Federal Reserve rescue of AIG

Discussion in 'Economy' started by gonegolfin, Sep 16, 2008.

  1. gonegolfin
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    gonegolfin Member

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    Reportedly, the Federal Reserve has reversed course and is stepping in to provide a bridge loan (reportedly a short term $85 billion loan) to AIG in return for warrants representing the right to buy as much as an 80% stake under certain conditions. Fed and Treasury representatives met with House and Senate leaders tonight to get their blessing on the plan to save AIG. Had the loan not come through, AIG would have had to declare bankruptcy in the morning. While it is certainly arguable that AIG is not insolvent (at least at present) as its insurance subsidiaries are quite profitable, it is the huge book of credit default swaps (nearly $500 billion) that is threatening the existence of AIG and creating what is at minimum a liquidity crisis for the company. The bankruptcy of Lehman put more pressure on the derivatives market and in particular writers of credit default swaps. As these spreads have widened (signaling the increased chance of failure of the debt these credit default swaps are written against), companies (such as AIG) writing these credit default swaps (and collecting the premiums) must put up more collateral to back the underwriting of these swaps. AIG does not have the cash to provide this additional collateral and thus must sell a significant stake in its assets to raise cash. The problem is that these sales take time ... time AIG does not have. Hence, the emergency loan. I think that the Fed and Treasury also believed that the bankruptcy of AIG would have been a systemic event, triggering losses by the counterparties in AIG's derivative book, resulting in a cascading effect throughout the financial system. Lehman did not pose the same risk (not nearly) and is the reason why they were let go. As a comparison, AIG's book of derivatives is approximately four to five times as large as that of Bear Stearns.

    Well, this loan is going to cost AIG shareholders dearly. The $85 billion in return for an 80% stake in the company nearly wipes out existing shareholders, but not completely. I have heard the rumors of conservatorship, but no such legal authority exists for the federal government to take control of a state regulated agency (although the government does effectively own a TBD portion of AIG, taking on the role of private insurer). There are supposed incentives in place for a timely sales of its assets.

    One legitimate question is how the Fed can actually make a direct loan to a non-depository institution. We know that primary dealers (investment banks such as Goldman Sachs, JP Morgan, etc.), which are non-depository institutions, can now participate in certain Fed lending facilities (as of March of this year). But now the Fed has extended these benefits to non-financial institutions that are not under federal regulation (AIG is state regulated). Is GM next? And it is more than just a collateralized loan. Under the collateralized loan label, the Fed can effectively make any investment it desires. This is more ammunition for the folks that have stated that the Fed can monetize anything. It is clear that the Fed has too much power and is putting our financial system more at risk with each passing day.

    One final thing ... for those that say moral hazard does not exist with this rescue because the shareholders are effectively wiped out (I heard this repeatedly on the financial news during my drive home tonight) ... they are wrong. Holders of AIG corporate debt are being made whole. This includes, no surprise, Bill Gross of Pimco. Pimco holds a significant stake in AIG debt that would have taken at minimum a haircut during a liquidation (depending on the seniority of the debt held). Bill Gross and Pimco were also very large holders of Fannie Mae and Freddie Mac agency debt and benefited nicely from the bailout. This rescue also benefits the parties that engaged in credit default swap transactions with AIG. Why AIG is in the business of writing credit default swaps is another matter.

    Brian
     

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