The Wall Street Journal reports, as was rumored on Friday, that AIG appears on the verge of approving a considerably enlarged and sweetened rescue package from the government.
We were less than happy with the idea when it first surfaced (see our rant “The Black Hole Gets Bigger: AIG Back for Yet Another Bailout“).
Let us review the basics:
1. AIG came desperate to the US government for a rescue, and a whopper at that. The Federal government has no oversight responsibility for AIG, which oh by the way, just happens to have very large overseas operations (in other words, one could take the position that AIG’s problems, for a whole host of reasons, are really not the Federal government’s problem). However, having seen the disruption that the collapse of Lehman caused, and knowing that AIG was a substantial and unhedged writer of credit default swaps, the powers that be were worried that a bankruptcy could be cataclysmic.
2. The initial deal was punitive by design. Some key elements of the Fed’s loan:
– An $85 billion, two year facility with interest at Libor + 850 basis points (and note the 850 basis point was the commitment fee, payable on the whole amount; the Libor addition kicked on on funds drawn down)– The loan was secured by all of AIG’s assets and those of its primary non-regulated subsidiaries
– The government received 79.9% of AIG and had a veto right on payment of common and preferred stock.
– The loan was to be repaid by asset sales
Now this could and should have been treated as a nationalization in all but name. The very top management was replaced (and realistically, only limited housecleaning would be possible given the specialized nature of many of their businesses).
The only reason the government did not take 100% of the equity was for the same reason they only took 79.9% of Freddie and Fannie in their conservatorship: going above that level would force the Federal government to consolidate their balance sheets.
But instead, stunningly, the accounting fiction, that AIG is an independent operation with rights, as opposed to a ward of the state, is not only being dignified, it is being acted upon.
Look at the list of terms above. The government has the right to seize absolutely everything of value AIG has until it pays off the loans, hold virtually all of the equity, and can veto many key actions (the senior position with respect to the assets gives it more rights than those listed above). Think of AIG as a felon: until it pays its debts to society, it has virtually no rights.
Well, that was the theory, but now the deal has been retraded twice. The first time was done with as little notice as possible, but the dispersal of another $37.8 billion was rather hard to hide. Per the Fed’s press release:
Under this program, the New York Fed will borrow up to $37.8 billion in investment-grade, fixed-income securities from AIG in return for cash collateral. These securities were previously lent by AIG’s insurance company subsidiaries to third parties.As expected, drawdowns to date under the existing $85 billion New York Fed loan facility have been used, in part, to settle transactions with counterparties returning these third-party securities to AIG.
Now this may sound all well and good, but recall the original deal. The loan was ALREADY collaterallized by ALL the assets. So despite the form of the transaction, the Fed is simply lending more money against the same pool of collateral.
Now given AIG’s liquidity needs, and the object of this exercise (not to have AIG go under) the second loan was presumably necessary, but the efforts to dress it up as as a loan against collateral is an amusing fiction (all this second loan does is degrade the collateral against the original loan. There are no free lunches here, except, of course, for AIG). Again, if we go back to the felon metaphor, the state had budgeted X for his care, but it turns out he has a really nasty disease that really has to be treated or it will infect the entire prison population and the guards too, so the cost of his incarceration has gone from X to X + Y.
But now we get to the heinous part. AIG should have no rights at this point. Zero. Zip. Nada. The government already on the hook for an open-ended liability. Yet the Fed is treating AIG as a party that has rights and is negotiating with them, as opposed to dictating terms. This is staggering.
Let us parse the Wall Street Journal story:
The U.S. government was near a deal Sunday night to scrap its original $123 billion bailout of American International Group Inc. and replace it with a new $150 billion package, according to people familiar with the matter.While the proposed arrangement would considerably ease terms on the faltering insurer, it would give the government an unprecedented role as an actor in financial markets. It could also spark a political backlash, especially from congressional Democrats, because the Treasury, while adding to its AIG obligations, has thus far refused to extend a hand to the struggling Big Three auto makers.
Before we get to the particulars, read the overview. AIG is getting yet more money, now close to double the initial commitment, and the terms are being made more favorable. And not by a little. Note the Journal, hardly a critic of Big Business, used the term “considerably”.
As we discussed in our earlier post, there is only one legitimate reason for modifying the terms of AIG’s loans: that the cash outflow for the interest might be so high that it is worsening the liquidity pressures on AIG. Fine, Keep the interest payments the same, but allow a significant portion (50%? 65%?) to be deferred and added to principal. A second issue mentioned in today’s Wall Street Journal was that AIG is now concerned that they might not be able to repay the loan in two years. Fine. Extend the term another year. Those are the ONLY changes warranted.
