The Federal Reserve Board has authorized the Federal Reserve Bank of New York to borrow securities from certain regulated U.S. insurance subsidiaries of the American International Group (AIG), under section 13(3) of the Federal Reserve Act.
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. This new program will allow AIG to replenish liquidity used in settling those transactions, while providing enhanced credit protection to the New York Fed and U.S. taxpayers in the form of a security interest in these securities.
How much this means depends on the price at which the Fed takes the collateral from AIG. It appears AIG is unable to sell certain instruments at prices it likes, and so is parking them at the Fed. Ahem, do we believe the prices the Fed is using to value this paper? If AIG can’t unwind them, one must wonder what they are really worth (although in this credit crunchy environment, it is possible that decent paper isn’t fetching very good prices. But when will more favorable markets return, pray tell?).
Another not-so-pretty aspect of this development is more obvious: $85 billion wasn’t enough? Did AIG misrepresent its cash needs, or not have a good enough grasp of its near term liquidity requirements? Or was this simply something a tad more defensible, that the market seized up on paper that would normally be salable?
And reader Marshall had another reason to take a dim view:
That they’ve got a new loan just tells me that we’ve truly crossed the Rubicon. No restraints any longer. Just stuff everything with money, money, money and forget about how much debt you have. It’s going to be like this until after the election I think. No deliberations, it just gets done.
When I read of the loan, I had assumed it was a parent company loan to cover AIG’s credit default swaps exposure. Tomorrow is settlement day on Lehman CDS. AIG was a major protection writer, and unlike investment banks, which claim to have hedged their positions (although offsetting swaps are the only means to do so, since the underlying cash bonds are, in the vast majority of cases, illiquid), there is no reason to think AIG did so, or at least did so consistently.
The Lehman settlement is expected to require dealers who wrote guarantees to pay out between 80 and 85 cents on the dollar. Lehman had $128 billion of bonds as of its last balance sheet, but CDS written are typically a big multiple of the value of the underlying bonds. That’s a long winded way of saying AIG could be writing some very big checks very soon.
But this is a different issue. Tomorrow, as they say, is another day.