The Wall Street Journal reports, as was rumored on Friday, that AIG appears on the verge of approving a considerably enlarged and sweetened rescue package from the government.
We were less than happy with the idea when it first surfaced (see our rant “The Black Hole Gets Bigger: AIG Back for Yet Another Bailout“).
Let us review the basics:
1. AIG came desperate to the US government for a rescue, and a whopper at that. The Federal government has no oversight responsibility for AIG, which oh by the way, just happens to have very large overseas operations (in other words, one could take the position that AIG’s problems, for a whole host of reasons, are really not the Federal government’s problem). However, having seen the disruption that the collapse of Lehman caused, and knowing that AIG was a substantial and unhedged writer of credit default swaps, the powers that be were worried that a bankruptcy could be cataclysmic.
2. The initial deal was punitive by design. Some key elements of the Fed’s loan:
– An $85 billion, two year facility with interest at Libor + 850 basis points (and note the 850 basis point was the commitment fee, payable on the whole amount; the Libor addition kicked on on funds drawn down)
– The loan was secured by all of AIG’s assets and those of its primary non-regulated subsidiaries
– The government received 79.9% of AIG and had a veto right on payment of common and preferred stock.
– The loan was to be repaid by asset sales
Now this could and should have been treated as a nationalization in all but name. The very top management was replaced (and realistically, only limited housecleaning would be possible given the specialized nature of many of their businesses).
The only reason the government did not take 100% of the equity was for the same reason they only took 79.9% of Freddie and Fannie in their conservatorship: going above that level would force the Federal government to consolidate their balance sheets.
But instead, stunningly, the accounting fiction, that AIG is an independent operation with rights, as opposed to a ward of the state, is not only being dignified, it is being acted upon.
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.
Well, that was the theory, but now the deal has been retraded twice. The first time was done with as little notice as possible, but the dispersal of another $37.8 billion was rather hard to hide. Per the Wall Street Journal story:
The U.S. government was near a deal Sunday night to scrap its original $123 billion bailout of American International Group Inc. and replace it with a new $150 billion package, according to people familiar with the matter.
While the proposed arrangement would considerably ease terms on the faltering insurer, it would give the government an unprecedented role as an actor in financial markets. It could also spark a political backlash, especially from congressional Democrats, because the Treasury, while adding to its AIG obligations, has thus far refused to extend a hand to the struggling Big Three auto makers.
Before we get to the particulars, read the overview. AIG is getting yet more money, now close to double the initial commitment, and the terms are being made more favorable. And not by a little. Note the Journal, hardly a critic of Big Business, used the term “considerably”.
As we discussed in our earlier post, 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. Back to the Journal:
Details of the revised deal could be announced as soon as Monday — when the company is expected to report third-quarter earnings — but remained in flux. Under the terms being discussed late Sunday, the government would give AIG more money, including $40 billion from the U.S. Treasury’s $700 billion Troubled Asset Relief Program. It would also demand less interest than on the bulk of the original loan, while freeing AIG from exposure to some of the risky financial instruments that nearly caused it to file for bankruptcy protection.
The $150 billion in government aid consists of a $60 billion loan, a $40 billion preferred stock investment and $50 billion in capital largely to buy and backstop distressed assets in two special financing vehicles.
Well, actually there is a reason, and it stinks to high heaven. Remember the original consternation about the TARP, when it was thought to be a vehicle for buying bad assets from banks. The only way that arrangement made sense was if the Treasury paid inflated prices, which served two purposes. First, it was a back door mechanism for recapitalizing banks. Second, the inflated prices could be used by banks holding similar assets for valuation purposes. When banks are reluctant to lend to each other because they are worried about the solvency risk of their counterparties, that means they already distrust their published financials. But the Treasury department thinks that making their statements even more dubious by letting them uses phony valuations is a solution.
And lo and behold, the Treasury is going to buy crap assets at amazing prices:
Under the terms being finalized on Sunday night, the government would replace its original $85 billion loan with a two-year duration with a $60 billion loan with a five-year duration. Interest on the loan would drop from 8.5% plus three-month Libor interest-rate benchmark to 3% plus Libor. (Libor, the London interbank offered rate, is a common short-term benchmark.)
Yves here. We aren’t to the dud asset part yet, but behold the nonsense. AIG gets a 5 year term, up from two, and a massive gift in the form of a 5% reduction in its rate of interest. A complete gimmie.
Every mortgage borrower in America whose bank has gotten any money from the TARP should write their Congressman asking to know why they aren’t getting a their interest rate reduced by nearly half. Ah, but I forget. Your bankruptcy, sadly, does not pose a threat to the financial system.
Back to the Journal:
In addition, the government would tap the $700 billion Troubled Asset Relief Program to inject $40 billion into AIG in return for preferred shares. Those shares would carry 10% annual interest payments. The government’s equity interest in AIG would remain at 79.9% following the changes.
Yves here. Um, shares do not carry interest payments. They can have dividends paid at a fixed rate. The terminology here is highly misleading and gives the impression that the preferred dividends have the same standing as interest payments, when they are subordinate.
Back to the article:
The government’s initial intervention was driven by concern that AIG’s failure to meet it obligations in the credit default swap market would create a global financial meltdown. (A credit default swap, or CDS, is essentially an insurance policy on a bond acquired by investors to guard against default. AIG wrote tens of billions of dollars worth of these contracts.)
Under the revised deal, AIG would transfer the troubled holdings into two separate entities that would be capitalized by the government.
