More AIG Controversy: Maiden Lane III

By James Kwak

As everyone knows by now, Neil Barofsky, special inspector general for TARP, has a new report out on the decision by the Federal Reserve Bank of New York last Fall to make various AIG (AIG) counterparties (primarily some very big banks with names you know) whole on the the CDS protection they had bought from AIG to cover their risk on some CDOs. The potentially juicy bit has to do with the Maiden Lane III transaction (New York Fed summary here).

There are a couple of details I can’t quite reconcile (for example, the Fed balance sheet shows initial funding of $29.3 billion, but everyone says Maiden Lane III paid $29.6 billion for the CDOs), but essentially it went like this. The banks had bought CDS protection on $62.1 billion of CDOs (some of those CDOs they owned — some they did not, meaning those were “naked” CDS*). As of November, the market value of those CDOs was $29.6 billion. At that point, the banks already held $35.0 billion in cash collateral from AIG to cover the difference. (If you have a derivatives contract with someone under which your counterparty may have to pay you a huge amount of money, you generally negotiate a term under which the counterparty has to give you money as the trade moves against him, to protect you from default. In this case, a lot of the collateral came from the $85 billion credit line the Fed gave to AIG in September — otherwise AIG would have gone bankrupt because of collateral calls.)

In the transaction (I’m working off the New York Fed summary), first AIG contributed $5 billion to Maiden Lane III and the New York Fed gave it a $24.3 billion loan. Then Maiden Lane III gave all $26.8 billion to the banks in exchange for the CDOs. (The banks accepted $26.8 billion because they already held $35.0 billion in collateral; together that makes $61.8 billion — as I said, I can’t get $300 million to reconcile.) Then Maiden Lane III gave $2.5 billion right back to AIG (this is the amount by which AIG had overcollateralized). As part of the deal, the banks agreed to tear up the original CDS on the CDOs, so AIG couldn’t lose any more on the CDS (which, remember, are separate from the CDOs).

The controversy is not over paying $29.3 (or $29.6) billion for the CDOs, since that was the market price. The controversy is over whether AIG should have agreed to settle the CDS at 100 cents on the dollar (meaning that the banks get the difference between the face value of the CDOs and their current market value). Bloomberg reported a while back that prior to the government bailout, AIG had been trying to negotiate a settlement at 60-70 cents on the dollar, but that that portion of the term sheet was crossed out in the final agreement. The implication is that paying the swaps off in full was a back-door, off-the-books way of funneling cash to banks that we didn’t want to fail.

The argument for the NY Fed is that the banks had legal contracts that entitled them to the money. AIG might have been able to negotiate a haircut because it was going bankrupt and counterparties will take less money up front rather than risk getting even less in bankruptcy. However, once the government stepped in, it had no way to abrogate the contracts. The Agonist has a long post with much more detail than I have provided, arguing in conclusion that Federal Reserve Bank presidents are technocrats, and technocrats abide by the advice of their lawyers, which was almost certainly that AIG had to pay off the swaps in full. (He says the mistake was bailing out AIG in the first place back in September.)

Various people have argued, however, that the Fed could have negotiated a better deal. The Epicurean Dealmaker argues that, given the considerable powers of the Federal Reserve and the federal government in general, the banks could have been intimidated into accepting a modest haircut.

Robert Pozen, in his very worth reading book Too Big to Save?, says (p. 79) that AIGFP could have been forced into bankruptcy without putting the rest of AIG into bankruptcy; threatening to put AIGFP into bankruptcy would have provided the leverage to induce the banks to take a haircut. Lucian Bebchuk, a Harvard law professor, argued back in March that because AIG had guaranteed the obligations of AIGFP, this would constitute a default by AIG — but that wouldn’t affect AIG’s insurance subsidiaries, which could stand alone quite nicely (insurance companies get most of their money from customer premiums, not from debt).

I think that given the state of the world in November 2008, paying the banks off in full was definitely the easy choice — it’s always easier to abide by the contract and pay up, especially when you have very deep pockets. And the fact that it helped out the banks as well was probably seen as another argument for it, given the perceived need within the government to bolster the banks’ balance sheets by any means necessary.

* Apparently there is some controversy about this. In an interview, Representative Peter DeFazio said the following:

“Geithner would not answer my question when I said, ‘Were those naked credit default swaps by Goldman or were they a counter party?’ He said, ‘I will not answer that question.’”

