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Alan Grayson Asks Bernanke for Answers in Latest Retrade of AIG Deal

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The ongoing tempest in a teapot about executive compensation at AIG appears to be a bit of Kabuki theater designed to divert attention from the real drama, which is the continuing sweetening of the deal to the troubled insurer. We will get to Congressman Alan Grayson’s pointed questions to Bernanke about the latest de facto handout to AIG, but we wanted to give some of the sordid context first.

Let us deal with some simple facts of life. Troubled borrowers pay a high rate of interest. And the Bagehot rule, a principle much admired by central bankers, but seldom observed of late, holds that the central bank should lend freely to a failing bank, against high-quality collateral and at a punitive rate. That was the logic of the original AIG deal, which from a structural standpoint, was the only bailout that made any sense.

But then the deal was retraded. The original financing was $85 billion, secured by all of AIG’s assets, with a interest rate of 8.5% over Libor, which translated into 11.5%, From the Fed’s press release:
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 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.

Now as readers of Andrew Ross Sorkin’s Too Big Too Fail may have noticed, there was a stunner in how this came about. Wall Street (namely, the god of syndicated lending, Jimmy Lee) has determined he could raise $50 billion on the terms outlined above, which fell short of what AIG needed. (There is another amazing vignette, when AIG needs a $14 billion overnight loan from the Fed, and Geithner demands collateral. CEO Wilmustad wonders how they will come up with that “in the next few minutes” and someone remembers “the unofficial vaults.” In the same office, AIG had “tens of billions” of physical bonds, apparently not recorded on the balance sheet. WTF? What kind of organization is about to run completely out of money, and then remembers it has “tens of billions” sitting around? Obviously someone DID know, and chose to keep that little fact secret.)

So why did the NY Fed suddenly decide to fund all on its own? Why didn’t the Fed just lend along side the other firms on the same terms? I’d much rather have a bunch of Wall Street SOBs overseeing AIG than the half-hearted minders at the Fed. When the financial services industry rescued LTCM, the consortium insisted, despite the howl of protest, that the LTCM principals receive a mere $250K a year (no performance bonuses) to wind down the operation. Adjusted for inflation, that’s less than $400K in current dollars.

Then we get to all the insane retrades of the deal, with no attempt at justification. Less than a month after the original deal, AIG was back to the well, and received an additional $37.8 billion:

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.

Now there had been discussion at the time of the initial loan that part of it was to cover a big hole in the insurer’s securities lending operations. Note that there was no mention of the terms, which are presumably less punitive than the original facility, and it glosses over the little fact that since the original loan was secured by all the assets of AIG, that securing this loan with those particular securities reduces the collateral backing the original $85 billion loan.

Then a week later, AIG asked for permission to borrow up to $10 billion under the Fed’s commercial paper facility.

Given the inability to latch on to more assets to support a loan, any normal lender would insist on even more harsh terms for incremental financing. And the evidence was clear, as of mid-October 2008, AIG was having difficulty finding buyers for its insurance operations. Even with the miraculous recovery in the stock market, AIG has still had trouble monetizing its supposedly valuable operations.

As we said back in November 2008, went in for a third retrade:

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….

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.

And what happened? The original facility was scrapped, a new one, nearly twice as large as the original ($150 billion) was put in place, with “considerably” more favorable terms. As we noted earlier:
.

… 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.

And we have had…..drumroll….yet another retrade! But notice how little attention this one received (and I have to confess I did not make noise about it at the time due to competing deadlines).

This time Congressman Alan Grayson has done the honors of questioning the logic of these continued subsidies to a ward of the state. This is the text of a letter he sent today:

Ben Bernanke
Chairman
Federal Reserve System
20th Street & Constitution Avenue, NW
Washington, DC 20551

Dear Chairman Bernanke,

I write with concern about two announced deals that are lauded by AIG CEO Robert Benmosche as AIG’s plan to ‘pay back the taxpayer’. In reading through the deal, it looks to me like the Federal Reserve is simply engaged in yet another disguised bailout of AIG. It’s not surprising that the New York Fed continues to shovel money at AIG using its balance sheet, since this seems to be official policy, but this time, the bailout also involves cheating the IRS.

According to AIG’s November 6, 2009 10Q and the announcement from AIG, the deal works as follows.

• AIG will owe $25 billion less to the Federal Reserve Bank of New York, in return for which the FRBNY gets preferred shares in two AIG subsidiaries.

• AIG gets to appoint the entire board of managers for both subsidiaries ‘owned’ by the New York Fed.

• The New York Fed loses its status as a creditor in the event of a bankruptcy.

• AIG will take a prepaid charge to earnings of $5 billion in return for giving up part of the credit line from the New York Fed, allowing it to escape tax liabilities.

• These two subsidiaries are placed in special purpose vehicles (SPVs), and those SPVs will still be on AIG’s consolidated financial statement even after these subsidiaries are sold to the New York Fed.

• AIG gets to keep between 95-99% of the upside of anything beyond repayment of the preferred share amount.

• The valuation of these two subsidiaries is at the sole discretion of the Federal Reserve.

This relationship is not significantly different from just making the subsidiaries collateral for the existing loan from the New York Fed, with four exceptions. One, the FRBNY’s rights are downgraded in this deal from creditors to preferred shareholders. Two, AIG gets to claim “repayment” and take a tax loss to reduce the company’s income taxes. Three, the FRBNY credit facilities are already collateralized. Four, the New York Fed owns nearly 80% of AIG, putting it on all sides of the deal.
My questions are as follows.

1) Considering that these subsidiaries haven’t actually been sold, how did you arrive at the valuation of these subsidiaries for the purposes of this deal?