The first such vehicle would be capitalized with $30 billion from the government and $5 billion from AIG. That money would be used to acquire the underlying securities with a face value of $70 billion that AIG agreed to insure with the credit default swaps. These securities, known as collateralized debt obligations, are thinly traded investments that include pools of loans. The vehicle would seek to acquire the securities from their trading partners on the CDS contracts for about 50 cents on the dollar.
The securities in question don’t account for all of AIG’s credit default swap exposure but are connected to the most troubled assets. Most of the trading partners AIG would seek to acquire the assets from are other financial institutions. The government may be betting that federal involvement will encourage the trading partners to sell the assets to the AIG vehicle.
A price of 50 cents on the dollar for CDOs across all tranches, particularly when the objective is to buy the dreckiest dreck (the ones where AIG’s losses on its CDS guarantees would be greatest) is simply breathtaking. It’s a wet dream for anyone who owns them.
Remember, this would be the price across ALL tranches. Recall that in Merrill’s not-all-that-long-ago sale of its super-senior CDOs (the very best tranches) it got a nominal price of 22 cents on the dollar, but that did not accurately represent the economics of the transaction. The hedge fund Lone Star paid only 25% of that amount (or 5.5 cents) in cash, the rest was contingent on performance. So Merrill might have sold the CDOs for as little as 5.5%.
Ah, I bet Lone Star is now scrambling to see if it won the lottery. If its Merrill CDOs happened to be guaranteed by AIG (and Sunday’s story by Gretchen Morgenson said they were until AIG got leery of its exposures) then Merrill (and BofA) have just gotten wildly lucky. BofA will get the maximum it was entitled to, and Lone Star, having paid only 5.5% of face in case, will get to recoup 50% less the 16.5% contingent payment it will have to make to BofA. So it will get over six times the amount it put as risk in less than a year.
Back to the Journal:
Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted back the contracts. The total collateral at stake is about $30 billion.
It may also have some unintended consequences across the markets. For the plan to work, AIG’s trading partners — the banks and financial institutions that are on the other side of its credit-default-swap contracts — may have to agree to any changes in the terms of their agreements with AIG.
Such changes could cause those partners, which have pried billions of dollars worth of collateral from AIG over the past year, to return some or much of the collateral. That could be a costly exercise for some financial institutions, because the cash they received from AIG has in recent months been a cheap source of funding for many banks.
The agreements may be difficult to work out. Some financial institutions that face AIG in credit-default swaps don’t actually hold the physical securities on which they purchased protection. Merrill Lynch & Co., for example, previously sold many mortgage CDOs it underwrote to European banks. Through a complex set of transactions, Merrill took back the credit risk of some of those assets and hedged that risk by buying credit-default swaps from AIG. When the securities fell in value, the European banks demanded collateral from Merrill which in turn demanded collateral from AIG.
Frankly, I regard this section as noise. The real objective is to overpay for the CDOs and provide a huge subsidy to the current holders, who are presumed to be banks (a lot of the really crappy late vintage CDOs were sold in Europe) but per the Lone Star example, some of the fortunate beneficiaries may turn out to be hedge funds. If AIG can unwind any of these CDOs, good luck. My understanding is that this has only been done in cases of payment failure. If the CDO is substantially held (meaning each of the tranches as well as the whole) by an entity friendly to AIG, then the game changes, but given the cost of unwinding a CDO, query whether that would be the best route to go.
This statement (from the middle of the story) sums up the sheer dishonesty of the entire exercise:
The revised structure is designed to improve both AIG’s ability to sell assets for a decent price and the taxpayer’s ability to recoup the money that has been pumped into the insurer. It also transfers to the government many of the risks once absorbed by AIG, potentially exposing the government to billions of dollars in future losses.
The phrase “designed to improve….the taxpayer’s ability to recoup the money that has been pumped into the insurer” is a complete and utter lie. The authors (Matthew Karnitsching, Liam Pleven and Serena Ng) and whoever edited the piece should be ashamed of printing such a blatant falsehood. The changes in terms, in every respect, make the deal worse for the taxpayer.
But for the Journal to perpetuate such pro-business rubbish is par for the course.
We said in our title that the AIG case constitutes looting. We refer to notion as set forth by Nobel prize winner George Akerlof and Paul Romer in their 1994 paper, “Looting: The Economic Underworld of Bankruptcy for Profit.” Its abstract:
During the 1980s, a number of unusual financial crises occurred. In Chile, for example, the financial sector collapsed, leaving the government with responsibility for extensive foreign debts. In the United States, large numbers of government-insured savings and loans became insolvent – and the government picked up the tab. In Dallas, Texas, real estate prices and construction continued to boom even after vacancies had skyrocketed, and the suffered a dramatic collapse. Also in the United States, the junk bond market, which fueled the takeover wave, had a similar boom and bust.
In this paper, we use simple theory and direct evidence to highlight a common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which countries took on excessive foreign debt, governments had to bail out insolvent financial institutions, real estate prices increased dramatically and then fell, or new financial markets experienced a boom and bust. We describe the evidence, however, only for the cases of financial crisis in Chile, the thrift crisis in the United States, Dallas real estate and thrifts, and junk bonds.
Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.
This is precisely what happened at AIG. Executives there are handsomely paid, yet senior management cast a blind eye as one unit earned outsized profits while taking risks that would have driven AIG into bankruptcy were it not for the Fed’s rescue. Before you say, “Well, it was just a few bad apples,” the biggest single job of senior management in a financial institution ought to be to assure the health and survival of the entity, which means risk management and control is top of the list (it was at Goldman when it was a private firm). Anytime a unit starts reporting very large profits, managers should be all over it like a cheap suit to make sure the earnings are not the product of massive risktaking. It only takes one aggressive trader plus inattentive management to bring down an entire firm, as Nick Leeson demonstrated with Barings.
