Fed Ponders Provides $85 Billion Rescue for AIG (Update: Now Official)

The outlines of a deal to prevent the world’s biggest insurer from filing for bankruptcy may be emerging. In concept, the outline of provisions is about as good as the government could likely extract, absent taking control, which runs the risk of loss of talent (and having considerably lost by various “helpers” as Warren Buffet calls them, pulling fees out as they pick over the remains) The terms bandied about would have the Fed having a secured loan (which in simplified terms means they could seize specific assets in the event of non-payment) and equity warrants, so if the company recovers, the Fed gets the upsisde.

So whether the deal is a good one depends on the details, namely, the quality and amount of assets securing the loan, and the amount of warrants. Given that the Fed is the only game in town, it ought to be able to drive a tough deal. But whether it will remains to be seen.

From the Wall Street Journal:

The Federal Reserve is considering an $85 billion rescue for embattled American International Group that could leave the government in control of the firm, according to a people familiar with the matter, though the structure of a deal remains unclear.

The plan under consideration late Tuesday involved the Federal Reserve providing AIG with a secured bridge loan in return for warrants, the people said. AIG would commit to sell a basket of assets within a certain timeframe and offer incentives to buyers to complete the sales quickly.

In return, the government would get warrants for most of AIG’s equity, diluting existing shareholders.

I’d like to know what “most” means. AIG will no doubt need to raise new equity, which would be senior to the warrants.

With the government support, AIG’s favorable credit ratings would likely be restored, allowing the firm to avoid bankruptcy,,,

AIG shares, which fell 61% on Monday, closed down 21% at $3.75, with trading volume during the day at more than 10 times the average. AIG, whose shares fell as low as $1.25 Tuesday, has lost more than $25 billion in market capitalization since the start of trading Monday….

An AIG bankruptcy would take the financial crisis to another level, given the company’s size and wide reach. The New York-based company is used by many companies around the world to manage a range of risks, including exposure to investments in subprime mortgages.

Update 8:20 PM The New York Times weighs in (hat tip reader Dwight):

In an extraordinary turn, the Federal Reserve was close to a deal Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people briefed on the negotiations.

All of A.I.G.’s assets would be pledged to secure the loan, these people said, and in return, the Fed would receive warrants that could be exchanged for an ownership stake. Stock of existing shareholders would be diluted, but not wiped out.

Wow. They have a $100 billion investment portfiolio in their Japan/Korea operations alone, Query how the Fed might stand relative to policyholders, since the loan is at the parent level and the assets are (presumably) in regulated subsidiaries. But rules vary by jurisdiction. So what they have is a priority position against parent assets (which have other claims against them against which the Fed might not want to assert its priority position) and (one assumes) the parent’s equity in the subs. Nevertheless, on first blush, this is WAY overcollateralized,. Addition at 9:25 PM: I needed to clarify one bit of the logic: you’d have thought that AIG would have been able to get a loan at the parent level if the collateral was sufficient, that is, it was a liquidity rather than a solvency problem in that entity. However, some parties were thinking about a last minute bid because they were convinced that there was enormous value in the company as a whole. And the requirement to sell assets means that some of the value in the subs will be extracted,

If the Fed takes a controlling stake, it is likely that it would want to replace A.I.G.’s board as well as its chief executive and chairman, Robert B. Willumstad….

Attending the meeting on the Capitol Hill were Democratic Senate leaders that included Charles E. Schumer of New York, Richard Durbin of Illinois, Christopher J. Dodd of Connecticut and Kent Conrad of North Dakota A contingent of Republicans was led by Mitch McConnell of Kentucky, the minority leader, and included Richard Shelby of Alabama, John Kyl of Arizona and Judd Gregg of New Hampshire. House leaders included John Boehner of Ohio, the Republican leader; Spencer Bachus, Republican of Alabama; and Barney Frank, Democrat of Massachusetts. Members of the leaders’ staffs were asked to leave the meeting shortly after it began.

Update 8:35 PM: The Journal reports AIG’s board has approved the plan, except the plan is in flux. Talk about fire, aim, ready:

The U.S government moved toward an emergency rescue of American International Group Inc. — one of the world’s biggest insurers — signaling the intensity of its concerns about the danger a collapse could pose to the financial system.

The board of AIG approved a government-led rescue plan late Tuesday….

he precise details of the government’s plans were still being formulated. The primary option being hammered out involved the Fed providing AIG with a short-term loan of $85 billion, according to people familiar with the situation. In exchange, the government would receive warrants in AIG representing the right to buy its as much as 80% of its stock under certain conditions, according to one person familiar with the matter.

That could put the government in a position to potentially control of a private insurer, a historic move, especially considering that AIG isn’t directly regulated by the federal government.

Update 10:00 PM. Reader Jesse pointed to the Fed press release. The juicy bits not covered above are 24 month term, interest rate Libor plus 850 and the right to veto dividends on common and preferred. Other verbiage:

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers…..

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets.

A reader noted on an earlier AIG post:

Neither the Fed nor Treasury had the power to impose a conservatorship. The Fed does, however, have the power to make collateralized loans.