Remember, AIG does NOT has any God-given right to existence. If every significant operation AIG has must be sold to repay the taxpayer, and AIG ceases to exist, that would be a perfectly fine outcome. A systemic collapse would have been avoided, taxpayers would have gotten as much as possible out of a bad situation, and AIG would be liquidated in an orderly fashion. What is wrong with that picture?
Instead, AIG is being coddled for no reason whatsoever. Back to the Journal:
Details of the revised deal could be announced as soon as Monday — when the company is expected to report third-quarter earnings — but remained in flux. Under the terms being discussed late Sunday, the government would give AIG more money, including $40 billion from the U.S. Treasury’s $700 billion Troubled Asset Relief Program. It would also demand less interest than on the bulk of the original loan, while freeing AIG from exposure to some of the risky financial instruments that nearly caused it to file for bankruptcy protection.The $150 billion in government aid consists of a $60 billion loan, a $40 billion preferred stock investment and $50 billion in capital largely to buy and backstop distressed assets in two special financing vehicles.
Well, actually there is a reason, and it stinks to high heaven. Remember the original consternation about the TARP, when it was thought to be a vehicle for buying bad assets from banks. The only way that arrangement made sense was if the Treasury paid inflated prices, which served two purposes. First, it was a back door mechanism for recapitalizing banks. Second, the inflated prices could be used by banks holding similar assets for valuation purposes. When banks are reluctant to lend to each other because they are worried about the solvency risk of their counterparties, that means they already distrust their published financials. But the Treasury department thinks that making their statements even more dubious by letting them uses phony valuations is a solution.
And lo and behold, the Treasury is going to buy crap assets at amazing prices:
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.)
Yves here. We aren’t to the dud asset part yet, but behold the nonsense. AIG gets a 5 year term, up from two, and a massive gift in the form of a 5% reduction in its rate of interest. A complete gimmie.
Every mortgage borrower in America whose bank has gotten any money from the TARP should write their Congressman asking to know why they aren’t getting a their interest rate reduced by nearly half. Ah, but I forget. Your bankruptcy, sadly, does not pose a threat to the financial system.
Back to the Journal:
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. The government’s equity interest in AIG would remain at 79.9% following the changes.
Yves here. Um, shares do not carry interest payments. They can have dividends paid at a fixed rate. The terminology here is highly misleading and gives the impression that the preferred dividends have the same standing as interest payments, when they are subordinate.
Back to the article:
The government’s initial intervention was driven by concern that AIG’s failure to meet it obligations in the credit default swap market would create a global financial meltdown. (A credit default swap, or CDS, is essentially an insurance policy on a bond acquired by investors to guard against default. AIG wrote tens of billions of dollars worth of these contracts.)Under the revised deal, AIG would transfer the troubled holdings into two separate entities that would be capitalized by the government.
The first such vehicle would be capitalized with $30 billion from the government and $5 billion from AIG. That money would be used to acquire the underlying securities with a face value of $70 billion that AIG agreed to insure with the credit default swaps. These securities, known as collateralized debt obligations, are thinly traded investments that include pools of loans. The vehicle would seek to acquire the securities from their trading partners on the CDS contracts for about 50 cents on the dollar.
The securities in question don’t account for all of AIG’s credit default swap exposure but are connected to the most troubled assets. Most of the trading partners AIG would seek to acquire the assets from are other financial institutions. The government may be betting that federal involvement will encourage the trading partners to sell the assets to the AIG vehicle.
A price of 50 cents on the dollar for CDOs across all tranches, particularly when the objective is to buy the dreckiest dreck (the ones where AIG’s losses on its CDS guarantees would be greatest) is simply breathtaking. It’s a wet dream for anyone who owns them.
Remember, this would be the price across ALL tranches. Recall that in Merrill’s not-all-that-long-ago sale of its super-senior CDOs (the very best tranches) it got a nominal price of 22 cents on the dollar, but that did not accurately represent the economics of the transaction. The hedge fund Lone Star paid only 25% of that amount (or 5.5 cents) in cash, the rest was contingent on performance. So Merrill might have sold the CDOs for as little as 5.5%.