But the worst is that not only was the initial AIG de facto bankruptcy a case of looting, the government has now decided to aid and abet AIG management in further looting. What pro-taxpayer purpose is there in the improvement of terms above? None. As we pointed out, there were only a couple of reasons for easing up on AIG, and they could have been provided for with minor changes that would not leave the taxpayer materially worse off. Instead, major concessions have been made to AIG, all to the detriment of the taxpayer. AIG management now has job security for five years (and AIG top brass is very well paid) and better odds of salvaging something for themselves when the five years are up thanks to the government giving them an unwarranted subsidy.
When the TARP was announced, we called it “Mussolini-Style Corporatism in Action.” Sadly, it looks as if events are panning out as foretold.
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“Instead, AIG is being coddled for no reason whatsoever”
The reason is political corruption and basically both major political parties are behind the moves. The financial sector has markers and they are being paid. Get use to it!
Doesn’t this fit under the “Banana Republic Watch”??
But let’s get real, this is NOT a democracy, it is a sham. There can be no outrage, because there is no alternative.
There is no fear in our political class. Paulson and friends can loot because they will walk, even should America crash and burn.
I see almost all our business leaders and politicians as sociopaths.
Our society is comprised of 350 million individuals. It cannot be represented by a few thousand people elected by corporations.
I read somewhere that (all together now) Goldman Sachs is long a lot of AIG CDS. Now it wouldn’t do to let Goldman Sachs be hurt even more, would it?
The lot of them should rot in prison if they live that long. Including their government enablers. How can the people stop this!?!? We rose to the occasion for the Paulson Bailout and at least made them uncomfortable. We need another coordinated push. But with Congress out and the election past, I do not know how we could scare them.
anonymous 11:57 you are right. From long experience in the corporate world I know that they are indeed sociopaths and reprobates. No punishment is too much. They cannot be reformed so lock them up and lose the key.
Anon of 11:57 PM,
Good point. I added that to the headline. Thanks!
Anon of 12:14 AM,
One thing to recall is that despite how upset taxpayers were, the media was 100% behind the bailout plan. They played up the "if nothing is done, the world as we know it will come to an end" line.
Now we have a new President coming in, and Paulson & Co. still up to their old tricks. The media tends to have an appetite for scandal. The trick is to somehow get stories like this on the radar of the MSM (obviously, excluding the Journal).
Excellent analysis Yves.
Such is the situation that nobody will blink an eye anymore. Bailouts for everyone and everywhere and anyhow.
All this distortion in the markets means that the resulting recession will be made much worse as the misallocation of capital continues to make the situation worse.
The sad reality is that the Big three automakers should entangle themselves in a further web of financial derivatives, claim the risk of systemic collapse and hence be saved by Lord Ben of FED Sachs.
You have to be too big to fail to survive it seems. Someday soon, all these firms will become too big to bail.
(Standing on chair clapping.) Best NC post ever. Or close to it.
I’m going to be so PO’ed if the Obama administration continues this kind of garbage accounting. I mean, geeze, if we’re going to elect socialists, they’d better at least know how to nationalize a company.
Call a spade a spade and put it on the freakin’ balance sheet! Be a man, assume the liabilities, seize the assets. It’s not like you can’t sell them later, if there’s anything left worth selling. (And my impression is with AIG there is.)
Thank you so much, Yves. You are indispensable.
YS:
This post echoes my thinking so closely it’s uncanny. Believe it or not, bankruptcy fraud is an enumerated federal crime, 18 USC 152. I see so much of it that is not prosecuted it used to disgust me, now I’m just numb. Look at Asarco, $8 billion of assets was taken from Asarco and no one has gone to prison. But some Joe Schmoe fails to schedule a $24,000 car on his bankruptcy form and he’ll get indicted. True story!
YS:
Ah, for the good old days when the Mob did bust outs for profit. They were small by today’s standards; all $2-$10 million in 2008 dollars. For a description of a bust out: http://skepticaltexascpa.blogspot.com/2008/07/london-banker-on-covered-bonds_30.html.
And PwC, AIG’s auditor, continues to treat AIG as a going concern and give it unqualified audit opinions. I have already said many times on my blog and elsewhere that PwC should be fired and the PCAOB should cut out the middleman and audit AIG (and Fannie and Freddie ) directly.
When you own 79.9 % of something, don’t you even get a few seats on the Board? How did this happen?
Yves,
I won’t comment on everything since there is too much. The one thing that you keep missing is that the AIG shareholders like myself never got a say in any of these deals. We were never given the chance to vote on the Chapter 11 alternative and avoid all of this government intervention. The reason why the deal got restructured is that the largest shareholders complained that they got sold down the river by the BOD which was only looking out for its own interest. That is why the government doesn’t have the right to tale 100% of our equity and completely nationalize out company. Punish the BOD or management but don’t punish the shareholders.
In addition, the old plan did not stabilize AIG. It would simply have bled cash, got downgraded further which would have caused more bleeding. It would have been a death spiral. They can’t sell their subsidiaries in this market. They needed capital to keep the ratings agencies from downgrading. That is what they got.
I think it is a good plan despite the fact that the 79.9% dilution remains. It is not a great compromise for AIG shareholders but better than what we had before. It is hard to say what is fair in the age of the TARP.