That said, anyone who is clever should have realized (or is probably starting to realize) that a limitation to making “only” collateralized loans is not much of a limitation at all.

For example, a good lawyer can write what is basically an “equity” investment with loan documents (like a participating subordinated loan or a thinly collateralized loan with warrants like what the Fed is doing). In much the same way, a lawyer can also write what is basically a “debt” investment with equity documents (a joint venture agreement where the money provider gets all its “equity” back plus a preferred return prior to any other distributions (and you could also include a guarantee)).

My point is that this smells very much like a senior preferred equity investment. And this shows how saying the Fed can “only” make collateralized loans is really meaningless. The Fed can make any investment it wants and just slap a “loan” label on it.

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61 comments

  1. ruetheday

    Under what authority could the Fed give AIG an $85 billion loan?

    When the government bailed out Chrysler with a big loan in 1979, it had to be approved by Congress and signed by the President.

    Congress (in a dereliction of duty IMO) gave the Treasury blanket authority to deal with Fannie/Freddie as they saw fit. Who has given Bernanke authority to deal with AIG as he sees fit?

  2. Yves Smith

    Dean,

    They left 20% of the equity in the Fred/Fan conservatorship. Is this a formula? With the GSEs, there was no reason I can fathom to leave the shareholders in place. With AIG, it is being preserved as a private company but (hopefully) the Fed gets some upside….

  3. Dean

    I believe the big issue here is Fed insolvency. Their balance sheet shows Fed is using twice the leverage ratio than the allowed maximum for the regulated markets under their watch.

  4. Nick

    What do you mean “senior to the warrants”? Presumably the warrants are on the common equity. If there’s a ratchet provision, the Fed would maintain it’s percentage. But at worst, they are on par with common equity, no?

  5. Dean

    Check this out. CNN did not fall for the fancy clothing; it’s calling the emperor almost naked:

    “Fed Bailut of AIG” is the title.

  6. Anonymous

    Does anyone know if someone could have standing to sue the Fed for damages or injunctive relief if it took illegal actions to bail out a company? A subordinate investor in the company that gets wiped out? A hedge fund with short positions that gets wiped out? A concerned citizen and taxpayer? A member of Congress?

  7. dd

    Reserve Primary Money Fund Falls Below $1 a Share
    Reserve Primary Fund became the first money-market fund in 14 years to expose investors to losses after writing off $785 million of debt issued by bankrupt Lehman Brothers Holdings Inc.

    The fund, whose assets plunged more than 60 percent to $23 billion in the past two days, said the Lehman losses forced the net value of its assets below $1 a share, known as breaking the buck. Reserve Primary, the oldest money fund in the nation, fell to 97 cents a share and redemptions were suspended for as long as seven days

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aycQDd9pEdCA&refer=home

  8. Anonymous

    “If it does not, liquidity dries up again and everything seizes up.”

    There’s always ebay!

    I suggest we auction off a few states such as Ohio and possibly Florida. Their love for ‘Bush at all costs’ has brought us here. They’re both likely to go for Mccain.

    Sell the bums out!

  9. Matt Dubuque

    MATT DUBUQUE

    If the ONLY competent solution to this particular fiasco requires a FEDERAL solution because the abysmal mismanagement of AIG threatened to irretrievably harm the GLOBAL financial system, no legitimate claim can be made that it is appropriate to regulate them on the STATE level.

    Their conduct has posed a threat to the ENTIRE world.

    As such, at a minimum, they need supervision on a NATIONAL level, preferably with the Federal Reserve having the option to assert primary regulatory jurisdiction over all issues pertaining to systemic risk.

    Surely the Fed is insisting upon this. Whether the thoroughly corrupt Congress grants it is another matter.

    Barney Frank needs to shape up.

    MATT DUBUQUE

  10. Anonymous

    “go on, take the money and run” – Steve Miller

    alas, business as usual. executives ensuring their millions in compensation at the cost of regular janes/joes.

    lyrics so appropriate for today.

    can we, the people, get a piece of this pie? i, for one, will have my hand out.

  11. Anonymous

    ***For example, a good lawyer can write what is basically an “equity” investment with loan documents (like a participating subordinated loan or a thinly collateralized loan with warrants like what the Fed is doing). In much the same way, a lawyer can also write what is basically a “debt” investment with equity documents (a joint venture agreement where the money provider gets all its “equity” back plus a preferred return prior to any other distributions (and you could also include a guarantee)).
    ***

    Lawyers representing Lincoln Savings received fines and worse for drafting fraudulent documents to distribute cash from the regulated sub to its parent. If the Fed is advancing cash for an instrument that is equity in substance, why isn’t that illegal? And who can sue the Fed for damages or an injunction unwinding the deal or preventing more of them? Citizens? Congress? Anyone?

  12. DownSouth

    The most disturbing aspect of all these multi-billion dollar deals the Fed and the Treasury are up to is there is absolutely no transparency.