Ah, I bet Lone Star is now scrambling to see if it won the lottery. If its Merrill CDOs happened to be guaranteed by AIG (and Sunday’s story by Gretchen Morgenson said they were until AIG got leery of its exposures) then Merrill (and BofA) have just gotten wildly lucky. BofA will get the maximum it was entitled to, and Lone Star, having paid only 5.5% of face in case, will get to recoup 50% less the 16.5% contingent payment it will have to make to BofA. So it will get over six times the amount it put as risk in less than a year.
Back to the Journal:
Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted back the contracts. The total collateral at stake is about $30 billion.It may also have some unintended consequences across the markets. For the plan to work, AIG’s trading partners — the banks and financial institutions that are on the other side of its credit-default-swap contracts — may have to agree to any changes in the terms of their agreements with AIG.
Such changes could cause those partners, which have pried billions of dollars worth of collateral from AIG over the past year, to return some or much of the collateral. That could be a costly exercise for some financial institutions, because the cash they received from AIG has in recent months been a cheap source of funding for many banks.
The agreements may be difficult to work out. Some financial institutions 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 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 banks demanded collateral from Merrill which in turn demanded collateral from AIG.
Frankly, I regard this section as noise. The real objective is to overpay for the CDOs and provide a huge subsidy to the current holders, who are presumed to be banks (a lot of the really crappy late vintage CDOs were sold in Europe) but per the Lone Star example, some of the fortunate beneficiaries may turn out to be hedge funds. If AIG can unwind any of these CDOs, good luck. My understanding is that this has only been done in cases of payment failure. If the CDO is substantially held (meaning each of the tranches as well as the whole) by an entity friendly to AIG, then the game changes, but given the cost of unwinding a CDO, query whether that would be the best route to go.
This statement (from the middle of the story) sums up the sheer dishonesty of the entire exercise:
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.
The phrase “designed to improve….the taxpayer’s ability to recoup the money that has been pumped into the insurer” is a complete and utter lie. The authors (Matthew Karnitsching, Liam Pleven and Serena Ng) and whoever edited the piece should be ashamed of printing such a blatant falsehood. The changes in terms, in every respect, make the deal worse for the taxpayer.
But for the Journal to perpetuate such pro-business rubbish is par for the course.
We said in our title that the AIG case constitutes looting. We refer to notion as set forth by Nobel prize winner George Akerlof and Paul Romer in their 1994 paper, “Looting: The Economic Underworld of Bankruptcy for Profit.” Its abstract:
During the 1980s, a number of unusual financial crises occurred. In Chile, for example, the financial sector collapsed, leaving the government with responsibility for extensive foreign debts. In the United States, large numbers of government-insured savings and loans became insolvent – and the government picked up the tab. In Dallas, Texas, real estate prices and construction continued to boom even after vacancies had skyrocketed, and the suffered a dramatic collapse. Also in the United States, the junk bond market, which fueled the takeover wave, had a similar boom and bust.In this paper, we use simple theory and direct evidence to highlight a common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which countries took on excessive foreign debt, governments had to bail out insolvent financial institutions, real estate prices increased dramatically and then fell, or new financial markets experienced a boom and bust. We describe the evidence, however, only for the cases of financial crisis in Chile, the thrift crisis in the United States, Dallas real estate and thrifts, and junk bonds.
Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.
This is precisely what happened at AIG. Executives there are handsomely paid, yet senior management cast a blind eye as one unit earned outsized profits while taking risks that would have driven AIG into bankruptcy were it not for the Fed’s rescue. Before you say, “Well, it was just a few bad apples,” the biggest single job of senior management in a financial institution ought to be to assure the health and survival of the entity, which means risk management and control is top of the list (it was at Goldman when it was a private firm). Anytime a unit starts reporting very large profits, managers should be all over it like a cheap suit to make sure the earnings are not the product of massive risktaking. It only takes one aggressive trader plus inattentive management to bring down an entire firm, as Nick Leeson demonstrated with Barings.
But the worst is that not only was the initial AIG de facto bankruptcy a case of looting, the government has now decided to aid and abet AIG management in further looting. What pro-taxpayer purpose is there in the improvement of terms above? None. As we pointed out, there were only a couple of reasons for easing up on AIG, and they could have been provided for with minor changes that would not leave the taxpayer materially worse off. Instead, major concessions have been made to AIG, all to the detriment of the taxpayer. AIG management now has job security for five years (and AIG top brass is very well paid) and better odds of salvaging something for themselves when the five years are up thanks to the government giving them an unwarranted subsidy.
When the TARP was announced, we called it “Mussolini-Style Corporatism in Action.” Sadly, it looks as if events are panning out as foretold.