I agree that you did a great job. Wow. Don the libertarian Democrat
I’ll probably consider Buiter’s post, but you basically said it all.
Tremenduous work, Yves!
It is hard to imagine that my blood can boil again after so many Paulson outrages over the past 9 months. But Paulson’s latest outrage with AIG is unbelievable. First, Paulson and AIG rob the taxpayers for $85 billion. The cops don’t respond. So, Paulson and AIG rob the taxpayers again for $37.8 billion in broad daylight. The cops don’t respond. So, Paulson and AIG rob the taxpayers again for $27 billion in broad daylight and re-write the penal code reducing punishment for looting banks.
From 1999 to 2006 Hank Paulson as boss of the Goldman Sachs was overseer of the subprime CDO fraud and Ponzi schemes that fleeced investors and pension funds. Paulson greatest coup, and the thing that made him “boss of all bosses” was his July 2006 appointment as U.S. Secretary of the Treasury. Why lobby (a.k.a. bribe) government officials when you can become a government official yourself. And not just any government official…the freaking U.S. SECRETARY OF TREASURY.
Paulson has committed one outrage after another over the past 9 months. Now, under cover of TARP, Paulson has hired more Goldman Sachs banksters and other Wall Street looters and is committing the largest bank robbery in U.S. history…the $700 billion looting of the U.S. Treasury…in broad daylight.
Is there a federal prosecutor with the testicular fortitude to stop this serial looter?
“In addition, the old plan did not stabilize AIG. It would simply have bled cash, got downgraded further which would have caused more bleeding. It would have been a death spiral.”
This is exactly what should have happened to AIG, they just didn’t make the cushion big enough the first time. It became apparent almost immediately that the underlying value of AIG’s assets were worth considerably less than was once believed. I digress.
On a different note, consolidation of balance sheets can occur with as little as 20% ownership, as long as control is established. I believe it is on PwC to enforce this (yeah right), but I’m not far enough along in the class to really know the answer to that.
David. Boo hoo. Seriously. What part of bankruptcy don’t you understand? AIG was BEYOND TOAST. Your shares should be worth ZERO. The fact that you have any value left in those shares is because of a giveaway from taxpayers.
There is no responsibility on the part of the government to guarantee your shares. NONE. And by the way, the BOD wasn’t acting in their own best interest. They were acting in YOURS.
I will stop now before I start throwing insults at you. Your comment certainly warrants them.
AIG Part II:
Hank Greenburg as Hyman Roth
Technical Question:
Who owns the 79.9%?
USG or FED?
Where is Maverick McCain?
Hell, were’s Maverick Palin? If she wants to make a name for herself for the 2012 run, here’s a golden opportunity.
…AIG shareholders like myself never got a say in any of these deals.
AIG is insolvent. Shareholders are the first bagholders in line and have no legal say.
Them’s the rules of the game, sorry.
Gavin,
Obviously you don’t know the details. You apparently also don’t know what Chapter 11 is. It is for restructuring not liquidation. Shares don’t go to zero just because you go into Chapter 11. They would almost certainly have higher value if they didn’t give away 80% of the company in turn for a loan.
The BOD didn’t go into Chapter 11 because their lawyers advised them not to. In Chapter 11, they would lose the ability to fund their legal defenses with company money. It is in the news, go read about it.
What is wrong with some of you people? Why do despise the business world so much. Go buy yourselves some shares and quit whining. Geez.
anon,
There is a difference between cash flow insolvency and balance sheet insolvency. AIG has positive equity but illiquid assets. There is a way for dealing with such situations. It is called Chapter 11 bankruptcy. It doesn’t mean shares go to zero. People who don’t understand bankruptcy always think that. Shareholders most certainly have a say when there is positive equity in a business.
>Hell, were's Maverick Palin?
She can't spell AIG.
It seems to me that AIG should have to provide something in this exchange like performance or cash flow, or I don’t know … seems like some restrictions or terms should be kinda connected to the loan they were given and … ahhh, well, yah know, some accountability, some thread that connects the loot to the pirates — otherwise this would actually be stealing and someone like Paulson could end up in prison, for the rest of his life, where he can have lots of time for writing about the explanation as to why he thinks he can subvert The Constitution and distort the powers of The treasury and usurp power from Congress … ok, don’t get me started on how inept those retards are, and have been and will continue to be.
This is not a Banana Republic, it’s a genetically modified, Large Hadron Collider Mutation Nation — one nation, under mutation, divisible, without justice!
David,
With all due respect, you are off base in a very large number of respects.
First, you own shares in the parent company. That without a doubt has negative net worth. The only possibility of positive net worth is if any of the positive net worth in the subs could be made available to the parent. That in turn can happen only if the subs can dividend cash to the parent (clearly they can’t, due to regulatory restrictions or lack of excess cash) or the value in the subs can be monetized via their sale. That route is not open now, and may not be as attractive as you think in the future. The entire financial services industry is deleveraging, which means it is shrinking, and tons of regulations and tax rules will be rewritten. It is not clear how AIG’s subs will come through all these sea changes.
You seek to dismiss the issue of a parent company illiquidity problem as if the positive net worth elsewhere makes it OK. That reveals a frightening ignorance of how things work. Drexel Burnham Lambert went poof over a weekend over the very same sort of liquidity issue.