    It seems like, if they were indeed interested in regaining the faith and confidence of the public, they would bend over backwards to get as much information out to the public, and as quickly as possible. This has not happened.

    Instead, we find out belatedly that the Fed reimbursed an $87 billion bridge loan to Lehman. And nobody seems to know what that means.

    Are we any closer today knowing what the $29 billion package of assets the government bought off of Bear Sterns last March is really worth?

    Nouriel Roubini had some figures the Fannie/Freddie bailout may cost the taxpayers between $500 and $600 billion. Has the Fed or Treasury had anything to say in this regard?

    Everything that is done is an “emergency.” I suppose that does away with such silly notions as open meetings and freedom of information laws.

    Our federal government has evidently become the blackest of black boxes. That’s about as anti-democratic as you can get.

    I fear what is under attack here is not just the financial system, but democracy itself.

  13. Yves Smith

    Ratchet rights would make it hard to raise public money, They may be in there, but look what the Temasek anti-dilution provisions did to Merrill (similar in intent if different in operation), It made it prohibitive to raise new money and drove Merrill into BofA’s arms. That isn’t to say they didn’t get them, but from my vantage, they only work in VC deals, when you use them to dilute management that still has a substantial stake. When a VC company is underperforming, it’s usually the original investors who pony up more dough.

    See post for updates The AIG board has approved the deal.

  14. Confused

    Does this mean the Treasury or FED becomes a counterparty to all that CDS that AIG sold? What happens if the Gov’t is a CDS counterparty?

  15. Anonymous

    THe FED and Treasury have had no problem rewriting their regulatory constraints. Why should AIG be different. If they are too big too fail, they are too big to remain independent.

    Keeping this zombi alive, competing with efficient businesses, with the help of the US taxpayer, puts us on a par with Russia or worse.

    AIG should be taken over as a bank, put into recievership and be auctioned off.

    Period.

  16. Yves Smith

    DownSouth,

    Agreed, Let me be clear: the Fed deal isn’t terrible given the circumstances, but why the hell did these circumstances come about? And why is the disclosure so limited? These matters have no reason to be on a “need to know” basis. There may be more detail, but given the way the GSE conservatorship was handled, I wouldn’t hold my breath.

    And my other huge beef is the lack of planning, which is this case is the result of drinking their own Kool-Aid. By the Bear bailout time, Paul Krugman was saying that the interventions were not working, and it might be for good reason (different turn of phase, but that was the drift of his gist). Krugman is a Princeton colleague of Bernanke’s, so I find it hard to believe that this didn’t get back to him. I’m sure he heard similar things from not-so-visible sources.

    So Bear falls over, and one of the big issues unearthed is how a rating agency downgrade can push a brokerage firm into liquidation pronto.

    Here the housing bill was passed with all sorts of unrelated provisions tacked on. You’d have thunk that some combination of regulatory or legislative measures would have been implemented to throw firebreaks in to allow, say, for partial liquidation or some other attenuation.

  17. Anonymous

    “…. The value of the debt securities issued by Lehman Brothers Holdings, Inc. (face value $785 million) and held by the Primary Fund has been valued at zero effective as of 4:00PM New York time today. As a result, the NAV of the Primary Fund, effective as of 4:00PM, is $0.97 per share. All redemption requests received prior to 3:00PM today will be redeemed at a net asset value of $1.00 per share…..”

    From “Money market giant freezes redemptions” @
    [u]http://www.marketwatch.com/news/story/money-market-giant-freezes-redemptions/story.aspx?guid={691A8CB9-B98F-4677-87D3-1CC274AB5103}[/u]

  18. Anonymous

    “I believe the big issue here is Fed insolvency. Their balance sheet shows Fed is using twice the leverage ratio than the allowed maximum for the regulated markets under their watch.” — dean

    Several months ago, a Bloomberg reporter tried to find out whether the Fed carries all the junk it has taken onto its balance sheet at cost or market. Getting no response, he FOIA’d the Fed’s accounting manual. When it was finally released, portions of it had been REDACTED. So much for transparency: full disclosure, audits, sh*t like that — that’s for little people … for suckers.

    Bernanke has destroyed the Fed’s balance sheet. With its assets valued at market rather than cost, the Fed may have no equity. Unlike the case of AIG, though, the Fed’s liabilities can’t be redeemed. If you “redeem” a paper dollar, all you’ll get in return from the Fed is another paper dollar. So there can’t be a “run on the Fed,” even if it now has negative net worth. (The negative net worth of USGOV is estimated at $60 trillion.)

    However, there sure as hell can be a run on the US dollar, as well as the Fed’s jakeleg $2.4 billion “custody account” slush fund.

    If the Federal Reserve does become insolvent, conservatorship is not the answer. There’s only one way to fix a mess this big: execute the entire Fed board; dynamite the Eccles Building; and turn the site into a nuclear waste dump. Nothing shall grow at the site of this monstrous crime for 10,000 years. Goodbye and good riddance, statist sociopaths!

  19. Anonymous

    off topic on the topic of AIG…

    what are the risk/possbile otucomes of holding/buying AIG stock at this moment in time ?