2) Did you solicit bids for the third party group or groups that valued these subsidiaries?

3) Did AIG attempt to sell these subsidiaries in the open market? If not, why not? If so, what were the results of these attempts?

4) As the New York Fed owns most of AIG, this deal could be considered a faked sale to generate a capital loss for the purposes of injecting Treasury funds into AIG without the consent of Congress. Please explain the legality of the arrangement.

Thank you for your time and attention to this matter.

Sincerely,

Alan Grayson
Member of Congress

Cc: Douglas H. Shulman, Commissioner of Internal Revenue

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14 comments

  1. psychohistorian

    I love it! What a hoot.

    Congrats to Alan Grayson for asking pointed questions about the obvious criminality that is taking place.

    I have to go find me some Hopium to take now……

  2. NYT

    Some more questions: Why is it that 15 months after the first bailout, not a single large subsidiary of AIG has been sold?
    They have large operations in Asia and the markets have to a large extent recovered there so how come nobody wants to buy them?
    How come, according to Sorkin’s book, Buffett was asked if he wanted ANY piece of AIG, at what would obviously been a very distressed price and he still wouldn’t bite.

    Its almost as if the non-AIGFP subsidiaries are actually worthless or something.

    1. jdmckay

      Some more questions:

      Yah, I can think of a bushel of ‘em.

      I’d like to see these questions move up the ladder, publicly, to BO. He’s the CEO, he should explain.

      In comments to Yves’ links yesterday I mentioned in my garbled tags post every biz section I saw yesterday had headlines of Treasury’s improved projections on TARP balance sheet, and that I didn’t believe it.

      This is part of why.

    1. Dippy

      Win the ring toss an ya get a Kewpie prize too. Personally I keep mine in the sock drawer so I can gaze upon its glories at my leisure.

      Too bad one must win like a trillion rimes to get any thing worth bragging about. Still I had one win, and that is all that matters …eh.

  3. craazyman

    Senator Bernie Sanders of Vermont has a petition on his web site that you can sign to help send Chairman Bernanke back to Princeton — to resume his professorship of the sort-of-kind-of-body-of-every-once-and-a-while-a-real-thought that parades in various conclaves held periodically in the globe’s capital cities and in the pages of opaque and socially useless academic journals under the appelation “economics”. It used to be called “political economy” and maybe, when all is over, it will be again.

    Here is the petition:
    http://sanders.senate.gov/petition/?uid=5d1836fe-d883-42bc-af09-4e593a6cab76

    Alan Grayson for president! I gave Mr. Grayson $25 over the web, and I may give him another $25 if he keeps writing letters like that.

    But the only downside is that I now get daily emails from Democrat operatives warning about the threat Sarah Palin poses to our nation, and asking for more of my money.

    I wrote back, and said that I plan to vote for Ms. Palin if the Democrats can’t find a bigger stick when it comes to Wall Street. Although it’s admittedly hard to hit back with the stick the other guy gave you.

  4. Amit Chokshi

    Grayson is one of the only honest politicians around that actually cares for his constituents. Vanity Fair had a great piece on him a while ago. I’d love for this guy to run in 2012 for president but unlikely. The village idiots in the DC circuit think we need “centrists” irrespective of the consequence. So if someone says 2+2 = 4 and another says 2 + 2 = 18924, the “centrist” solution would be the average of the two answers.

  5. Francois T

    “I’d love for this guy to run in 2012 for president but unlikely.”

    Ditto. It is unlikely; however, Obama should be careful. He is already making noise that rings hollow and emanate a distinctive small of neoconsevatardism about how the money is tight when it comes to programs targeted at helping with unemployment. Anyone recall the President having the same problem with Afghanistan and Wall Street?…Not really!

    Pitch in a second leg of the Great Recession with Wall Street Grand Party going on unabatted and a worsening job situation, a health care bill that has all the trappings of cosmetic reform only, a failed financial reform and voila! He’d be in trouble in more ways than ones.

    And since we are in polite society, we shall avoid any mention of his dismal record on civil rights and his steadfast refusal to investigate anything related to abuses related to the so-called war of terror.

  6. Doug Terpstra

    Great post, Ives. A few more of these and those nice young men in their clean white coats will come to take us all away … ha-ha, he-he, ho-ho.

    Though maddening to read, the detangling you do, if not of immediate remedy, will offer important documentation for future historians to do a proper post-mortem on the American Empire.

    Taking a step back, it’s truly puzzling to ponder what is really the driving force behind such apparent burgeoning criminal fraud on the part of people otherwise not generally disposed to, nor significant beneficiaries of, such crime. One could conclude that they are driven by the sheer terror of reality that we are not privy to (“you can’t handle the truth!”) that will bring down civilization as we know it, perhaps Osama’s ultimate triumph. I suspect this is why there can never, ever be a real open audit of the Fed because the fraud has now gone too deeply into the rabbit hole.

    Grayson would be wise to get a remote starter for his car.

    1. Yves Smith Post author

      My understanding is that it was sent Monday afternoon, so it is a tad early to expect a reply.

  7. Charlie J

    Like most of you, I think it’s great that Grayson is asking tough, pointed questions about all the financial shenanigans that have been going on.

    But, please, he’s not Presidential material. He recently said that Republicans and Fox News are “the enemy of the state.”

    I served 14 years as a Marine officer and I’m still registered as a Republican. So he just called me an enemy of the state. Think about that.

    I’ll tell you this – if he had been standing in front of me when he said that, I would have decked him on the spot.

    Encourage him to keep after the financial stuff, but spare me the “he should run for President”.

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