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:
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.
Member of Congress
Cc: Douglas H. Shulman, Commissioner of Internal Revenue