Your assertion that AIG could use Chapter 11 is dubious (as in it would not be an effective tool). Financial institutions are subject to triggers, such as withdrawal of counterparties and required posting of collateral that are not applicable to industrial companies. From the Wall Street Journal Law Blog:
An ordinary bankruptcy petitioner, like an airline or a steel mill, gets immediate protection from its biggest creditors by the operation of law: as soon as it files for bankruptcy, an “automatic stay” takes effect which prevents those creditors from going forward with lawsuits and seizing the debtor’s assets. Metaphorical runs on the bank are prevented, and management gets time to organize its affairs in a way that will, theoretically, maximize value for all creditors, and maybe even allow the company to reemerge in sound health. . . .With a financial institution, however, the automatic stay offers no protection against many of its most important creditors. In a trend that began in 1978 and was greatly expanded in amendments passed in 2005, most financial contracts — including securities contracts, swaps, repurchase agreements, commodities contracts, and forward trades — are unaffected by automatic stays.
Another reason most financial institutions go into liquidation is because once they are downgraded beyond a certain point, counterparties will not trade with them because they would be downgraded automatically. Reading between the lines of the second AIG rescue, the $37.8 billion, it was PRECISELY for that reason tha the Fed had to step in a second time.
John Hempton, who invests in financial institutions all over the world, thought he had a grasp of how bad the downside was at AIG but the latest developments have lead him to say things are far worse than he thought and he can no longer formulate a view as to how bad things will get. This is a professional investor who is an expert in this area. Yet you, who clearly from your various comments demonstrate that you do not understand financial institutiions very well, continue to assert that the board did you a dirty and you, with NO access to inside information, know better.
I suggest you steer clear from investing in financial institutions, period. You do not have a sufficient understanding of how they operate to assess the risks properly.
The simple fact is, which you refuse to hear, is you are bloody lucky your AIG shares have ANY value. They should by rights have gone to zero. And for you to have the temerity to say that your interests should rank above taxpayers, who unlike you, did NOT choose to take on AIG enterprise risk, also shows a lack of how capitalism is supposed to work. The government is not here to bail you out of your bad investment decisions, yet you are resentful that they have.
Don’t worry, Obama will fix it! He’s going to fix everything! Right…
Top job, Yves. Thank you for all your hard work
Thank you, Yves. You beat me to the slapdown. David honestly thinks the equity is going to make out better in Chapter 11. How little would you have to know to think such a foolish thing? The idea that people who are so ignorant like David, yet so arrogant to continue posting multiples times as if *they* really know what’s going on, is one of the great tragedies of life. Isn’t that like what Bertrand Russell once said? “The tragedy of the world is that the stupid are cocksure and the intelligent full of doubt”? I’d check it if I weren’t so tired. Great post, by the way. Having an outlet like this gives me hope for the future.
In fairness to Paulson & Co, the original deal with AIG was pretty much the only *good* one these guys negotiated. The government got a pretty good pound of flesh in return for 85 billion. The problem, IMHO, was the 700 billion slush flund which came afterwards, where Congress blindly authorized, with no oversight. This has created problems of fairness, and apparently it's a small coterie at the Treasury and the Fed which get to decide what is fair and what is not. Really, if the gov is giving away free money to Goldman Sachs and Morgan Stanley so they can pay their bonuses this year, why shouldn't it also give money to AIG? That's what a Democratic-controlled Congress authorized (in what one might call in hindsight a Faustian gamble to win the Presidency), and that's what we're getting.
What about this connection, i.e, Global partying with taxpayer loot… is there no shame anywhere, no justice, no one out there that cares?
RBS throws SECRET £300,000 champagne party… weeks after £20bn taxpayer bail-out
http://www.dailymail.co.uk/news/…r-bail- out.html
The Royal Bank of Scotland has blown £300,000 on a secret champagne junket for executives – less than a month after being given a £20billion handout by the taxpayer.
Bankers and their partners enjoyed the lavish party to mark their ‘success’ after a year in which the collapse of the banking industry led to global financial meltdown.
WOW!
I now believe that …
well, let me put it differently.
A prefrontal cortex removed from a cranial cavity and converted to spatter loses the capacity to direct the operation of a massive theft,
and this is the condign fate of the mind of one Henry Paulson.
Is there a patriot in the room?
Yves – you are becoming one of the best reads on the net!
Look for Paulson to give a mea culpa, like Greenspan, when he publishes his memoir in a year or two. “We HAD to do what we did!”.
Meanwhile, Joe taxpayer can just bend over, grab his knees and say “thank you kindly sir”.
a,
Agreed, The original AIG bailout was the only one I liked. It was punitive and it should have been punitive. AIG had no reason to expect any assistance, and they got it only because that they had made such a huge mess of themselves that they would bring down the financial system. And at the time, it looked as if there was enough value in the subs to pay off the parent company shortfall. AIG does have a lot of good businesses, at least in normal times.
But that parent company mess is lookin’ bigger and uglier with every passing day, which argues for a tighter leash (at least in terms of oversight, board seats, reporting) and an eye to still salvaging as much as one can for the taxpayers.
And I don’t buy these fairness arguments. Goldman and Morgan Stanley are important credit intermediaries. Even thought they are not banks (until recently) they do play an important in interemdiating between savers/investors and borrowers. Investment banks ate a lot of commercial bank lunches over the last two plus decades. Insurance is NOT a vital part of credit or capital markets intermediation, except for the way AIG and the monolines stuck their noses in, via CDS (and I hope that product is severely restricted in the future).
I do not see any reason AIG has to be treated the same way as banks and broker dealers. As I have said earlier, they should be incredibly grateful that they got any help at all.
@anon 3:18
I’d check it if I weren’t so tired.