  20. doc holiday

    Here we go again, with The Fed going into yet another business as another corporate entity, using taxpayer money to pay dividends and rewards to a group of close friends that can’t be tried for crimes, accounting fraud, conspiracy to defraud and obviously can’t be held accountable for anything or held to any standards beyond being friends and lovers with the Bush Mafia/Coup or whatever this is called now.

    Can someone (anywhere) show me the Constitutional authority being used to defraud taxpayers? Can anyone show me a Congress women or mancub connected to a lobby group or perhaps maybe provide a link to some comment from an elected representative of the people? These elected Reps are too big to speak, too big to think, too big to be seen in public! Give them all berets and machine guns, gold chains and white powder around their drug laundry’d noses and pry that this is God’s plan!

  21. Cash Mundy

    UPDATE FROM THE CASH MUNDY STRATEGIC TRADING COMMAND

    Reserve Primary Money Fund Falls Below $1 a Share…known as breaking the buck

    @DD: Slim Pickens! WOOOOOOOOOOOOOO-Dawgies! YEEEEEEEEE-Haw!

    [Underling’s commentary: Mr Mundy loaded the double-wide in the Globemaster on Sunday, just finished third refueling. Mr Mundy last seen riding a bull off of loading ramp. For the second time tonight. Brighton seems very very far away.]

    UPDATE/CMSTC/EOT

  22. Anonymous

    Yves —

    I feel honored that you lifted my comment into your post.

    I just want to make sure no one thinks that I have any first hand knowledge whether the Fed’s loan to AIG is in fact thinly collateralized. I suspect it is solely because JP Morgan was unwilling to provide the $75B credit line requested earlier. Many of AIG’s assets are probably subject to claims of higher priority because they were pledged to secure other debts, and many are obviously segregated into subsidiaries and unable to be pledged directly to the Fed (or pledged at all in most cases). So I doubt there is great collateral, but I could easily, easily be wrong.

    Also, in response to one of the comments, I did not mean to imply that the lawyer would be doing anything illegal with such documentation or that the Fed would be committing fraud by labeling anything a “loan.” I was merely pointing out labels such as equity and debt are less meaningful than many assume. I have seen many deals that feel like equity written as loans and many deals that feel like debt written as equity investments. Often the labels are chosen by the contracting parties for regulatory reasons. But there is no fraud involved at all, just parties taking advantage of loopholes in regulations. Regulations unfortunately do not contemplate that (1) debt and equity is a continuum and (2) labels are not very useful in such situations.

  23. Anonymous

    ***Also, in response to one of the comments, I did not mean to imply that the lawyer would be doing anything illegal with such documentation or that the Fed would be committing fraud by labeling anything a “loan.” … Often the labels are chosen by the contracting parties for regulatory reasons. But there is no fraud involved at all, just parties taking advantage of loopholes in regulations.
    ***

    I know what you meant. And I know that the law often makes binary distinctions between debt and equity, even though there is a spectrum. The law required substance and form, whether for tax, bankruptcy, regulation, or otherwise. If the relevant court decisions in an area consider an instrument to be something in substance, the courts treat it that way regardless of what the parties call it.

    If the Fed labes something as debt, but it is stock in substance under applicable case law, then the courts can treat it that way, even if that means the Fed’s investment is illegal. So again, the question becomes, if the Fed is making illegal investments, who has a right to sue in court to stop the Fed? Or sue for damages?

    Say the Fed invests in personal checks written by Mr. Bernanke or Vice President Cheney. Is the only recourse for Congress to impeach members of the FOMC?

  24. Alan von Altendorf

    Bloomberg reporting: “a deal to turn over control in exchange for an $85 billion loan from the Federal Reserve, a person familiar with the situation said. AIG will replace management as part of the deal…”

    Bernanke picks new CEO. Completely idiotic, utterly and totally. Sell.

  25. Dean

    I agree with Yves. The lack of planning is distrurbing:

    “Dig the well before you are thirsty.”

    Chinese Proverb.

  26. Anonymous

    I share the comments above about Paulson doing these deals ad hoc. I think there is an interesting 'Goldman' angle that nobody is addressing: there is a Goldman 'winner' in each of these deals. Merrill – Thain & his boys take home a cool $200MM. AIG – Paulson let's Goldman roll up their sleeves and take a look to supposedly seek private capital…total b.s. How about he let them take a look at their CDS book and hedge themselves for the oncoming onslaught…again total b.s. Bear – a big Goldman kiss; totally demoralize Jimmy Cayne et al with $2 offer (worse than bankruptcy at the time). Anybody think the FNM/FRE deal was a little strange – hinting they would include the preferreds and then oops change of ourse….whamo. I'm sure Goldman was on the right side of that trade also. Paulson checks out of Goldman, heads to Treasury, puts his Goldman stock in a blind trust (& pays zero capital gains taxes on any sale btw) and then continues to feed the Goldman animal…can't wait for the book in a few years.