From the New York Fed web site:

“AIGFP, the LLC and the New York Fed have entered into agreements with AIGFP’s credit derivative counterparties to terminate approximately $53.5 billion notional amount of credit derivatives and purchase the related multi-sector CDOs. Of these, CDOs with a principal amount of approximately $46.1 billion settled on November 25, 2008. Settlement on the remaining $7.4 billion is contingent upon the ability of the related counterparty to obtain the related multi-sector CDOs and thereby settle with the LLC and terminate the related credit derivative contracts with AIGFP” (emphasis added).

Comments

[Harry Tuttle]

Geithner made absolutely no effort to negotiate the settlement. Why? because he was acting on the advice of the bankers. Why? because he thinks they know better and still does.

In addition, he STILL fails to recognize that the Greenspan-FED was a big part of the problem.

2009 Nov 20 03:42 PM

[Tony Petroski]

This is from Mr. Kwak:

"There are a couple of details I can’t quite reconcile (for example, the Fed balance sheet shows initial funding of $29.3 billion, but everyone says Maiden Lane III paid $29.6 billion for the CDOs), but essentially it went like this."

I was just about to nominate him for inspector general and then this

"The controversy is not over paying $29.3 (or $29.6) billion for the CDOs, since that was the market price. The controversy is over whether AIG should have agreed to settle the CDS at 100 cents on the dollar..."

Readers: Vote. AIG/Goldman or Mr. Kwak?

2009 Nov 20 03:43 PM

[professorpinch]

All in all, Agonist is right. The first & biggest mistake was the NY Fed stepping in to the mire known as AIG in the first place.

But, we can probably assume sitting by as AIG cratered was never an option, so you have to focus on the strategies available to act. Barofsky's report outlined 3 of them: 1) banks cancel the CDS, sell the CDOs and get equity in the SPV along with cash from the CDOs. 2) CDOs & CDS stay with the banks, but the SPV will make payments if/when a default event occurs for the CDO in exchange for eliminating collateral postings. 3) The option they chose.

Seems to me #2 would've been the easiest to do, especially if you structured the SPV to be backed by the other AIG assets (non-AIGFP) 1st, & then only a secondary guarantee from the NYFRB. The SPV would essentially be used to help wind down AIG, pay off the CDOs and everyone gets their fare share of lumps.

But as Agonist said, Geithner and the other senior government officials panicked. They wanted to sweep away several years of bad business practices - and even worse financial assets - as quickly as possible.

But in the end, they didn't accomplish anything except blow through billions in taxpayer money. Because, as Harry alluded to, they never saw themselves as the biggest part of the problem.

2009 Nov 20 10:21 PM

[john s. gordon]

it is clear that the fed could have created a better deal for the u.s taxpayer but they panicked & gave away the farm.
> jack

2009 Nov 21 09:19 AM

[Augustus]

It is pretty much impossible to determine if a particular CDS was really "naked" as you allude to. Suppose I've got insurance on IBM debt. Wouldn't that also theoretically protect me in event of default by the US Govt?

2009 Nov 21 09:21 AM

[Moon Kil Woong]

This is crooked and we all want to know who really benefitted. That is who insured Goldman and others on their AIG contracts and got premium witout having to pay a cent. The fact no one will tell is telling itself. Full disclosure is what we all want.

2009 Nov 21 10:26 AM

[Paul Bogdanich]

The whole bail-out as administered was just a series of really bad decisions predicated on saving the system from the top down. Predictably the bottom 80% got nothing but the bill and now they are starting to complain. The President's political support is drying up and everyone is becoming so risk averse that we are headed for a double dip which means the policy failed. Only next time around were broke as well. No more bail-outs if you didn't already get yours and no one but the bankers and bond-holders got theirs. It's going to be very ugly.

2009 Nov 21 11:14 AM

[a fat panda]

Milton Friedman noted that there are four ways to spend money, ranging from spending your money on yourself to spending someone else's money on someone else. He looked at the impact on quality and quantity of consumption. Here is a fifth, you are spending someone else's money on friends and family. The results shouldn't surprse anyone. "The argument for the NY Fed is that the banks had legal contracts that entitled them to the money. "

If you are going to talk about contracts, you can't talk about 2 lines within the contract ignoring the rest of it. The banks were owed money, yes, but these legal contracts carried counter-party risk. So the banks were owed money based on AIGs ability to pay. So the Fed's real argument should be the banks wanted money that didn't exist so we took it from the people who save in dollars.

2009 Nov 21 11:29 AM

[talld]

AIG management needs to go to prison, the whole "insurance in case the market goes down" without any reserves is pure nonsense and no first year business student would make such a mistake accidentally.