* Force plays a much larger part in the government of the world than it did before 1914, and what is especially alarming, force tends increasingly to fall into the hands of those who are enemies of civilisation. The danger is profound and terrible; it cannot be waved aside with easy optimism.
The fundamental cause of the trouble is that in the modern world the stupid are cocksure while the intelligent are full of doubt. Even those of the intelligent who believe that they have a nostrum are too individualistic to combine with other intelligent men from whom they differ on minor points. This was not always the case.
o “The Triumph of Stupidity” (1933-05-10) in Mortals and Others: Bertrand Russell’s American Essays, 1931-1935 (Routledge, 1998, ISBN 0-415-17866-5), p. 28
Your rant seems to have played well with the crowd, but misses a number of points.
First, AIG primarily blew up because of CDS’s in their capital markets unit which was an investment bank, dealing with other banks. The original deal was to keep AIG from blowing up the rest of the financial system.
AIG was functioning as a bank, and within 2 weeks, banks got a deal similar to the revised AIG deal, but more favorable, from the TARP. This is doing nothing but making the terms closer to the TARP deals given the banks. But the revised deal is still worse, but closer to the bank terms.
Secondly, $50 billion will be used to actually buy distressed assets with uncertain value. Again, the purpose of TARP. Most of the other money has gone to supporting takeovers and is being used to replace capital from vanilla loans, not hard to value CDO’s.
Thirdly, no one is saying that the assets being bought to settle the CDS’s are going to uniformly be purchased at 50 cents on the dollar. That may be an estimate of the net cost across all the assets.
The details of this are the single most important aspect of the change, but they aren’t explicitly stated. Among other things, if AIG guaranteed a CDO, then they “own it” at 100 cents on the dollar. Frankly, the article doesn’t explain how AIG could actually buy the assets they guaranteed for 100 cents on the dollar for 50 cents. If they could, it would be a nice windfall for AIG.
90+ percent of AIG’s businesses have nothing to do with any of this. American General was having their annual sales meeting for agents and they entertained them. Big fucking deal. They will be making money and their value is 100% contingent on selling vanilla life insurance. Cuomo wanted to go to the press on this, but it was just marketing for a business that is making money AND that the government owns. Most of the 90% of these businesses are solid and profitable. They can be run as going concerns or they can just be closed down. It is on the government’s dime now — but it makes no sense to screw up functioning businesses. In normal markets, they could be IPO’ed for $100 + billion but there were no IPO’s in the last quarter.
Even though the common stock is now trashed, there is still a lot of debt that is owned by pension funds, etc. that doesn’t need to default. But it will if AIG isn’t wound down in an orderly fashion to maximize recovery by everyone.
” Insurance is NOT a vital part of credit or capital markets intermediation, except for the way AIG and the monolines stuck their noses in, via CDS (and I hope that product is severely restricted in the future).”
That is the primary reason AIG got bailed out. Once again, it was bailing out the counterparties.
I wouldn’t worry about anyone wanting to insure structured finance crap in the future, but feel free to regulate something that isn’t being done anymore.
If the investment banks are important, then AIG as the entity backstopping them is equally important.
Anon of 4;13 AM;
Your argument is spurious.
First, as Willem Buiter spells out at considerable length, the TARP deals have been unacceptably, egregiously generous. The fact that the Treasury entered into bad deals for the taxpayer is no excuse for continued bad deals.
Second, AIG is NOT an investment bank, it was NOT regulated as an investment bank (subject to SEC, and FIRA regulations and oversight, and the rulebook is extensive). It cannot claim the bennies if it was not subject to the restrictions. That is tantamount to saying if I was conducting operations without a medical license, I should be treated the same as a doctor if something I did injured a patient. A doctor that screws up can be sued for malpractice, which is civll. A mere mortal acting as a doctor without a license is subject to criminal prosecution. I suggest you drop the investment bank argument, it leads to AIG being guilty of even more serious misconduct that it already has committed.
Third, AIG was not conducting its affairs as an investment bank would, Investment banks, as they asserted (and people like me doubted but have been proven wrong) hedged the CDS they wrote in the vast majority of cases with offsetting CDS. The Lehman settlement proved that out. AIG was acting as an insurer, treating CDS as insurance products (ie writing policies) with completely inadequate estimates of loss exposure and hence insufficient reserves. There was no investment-bank like behavior, this was an incompetently-run insurance operation.
Your “second” point makes no clear argument, I wrote several posts at the time the TARP was proposed disputing the initial stated purpose as a badly designed back door bailout. Economists who looked at the initial TARP proposal were as universally opposed as you ever see in that profession. Invoking TARP version 1.0 as a defense of the latest AIG subsidy wrinkle doesn’t hold water.
Your “third” point does not address my observation, and shows ignorance of the CDO market. 50 cents on the dollar is a simply outrageous price, particularly, when as CLEARLY stated, the intent is to hoover up the most impaired CDOs (ie, the ones where AIG will have to pay out the most). If you were at all up on this market you would recognize that.
Your comment about “AIG has businesses that are worth a lot of money in a better market” is similarly irrelevant. Fine. Let AIG pay off the bloody loans when the markets improve.
Anybody who is not a huge financial firm too big to fail who his the wall because of his incompetence or excessive risk taking goes into bankruptcy. Why you argue that AIG is deserving of special treatment is beyond any logic.
Not sure I get the game being played.
AIG insured CDO´s (mainly to European Banks?). If AIG stays solvent then CDO insurance should pay 100 on the dollar.