  27. Michael Fiorillo

    So, having cannibalized and outsourced so much of the productive wealth of the country, finance now finds itself terrified as the unsustainable and inverted pyramid it has created tips over, threatening the financial stability of the nation.

    Trillions down the rat hole in support of predators and parasites – aka investment bankers, hedge fund and private equity managers – and soon to come, a nasty regime of structural readjustment for the rest of us.

    My only consolation is the schadenfreude – no, the open delight – I feel in seeing these folks brought down by their infinite greed, even if rubes like us are taken down with them.

    As a lifelong New Yorker and public school teacher who witnessed the the school system hollowed out by the banks decrying the “excesses” of the welfare state in the 1970’s, and who must now contend with their propaganda about our supposed failures, caused by their disinvestment in the public sector, and their current efforts to privatize public education through charter schools, etc., I can only hope that there is enough public anger to repudiate them in time to salvage some scraps of the republic.

    Oh, foolish, sentimental heart.

  28. Jesse

    Here is the text of the Fed press release on the AIG deal

    “For release at 9:00 p.m. EDT

    The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

    The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.

    The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.

    The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

    The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.”

    That LIBOR plus 850 is tough love.

    What I still don’t understand is what happens if AIG pays back all the loan facility with interest, in lets say 12 months. Does the Fed still ‘own’ 79.9% of the company or is that for collateral and control?

    Any ideas?

  29. Anonymous

    Anon of 9:29 —

    You are absolutely correct. I did not read your post thoroughly, and I think I may have been thrown off the by the phrase “fraudulent documents.” I wish I could answer the questions you pose, but I do not have any idea who would have standing to sue here.

    That said, I doubt any judge would seriously consider a substance over form recharacterization with respect to actions of the Fed unless those actions were incredibly egregious. But there is no doubt that much jurisprudence supports the power of the judiciary to engage in such a substance over form analysis. I should have recognized that.

  30. Anonymous

    @ dean – merci, for your opinion

    too bad you are ruling out the chance the stock will hop back to a nice solid state. wish someone could prove you wrong :(

  31. Anonymous

    guys

    i live in this world of substance over form, i do complex commercial litigation usually in the area of financial instrument fraud and concomitant federal income taxation issues.

    anyway.

    if this were a private transaction (which, you know, it is, really) then the proper characterization from what i see, at least the most intelligent characterization, would be to bifurcate the transaction in two steps:

    first, and this simplifies it so that in my hypothetical the $85M check is written immediately, you would determine the value of the warrants to acquire the 79.9% interest (nevermind how, we handwave that for the “experts”).

    suppose the value of the warrants is $20B (by the way, if the warrants are plain vanilla then a black scholes model is not completely stupid for an eyeball, so figure that if the stock is trading at $3/share then warrants should be worth something less than that).

    then the transaction should be deemed bifurcated into debt and equity, or debt and a banana if you will (ie debt and non-debt), so there is $65B of debt and $20B of banana.

    of course, this means the interest is 3mL + 850 * 85 / 65.

    anyway, the second bifurcation applies to those “warrants”

    i dont know what is the strike price of those warrants, but if it’s a penny (there are such things) then we consider something called “substantial likelihood to be exercised”

    basically, an option that is substantially likely to be exercised is deemed for many purposes to be the underlying itself

    so a call option at a penny strike on ibm stock would be considered really to be ibm stock

    whether this is true for purposes of being owed fiduciary duties, having the right to vote, and so on is a set of interesting questions we don’t care about now.

    what we do care about is that those warrants my not really be warrants.

    since presumably the fed will keep aig running no matter what, we know that the warrants (im presuming theyre european exercise) will eventually hit their exercise date with aig intact

    therefore since the probability of maturing is functionally 100% the question is, what is the probability they will mature in the money?

    thats why its possible that both of your positions are correct, that this transaction is both debt and equity.

    (please note not only am i constrained by what little is known about the aig deal, but also im simplifying the hypothetical and also this bifurcation is not always the right analysis, very often if not almost always debt becomes equity, period, or equity debt, with no bifurcation…

    in this case, the presence of the non-cash boot warrants is the reason for the bifurcation.

    its also possible to consider this as a single contingent payment debt instrument, with total payments based both on libor and future stock price.

    but its not purely equity, almost surely, as one classic sine qua non of debt characterization in whole or in part is the existence of a non-silly maturity date at which repayment is due (and if you’re wondering how preferred stock is thus not really debt, sometimes it is).

    finally, another factor in these things is the expected return. returns that at the time of the transaction can be anticipated to be much more like those of equity than debt can count towards equity characterization.

    but all in all, as the parties chose to bifurcate the deal into loans plus warrants, so would a court likely do so as well.

  32. Anonymous

    anon 10:31pm,

    Wonderful to hear there may be a legal argument that that the Fed is investing in AIG equity. Now who can sue the Fed about making illegal investments? Senator Brunning and Representative Ron Paul? John Q citizen? Anyone?

  33. Peter Principle

    In much the same way, a lawyer can also write what is basically a “debt” investment with equity documents

    Which, of course, is one of the basic tools of Islamic finance.