2009 Nov 21 11:47 AM

[Michael Terry]

If you look closely into the situation, there was one bank that was willing to settle below par. When the rest of the banks refused (read Goldman), this bank obviously was not going to be the "chump". As well, the Europeans (read French) maintained that AIGFP could not settle for below par without being in bankruptcy. The Fed, sensing the geopolitical issues associated with a below par settle (you know, like the Merrill settle) and the impact on stressed US banks (yep, Goldman is a BHC), decided that it was easier to pay at par - especially as they were using someone elses money. This was a backdoor bailout of the banks - European banks used the insurance to lower capital requirements (a below par or bankruptcy option would make them pony up more capital, capital they didn't have and couldn't raise) and US banks would be forced to write down and further impair their own capital levels. Goldman, as it turns out from the report and other sources, was not fully hedged as they maintained at the time. This was nothing more than a scam, selling snakeoil to US taxpayers.

2009 Nov 21 11:49 AM

[Econ 101]

Can anyone spell RICO indictment??? This entire meltdown in September 2008 was a criminal enterprize to defraud the American Taxpayer for generations perpetrated by the Bush administration and the big banks, esp GS.

The real fraud occured much earlier when the CDOs were misclassifed as not being insurance. If AIG had been required to maintain reserves as tho they were insurance then it could never have entered into the mountain of risk and the banks wouldnt have either.

2009 Nov 21 01:25 PM

[ACEMAN]

Y'alls got no understanding of how MC methods are used in o/g reservoir calculations. In fact, y'all proves it twice in your vanity piece. Go look and read it again and yall will find it nice and pretty. MC is meant to make an educated guess within certain calculations and to not smooth out the curve as most Gaussian models do. Y'all got to know that implicitly. Also, y'all got to know fractual geometry and scaling distributions to narrow the parameters within which y'all is guessing and making a bet. And that bet is gonna be big and costly if y'alls is off. But y'all may not know for several years of production and even then there is new information coming up the pipeline to direct your attention to what you got in the ground or tunder the sea bed. Brother Kwak loves his politics and his conspiracy theories that's for sure. But before y'all now becomes crazed about representations of how much of a reservoir does Oil company X really have and thus call them cheats, how about y'alls banks that give you 0.5% while taking TARP moolah and not passing on to y'all the real return they are making on y'alls taxpayers money. It is time to focus on the real things instead of y'all petty vanities. Whew, time for that beignet and coffee at Cafe du Monde, NOLA.

2009 Nov 21 02:29 PM

[ACEMAN]

My BAD, my commentary was meant for Alan von Altendorf's "Oil Casino." I nearly choked on my beignet and spilled my coffee when I saw the miscue. Take a look at Oil Casino and see my commentary.

2009 Nov 21 02:39 PM

[Lone Wolf]

I think that what was occurring at the time was that the mark-to-market rules were still in effect. If I am correct in this regard [though my memory does not always serve me well], had the gov't merely stepped in to guarantee the CDO's [your option #2] the banks would still have had to mark them to market, which would have thrown their capital balances below legally-mandated levels. The use of option #2 would not have solved the over-arching problem of needing to ensure that the banks had adequate capital levels.

On Nov 20 10:21 PM professorpinch wrote:

> All in all, Agonist is right. The first & biggest mistake was
> the NY Fed stepping in to the mire known as AIG in the first place.
>
>
> But, we can probably assume sitting by as AIG cratered was never
> an option, so you have to focus on the strategies available to act.
> Barofsky's report outlined 3 of them: 1) banks cancel the CDS, sell
> the CDOs and get equity in the SPV along with cash from the CDOs.
> 2) CDOs & CDS stay with the banks, but the SPV will make payments
> if/when a default event occurs for the CDO in exchange for eliminating
> collateral postings. 3) The option they chose.
>
> Seems to me #2 would've been the easiest to do, especially if you
> structured the SPV to be backed by the other AIG assets (non-AIGFP)
> 1st, & then only a secondary guarantee from the NYFRB. The SPV
> would essentially be used to help wind down AIG, pay off the CDOs
> and everyone gets their fare share of lumps.
>
> But as Agonist said, Geithner and the other senior government officials
> panicked. They wanted to sweep away several years of bad business
> practices - and even worse financial assets - as quickly as possible.
>
>
> But in the end, they didn't accomplish anything except blow through
> billions in taxpayer money. Because, as Harry alluded to, they never
> saw themselves as the biggest part of the problem.