CDO prices go down – AIG has to post collateral. Counterparties get cash. Money comes from US. IN bankruptcy counterparties do not give money back. US as creditor screwed.
But US could change laws of Bankruptcy. Senior government money higher ranking than counterparties. Counterparties very uneasy.
Or CDO prices higher marked – counterparties to give back money to AIG which could give money back to US. Then AIG sells subs, pay Government, no value left for counterparties who did not tender at 50. Banks figure out preemptively and tender at 50. Better 50 than nothing. Bluff works. AIG stays solvent. Does not sell subs. Writers of CDS on AIG stay alive.
Keeps stinking game going.
Any corrections/ideas on that?
Hubert,
1. AIG wrote lots of types of CDS, Euro banks the biggest piece I think but even then probably not a majority of the portfolio (anyone have a breakdown?)
2. AIG’s contracts were written along insurance lines, not ISDA lines. I don’t know the particulars, but you are assuming ISDA type provisions. Specifically, I think their collateral posting is triggered by rating agency downgrades and NOT by falls in values of the risk. Insurers do not have to put up collateral, that isn’t their model.
3. The US is NOT changing bankruptcy laws. Look how long it took to get the 2005 changes through and how they are unable to get a relatively minor change passed, letting judges modify residential mortgages under the same protocols used for commercial mortgages. It has been obvious since the Bear failure that they need rule changes for financial firm failures but this is simply not on the radar. It should be, but it isn’t even being discussed in the media, in op-eds, or by economists.
Thanks to Anon of 5:07,
you know the stuff better, but
could the collateral driver not be both: ratings downgrade together with market prices of CDO´s ?
A change in Bankruptcy laws (at least for financial institutions) cannot be excluded from an Obama government with their majority in Congress so far. It could -theoretically – happen quickly. 2005 was another time, another year.
Question aside: If you were an European bank, knowing what you know, would you tender at 50?
Great work, Yves. Wonderfully comprehensive and lucid.
I’ve always feared that AIG, not the Lehmans failure, was the elephant in the room. If something too big to fail is actually failing then where does this lead the majority shareholder, the U.S. Govt? What do they wish to achieve? Clearly the enterprise is bust and the business model that got AIG to its “too big to fail” position is dead therefore the end result will be the same as letting the business fail, except it will be the U.S. Tresury that will go belly up.
Yves, great post. AIG is a good example of why ‘too big to fail’ will always bring out the worst in company executives…GREED.
From the company execs point of view there were few possible outcomes of their actions, none of them bad for people that had already collected enough money to live well the rest of their lives.
The company is liquidated in bankruptcy. Small chance because of blowups of CDSs (I suspect that some of these are synthetic with little or no value). Prosecution for negligence? Little chance because so many Friends of Paulson would become subject to prosecution. Legal nightmare would ensue.
The Fed Gov steps in and pulls their fat cat fat out of the fire. Home free plus operations continue with parties and paychecks.
So, the risks that the AIG fat cats took for big bonuses and paychecks were very small compared to the rewards. The fat cats might not be able to evaluate the risk of a CDS but they certainly could evaluate the small risk they took for large personal reward.
This is why ‘too big to fail’ is allowed to continue…It is for TPTB only, not the unwashed masses. Lord Acton was right, the real battle is between the banks and the people.
DEEP down in the bottom of the black hole of AIG is a black box of SECRETS. One can only speculate what that black box contains. Some already have.
If you really want to know WHY AIG?, do some detective work, connect the dots and draw your own conclusions.
keywords: AIG, Kroll, Convar, Marsh
Yves,
You say some pretty incredible things. The holding company that I own had full equity interest in the subsidiary companies. The subsidiary companies are worth a lot more than than book value. People have estimated the break-up value of AIG to be more than $250B. It is not hard to believe considering the strength of the underlying companies. Everyone knows that. Of course in this market, they may not be able to realize that value if sold. But in Chapter 11, some of their debt could be swapped for equity. Whether or not this would have worked out well for AIG shareholders is impossible to say. However there is some likelihood that doing so would have been better that what has happened. The shares have dropped in market value from $70 to $2. How much worse could it get? Well, the $2 could go to zero I suppose. But it would have been worth the attempt rather than simply giving up and seeking government help. At least in Chapter 11, we start out with full equity interest in hundred of billions of equity. Plus, for the bond holders there is damage beyond the shares going to zero and therefore the have incentive to avoid fire sales.
Of course the decision to avoid Chapter 11 had nothing to do with getting the best value for shareholders. It was a deal between the BOD and the government which each had different motives. As much as I feel for the taxpayers, keep in mind that us shareholders never asked for help. We never even got a say. Greenberg and others agree with this sentiment. They all think they would have been better off in Chapter 11.
Most of all, these liquidity issues could have been dealt with in other ways. The mark-to-market accounting rules should never have been allowed to reek havoc on our markets but that is another argument all together.
I appreciate you spending the time replying but I don’t feel that you are looking at the situation in an unbiased manor. I would rather you address the facts of my argument rather than simply dismissing my point of view and calling me naive.
Is the paper “Looting: The Economic Underworld of Bankruptcy for Profit.” available free anywhere?
David said…’The mark to market accounting rules should never have been allowed to reek havoc on our markets but that is another argument altogether.’
Yes, lets all value our assets at whatevery fantasy level that we desire. This is typical of the thinking that got the markets into the current train wreck! One of the markets primary reasons for existing is to provide a PRICE FINDING MECHANISIM. You want to find your own prices and disregard the market function? Good luck selling your stock or whatever assets you own at a price that you set on them…beyond ludicrous.