    So while we may have lemon socialism in this country now, at lesat it’s not Islamic lemon socialism.

    Thank God for that, because I think Sarah Palin would stroke out.

  34. Anonymous

    i have zero belief that private citizens have any standing to sue. i don’t claim exhaustive knowledge, but in general the only litigation i can imagine would be directed against aig control persons derivatively, and while i suspect that aig (i believe its a delaware company) did not appoint a disinterested committee to evaluate this, it seems comfortably on the side of the business judgment rule (i dont like that, but i dont mispresent what the situation is).

    a shame, because one thing that would be true would be that if, repeat if, aig control persons breached fiduciary duties, there’d be a claim against the fed for aiding and abetting (assuming they had the requisite mental culpability).

    a corporate litigator with way too much time available could file this for publicity value i imagine, but its not likely to survive long.

    what might have a shot (i dont know the facts) but doesnt seem to involve the fed would be to claim that aig control persons breached their duty in turning down that private money a few days ago.

  35. Anonymous

    Counselor that was a fascinating orderly implosion you walked us through.

    From the Jim Sinclair's Mindset website he states,

    > "…. The quoted amount of OTC derivatives on Lehman's books are not notional value, but some silly mark to no market. The real number is trillions. When either party to an OTC derivative fails the value of that derivative instantaneously become the size of what was previously called notional value. With one quadrillion, one thousand one hundred and forty four trillion (BIS) in notional value, there is NO means to stop this financial cataclysm.

    >The shit has hit the fan because trillions of dollars of OTC derivatives failed Monday.

    > The entity to fail is not the winner on those fraudulent pieces of paper but the loser. Otherwise it would not have failed.

    > Many other counter parties to those derivatives have fallen into potential bankruptcy….."

  36. Lune

    Call me a contrarian, but I’m cautiously supportive of the Fed’s move here. Don’t get me wrong: when I first heard of AIG going bust and the Fed considering stepping in, I was mad as hell. But I’ve changed my mind. So here are my reasons why I’m putting the pitchfork down (at least for today):

    1) AIG really was too big too fail. BSC, LEH, ML, etc. weren’t. GM, Ford, and Chrysler sure as hell aren’t. But if it’s true that AIG was an unhedged counterparty to a lot of CDSes, then like it or not, they would have caused a massive unwinding that wouldn’t be a simple cancelling out of equivalent positions. Don’t get me wrong, I still want to burn at the stake the people who got us into this mess, but there are better ways to do it than to set fire to the entire world’s financial system.

    2) If the terms hold, the Fed seems to be minimizing the risks of moral hazard. Libor + 850? 80% of equity? Change of management? The only thing missing is clawback of executive salaries for the past few years, but that would be hard for the Fed to force.

    3) The Fed is doing a reasonable job protecting the taxpayers. Firstly, while $85 bil sounds like a lot, compared to the devastation that a rapid unwind of the CDS market would impose, it’s not much. Secondly that $85 bil is secured with substantially all of AIG’s assets. This is markedly different than the BSC bailout, in which the Fed provided $30 bil in return for a package of crap that JPM selectively chose to dispose of. Everyone strongly suspects that that $30 bil of collateral is worth much less and that the Fed / taxpayer will end up footing the bill for the remainder while JPM walks off with any assets that actually had value. But in this case, even with a forced liquidation, AIG will likely be worth more than $85 bil. And if it’s not, there’s no one who gets to cherry pick the better assets a-la JPM in the BSC deal.

    4) The gestalt I get from the press release (although I’m by no means a professional Fed watcher) is that the Fed has no intention of getting into the private insurance business. The goal here is to allow time for a liquidation and eventual BK (or sale/merger). That’s why the Fed mentions that they expect to be paid back by sale of assets, not by ongoing revenue. And that’s why there’s a 24 month term. Can the Fed renew that term? Of course. But let’s be frank: if at the end of 24 months AIG is still in such lousy shape that they can’t get financing at anything better than Libor + 850, they won’t be able to compete for business anyway. One way or another, the Fed exits this thing in 24 months, as they should.

    So in the end, I think this deal satisfies the criteria for a reasonable bailout: it was done to preserve the financial system; it minimizes moral hazard; it protects taxpayers; and it has a defined end-game.

    Now if the Fed caves and sweetens the deal, I’ll gladly brandish my pitchfork with the rest of the peasants!

  37. Anonymous

    The US Government/Treasury (aka Federal Reserve) will not go broke because they own the keys to the printing press. What happens? Zimbabwe comes to mind.

    This financial coup has no protesters in any meaningful positions.

  38. Richard Kline

    Ohhhh, my achin’ back. Carrying around all these failed plutocrats. ‘S better than a face full of sharpnel from a CDS Big Blow, but only by comparison. I didn’t get any sugar on this deal on the way up, but I’ll be scraping excrement off my sandal soles like the rest of us on the way down. Don’t we even get to see any failed aristocrats up against the wall with the safties off for this? *sigh*

  39. Jesse

    Does it make sense that the Fed keeps the 80% of equity AFTER being paid back in full over a two year period at LIBOR+850?

