendas will no longer have to be hidden and strengthening AIG, Fannie and Freddie as independent companies and large employers could be objectives. All three need to be viable, publicly traded stocks as an incentive to keep their best employees. While Paulson and Bernanke spoke of public mission superseding shareholder benefits, I believe that Obama understands that is not a viable path forward.
Disclosure: Author is long AIG, ABK, MBI, FNM and FRE.