2009 Nov 21 03:12 PM

[User 319185]

Is it only me that has spotted the following irony: The Fed says that AIG should have renegotiated its USD165m of bonuses to the AIGFP traders, that any company would do this as a normal commercial thing, and then hangs them out to the media as evil symbols of Wall Street greed. Then the Fed says that they have to respect CDS contracts, you cant renegotaite contract law and then gives the rest of Wall Street a back door bail out.

AIG was stupid enough to write these CDS. In the AIG bonus crisis they were also stupid enough to let themselves be treated as fall guys for the politicians and cleverer Wall Street companies covering up theirs years of failed market fundamentalist ideology and bubble driven imaginary profits.

2009 Nov 21 08:39 PM

[professorpinch]

That's sort of my point: why mask the situation? If they're undercapitalized, they're undercapitalized. Senior management at these shops get paid millions. In times like this, as Blondie from "The Good, Bad, & the Ugly" would say "they're gonna have to earn it."

If the CDS were good, the hedges should've helped them manage the tail risk of being undercapitalized. It might not have solved the problem, but that's their fault for not estimating both the likelihood and the severity of that sort of tail event.


On Nov 21 03:12 PM User 496629 wrote:

> I think that what was occurring at the time was that the mark-to-market
> rules were still in effect. If I am correct in this regard [though
> my memory does not always serve me well], had the gov't merely stepped
> in to guarantee the CDO's [your option #2] the banks would still
> have had to mark them to market, which would have thrown their capital
> balances below legally-mandated levels. The use of option #2 would
> not have solved the over-arching problem of needing to ensure that
> the banks had adequate capital levels.
>
> On Nov 20 10:21 PM professorpinch wrote:

2009 Nov 21 09:48 PM

[Steve Soden]

There are often numbers of @ $650 Trillion tossed abouit in regards to the total amount of Deriviteves outstanding against US assets.

I believe the real question is how much of these Deriviteves are naked obligations, here and in other countries?

Tell us, how much?

Any guesses?

2009 Nov 22 04:45 AM

[Randy Miller]

One word: Clawback. GS and the other big financials profits and resulting bonuses are in the billions because of this sweetheart deal. Get the money back, and then see what their bonuses are. Sanctity of contracts? Are these the same guys who voided union contracts and 200 years precedence in paying secured debtors first? What a crock.

Quit whining like wimps and victims. Get the money back.

Financial reform should say:

THe US government will never again guarantee the existence of a private company or guarantee its debts. No implicit guarantees , no explicit guarantees. Companies must be allowed to fail, so better companies can absorb their human and physical resources, and put them to better use.

Rating agencies should be held accountable for their ratings, eliminate conflict of interest inherent in the company holding the rated bonds paying the rating agency. IF the ratings agencies had done their jobs, they would have rated those super senior CDO traunches correctly. Remember, the real panic last fall was that no one knew what anything was worth.

2009 Nov 22 12:49 PM

[Randy Miller]

One more thing. CDS has to be subject to gaming laws. IF somebody makes money on a naked CDS, they should have to pay an exorbitant tax rate. Even if they have the underlying asset, they should be taxed highly if they profit, as opposed to just being made whole.

For example. Company A sells B an asset valued at $1 million, B paying A that amount. The asset happens to be a package of mortgages in Des Moines Iowa.

B purchases Default protection. The mortgages perform, and B over the following 2 years, receives $100,000 in interest, and $100,000 in principal. The remaining balance on that mortgage pool is $900,000. On January 1 of year 3, Des Moines suffers a shock in their housing market, and everyone defaults on their loans. The foreclosure value of the homes is now $500,000, so B has lost $400,000 in market value.

IF the provider of default protection pays B $400,000, he is now whole, no tax liability. IF B purchased default protection from 2 different companies, and is paid $800,000, he has profited from this adverse event, and should be taxed heavily on the $400,000 profit he made from the unfortunate events in Des Moines.

IF C had no stake in the Des Moines market, and purchased default protection, and received $100,000 from counterparties, that should be taxed heavily, because he was purely betting on the failure.

We should also look at put options on securities.

Why all this? Because it is possible for someone to profit from unfortunate events, and in some cases, they can influence those events. IF B had the power to force the mortgage holders into default, and did so, he should not profit by that. It would be no different than if I bought insurance on my neighbors house, and when it started to burn one night, I failed to call the fire deparatment. I should not profit from my action in that case, or lack of action.

I have read through the SIG's report, and we still don't know how much of the CDS was naked. If the Fed really did end up with the underlying CDO's in toto, maybe none of it was naked.

2009 Nov 22 03:18 PM