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Monday, November 10, 2008

"AIG: The Looting Continues"

Yves Smith wasn't very happy with the initial terms of the AIG bailout, and she is even less impressed with the "considerably enlarged and sweetened rescue package" that appears to be in the works. [Update: Blinder's advice from yesterday comes to mind:

Barack Obama will have to begin with the troubled Troubled Asset Relief Program... [which is] in danger of becoming the most unpopular use of public money in the history of the republic...

If it’s not already too late, the new president must convince Americans that the bailout is being managed for their benefit, not for Wall Street’s. ... Quick changes in the bailout program ... are necessary. ...

I don't think these are the changes he had in mind. If there's a way for the gang that couldn't shoot (or talk) straight to make the government look incompetent, they will find it.] Here's a shortened version of Yves' reaction :

AIG: The Looting Continues: 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...

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...

Before we get to the particulars,... 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. ...

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 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. ... Ah, I bet Lone Star is now scrambling to see if it won the lottery. ...

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. ... 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.

    Posted by on Monday, November 10, 2008 at 12:15 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (43)

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