    Then if not, is it really a ‘purchase’ or an acquisition or something more like warrents that expire in 24 months?

    Not trivial if you are trying to value the shares, and the potential impact on the DJIA.

  40. Anonymous

    lune,

    You and I might be in the minority, but of all the Fed’s actions, I believe this bailout of AIG to be the most logical and protective of the taxpayer’s interests. I actually believe the Fed will come out on top in this transaction. Yes, I too want to tar and feather the people responsible for creating this mess. I too believe the gov should get out of the markets as much as possible, but given the current circumstances, this was the best outcome we taxpayers could expect.

  41. Anonymous

    September 16, 2008

    On the lighter side if you will:

    Dear Henry and Ben:

    There is a tragic, almost systemic, breakdown about to occur at the end of the month in my home town of Santa Cruz, CA. If I can’t make my payments due shortly (no pun intended) it will devastate not only my children and wife, but the local mortgage company (20 employees), my auto repair shop where my car is presently being repaired (10 employees), my local market (50 employees), and their wine staff (5 employees), and the local car wash (also 20 employees). This is just a beginning example that will ripple through our town to hundreds and even maybe thousand of innocent person including those that used to make a decent living pan handling quarters on our Downtown Pacific Garden Mall. Think of the devastation!

    And all of this can be avoided. Please remit $000,000,005,000 Billion to me by Fed Ex over night on the same terms that you just extended to Lehman and AIG. You know I’m good for it.

    Very truly yours,

    Earl L. Crockett
    Santa Cruz, CA

  42. Anonymous

    It only took a day but moral hazard’s back in town. Welcome to Wall St, the global capital of crony capitalism.

  43. Anonymous

    What about the parent company debt of AIG? It sounds like this secured facility gets repaid before debenture holders. And where is the CDS and other capital markets exposure in AIG–surely it conducted those businesses through a subsidiaries? What kind of capital support obligations did the parent company have to those entities?
    Is making the parent company debtholders whole part of the cost of this thing, or is it feasible to protect policyholders and counterparties without doing that+

  44. Hank

    Dear Earl,

    We would like to help out, we really would, but we’re just not geared up to write a check for $000,000,005,000 Billion. We’d have to retool, and it would be an accounting nightmare.

    Also, America wasn’t made the great nation it was by people thinking small. Face it, Earl, a few hundred people asking for a payout that none of us here can even count down to amount to nothing more than collateral damage. If you can arrange to overthrow an elected government somewhere, and kill at least a thousand or so bystanders in the process, get back to us. Otherwise, you need to quit whining and take one for the team like a good lemmingXXXXXX American.

    And another thing: when was the last time Santa Cruz elected a Republican? Face it, Earl, there are probably more registered Greens there than Republicans. Maybe you should ask the Japanese instead.

    It’s been a tough week, and I have an early tee time tomorrow, so I’ve gotta run. But we’re here to help, so drop us a line any time and best of luck.

    Hank

  45. a

    “I still want to burn at the stake the people who got us into this mess, but there are better ways to do it than to set fire to the entire world’s financial system.”

    Tell me, what are the better ways? I’m serious, I’d like to know what your ideas are. Wealth confiscation?

  46. Alan von Altendorf

    Sigh. Can you not see the obvious? If AIG was not rescued by govt, then in bankruptcy or otherwise CDS counterparties would have to unwind. By handing cash to AIG and LEH, all govt has done is keep $2 trillion default swaps unresolved and juiced the uncertainty.

  47. Anonymous

    More on the “Goldman angle” from Bloomberg’s article:

    “[New AIG CEO] Liddy is currently on the board of Goldman, the company Henry Paulson ran as CEO before becoming the U.S. treasury secretary in 2006.”

    Bingo! Another rampart of the economy’s commanding heights falls under Goldman’s control.

    This is cronyism and looting on an undreamt-of scale, in a caudillo-run banana republic.

    Leona Helmsley was right — little people are the suckers. The big boyz play by entirely different rules, in an alternate moral universe.

    That’s it; I’m givin’ up wage slavery and pursuing a glamorous life of crime from now on.

  48. Anonymous

    “What about the parent company debt of AIG? It sounds like this secured facility gets repaid before debenture holders. And where is the CDS and other capital markets exposure in AIG–surely it conducted those businesses through a subsidiaries? What kind of capital support obligations did the parent company have to those entities?
    Is making the parent company debtholders whole part of the cost of this thing, or is it feasible to protect policyholders and counterparties without doing that+”

    I don’t know about the priority of capital support obligations but the unsecured bondholders are automatically entitled to stand at the same rank than any future debtor, even if such debtor demands a lien on the asset (essentially, the unsecured bondholders gets automatically the same lien). What it means is that the collateralization is useless for the Fed from a credit standpoint, it serves only the purpose of having a loan that conforms to the format of section 13(3) of the Federal Reserve Act.

    Actually, the whole point of the exercise is anyway to avoid a Credit Event as per ISDA Definitions, because such events would force counterparties (Banks and various SPVs) to replace their terminated “hedge” derivative transaction with by a similar transaction with … nobody ! As the monolines, AIG was a “systemic risk warehouse” that wrote “low”-probability / high-loss protections and kept the risks in its books. No one is willing to take that role now so there is no replacement couterparty. Consequently, the underlying structure must be unwound, and it is such an unwind that creates havoc in the market.

    The Fed is buying time, but time is actually of the essence. I am convinced that it will more or less discretely ask all the counterparties it regulates to cancel their derivatives trades with AIG ASAP (and the foreign regulators will do the same), even if it means a loss for such counterparties. Once this is done, AIG is either back on its feet, or enters into a well-behaved run-off, something that happens routinely in the insurance domain.

    The Best case is that it indeed work this way,
    The worst case is that the couterparties stay put with their transactions and play the game of chicken with the Fed in two years time. Well, at least it won’t be Paulson’s and Bernanke’s problem at this point of time…

  49. Blissex

    «The Fed can make any investment it wants and just slap a “loan” label on it.»

    «By handing cash to AIG and LEH, all govt has done is keep $2 trillion default swaps unresolved and juiced the uncertainty.»

    «What it means is that the collateralization is useless for the Fed from a credit standpoint, it serves only the purpose of having a loan that conforms to the format of section 13(3) of the Federal Reserve Act.»

    As the above comments show, the whole set of deals is being structured around legal loopholes and accounting sophistries. Reminds me of the unlamented death of the 4th amendment.

    The letter and spirit of the law means nothing if the campaign donor class feels threatened.

    «They left 20% of the equity in the Fred/Fan conservatorship. Is this a formula? With the GSEs, there was no reason I can fathom to leave the shareholders in place.»

    As mentioned in another reply, keeping a purely fictitious 20.1% private shareholder interest means that certain provisions about the accounting of publicly listed companies are not triggered, and technically both GSEs and AIG are still off-balance-sheet, fully private, NYSE listed SIVs, I mean corporations, and no money has been spent by the Fed/USA, only a few “small”/”profitable” loans.

    As to some astonishingly naive comments above, the 8.5%+LIBOR interest rate is pure shysterism, because it is about the Fed as the 79.9% shareholder lending itself money to keep the company solvent.

    Loans by the controlling shareholders are treated as equity investments by any sane bankruptcy court.

  50. Anonymous

    In an economy that needs to and is trying to de-lever, how can it possibly be a good idea for the government to repeatedly protect debt holders from losses? How can the financial system provide badly needed equity capital when the government is essentially subsidizing debt capital?

  51. Blissex

    «but all in all, as the parties chose to bifurcate the deal into loans plus warrants, so would a court likely do so as well.»

    The problem here as hinted above is that a loan by a controlling shareholder to an insolvent controlled company will not be regarded as a loan by any sane court.

    If it was a minority investment and an arm’s length loan to a solvent company probably different.

  52. Anonymous

    Yves, I think it is odd that you think the GSE shareholders should have been completely wiped out but that the AIG shareholders deserve better than that. AIG was going to be filing Ch. 11 today if not for the government loan. The GSEs were still muddling through.

    I would argue that the government’s pre-emptive strike on the GSE equity was the trigger for the fall of LEH and AIG. Treasury’s action made it impossible for anyone financial institution to raise equity capital, just as Paulson’s lack of clarity on Treasury’s intent made it impossible for the GSEs to raise equity capital.

  53. Anonymous

    September 17, 2008

    Dear Hank:

    Thank you for your speedy reply. It restores my faith in my Federal Government, and politicians in general. And I do apologize for my weakness in the moment. I’ve been bent over grabbing my ankles since last Friday night, and the blood rushing to my head has caused me great confusion.

    But, as a good Lemming XXXXX American, I’ve sucked it up once again and have come up with a plan. I’ve decided to knock over the local branch of the Shadow Banking System, (SBS), but I’m having a real problem finding the damned thing, and felt really bad about it until I realized that you, and Ben, haven’t found the World Head Quarters either. So we’re in this together Hank.

    And one more request: In the event that I do find my local SBS Branch I would like you and Ben to go ahead and do one more of your many recent regulation hand wavings and make derivatives as fungible at my local market as Food Stamps. It would be a great help.

    Very truly yours,

    Earl L. Crockett
    Santa Cruz “Green and Mean” CA.

  54. Anonymous

    The whole deal is totally unconstitutional, Of course the very existence of the Fed is. It is about as much Federal Government as Federal Express. Where is Congress in all this, A Private Bank with more secrecy than the CIA has agreed to an $85 Billion loan for a private company AIG, and why do so many of you keep calling the Fed the government? They are a totally unconstitutional organization that was put in place in 1913 and all of their previous unconstitutional actions, deals and frauds have gotten us where we are today. This is just going to add to the problem. Congress didn’t even get to vote on this bailout. The comments who realize what a screwing the American taxpayers are getting are more right than most of them even can begin to realize. Just remember totally stepping all over our constitution and the Fed is not the Government.

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