Everyone is fine with markets discovering prices when assets are rising but when the bubble bursts and prices begin to fall suddenly the market is not pricing assets correctly and we need to disregard what the market is telling us about prices…Privatized profits and socialized losses…beyond rational.
The market exists for all and AIG, nor any other entity, is, or should ever be, an exception to the market. To believe and act otherwise is to abandon capitalisim for some other form of economy.
A Trillion Is An Unimaginably Large Amount
It would take almost 12 days to count to 1 million at the rate of one number per second.
It would take almost 32 years to count to 1 billion at the same rate.
A trillion would take 31,720 years.
In the case of AIG’s $150 million bailout, if the bandit Paulson dispersed $1 per second, it would take him 4 years and 9 months to give away our money.
David
If I get a margin call (as AIG did) and cant meet it, (as AIG cant) can I declare a liquidity issue and argue its the market, not me?
THE AIG BALANCE SHEETS
(The Adams Family)
WilliamBanzai7
Their creepy and their kooky,
Mysterious and spooky,
Their all together flukey,
The AIG Balance Sheets.
Their office is a museum
Where people come to see ’em
They really are a scream
The AIG Balance Sheets.
(Black Hole)
(Opaque)
(Indeterminate)
So get your Bailout shawl on
and some drums that you can roll on
We’re gonna pay a call on
The AIG Balance Sheets.
http://ftalphaville.ft.com/blog/2008/11/10/18033/aig-not-an-insurance-company/
That makes three TARPs
– The TARP
– Fannie and Freddie
– AIG
They are like tribbles, these TARPs.
People have estimated the break-up value of AIG to be more than $250B.
I’ll bet they have. People estimated Iraq War 2 would make money, too. And in any case, what are those generally-heavily-invested companies worth *now* when the stock market is down almost 40%?
That said, I agree that at this point AIG should go into bankruptcy. If this throws European banks into undercapitalization, we should deal with that directly – it would be more efficient than the backdoor bailout, where the bailing will go to many other interests, including AIG stockholders, AIG bondholders, and nonessential AIG CDS owners. And, if the assets can pay off the debts, the stockholders should get the remains.
It’s become a hobbyhorse of mine that the bankruptcy system is fundamentally very good and based on a lot of practical experience wrestling with thorny financial, legal, and moral issues. When anybody tries to come up with an on-the-fly replacement for bankruptcy, like these AIG bailouts, the result is inevitably grossly inferior. Centuries of hard work and thinking by intelligent, experienced, and mostly unbiased judges and philosophers can’t be matched in an emergency coffee-fueled overweekend bailout negotiation. That’s a real “Duh!”
Oh, and Yves – GREAT analysis. Have you applied for a job with the Obama administration?
I truly hope Yves continues this amazing blog and isnt silenced by the new bosses in town
Maurice “Hank” Greenberg, once floated as a possible CIA Director in 1995, is the CEO of AIG insurance…In the China trade, Greenberg became very close to Shaul Eisenberg, the leader of the Asian section of the Israeli intelligence service Mossad, and agent for the sales of sophisticated military equipment to the Chinese military. From 1988 to 1995, Greenberg was a director of the New York Federal Reserve bank – this branch of the system is the main instrument through which Federal Reserve chiefs and the Bank of England traditionally execute their U.S. political-economic policy.
In terms of the ACTUAL deal that was announced (and I recommend people read the joint Treasury/Fed announcement word for word rather than filtered through the prism of others), it looks like the Fed has taken note of Volcker’s arrival and the departure of Bush and Paulson in consenting to this restructuring.
The clear inference is that they are now willing to place MODEST additional bets (read the joint statement carefully to learn where the Fed REDUCES its exposure) that in 5 years the situation will be much more stable.
This is consistent with Volcker and Obama making a full fledged assault on what Bernanke warned (OVER the objections of Paulson) was the key accelerant of the tsunami: preventable foreclosures.
Look for Volcker to be involved in a hands on way with formulating an innovative, unique housing rescue plan to be announced no later than January.
You won’t find details of that plan in the American press any time soon.
Further details will likely be leaked in the British press in the next few weeks.
The details are highly likely to surprise you and Roubini.
That’s my view.
Matt Dubuque
Anonymous at 9:51.
Stay current and stay factual.
Greenberg is NOT the CEO of AIG.
He was fired.
Matt Dubuque
The substance of this post seems to be ‘the government is doing a shadow bailout on sketchy terms.’ I agree that is undesirable.
However, to the extent that the government is determined to do a shadow bailout, I can see why they don’t want to let AIG fail. Since AIG is such a large counter party, it serves as a relatively centralized clearinghouse for funneling money to all the people who made bad bets.
If the gov’t lets AIG fail, but is determined to continue its bailout policy, then it must turn to bailing out all of AIG’s counter parties individually, which would be much more difficult.
The problem that makes this situation perpetually unworkable is the familial connection between gov’t and Wall Street. The heads of each change places as often as elections. With two functions so interbred that they are really just one function, how can we ever expect impartiality and objectivity? All involved will alwaays take care of each other at the expense of the common citizen.
Yves, there is no possible way you can know whether 50c on the dollar is a fair price for a CDO without knowing a great deal about the specific CDO’s collateral. No way.
Yves,
I am sympathetic to your rant, but suggest that there is another way to look at what is happening. As you say, the government already owns AIG in fact. So any financial flows between AIG and the government are just rearrangements of the de facto unified balance sheet–like internal transfer pricing on a corporate balance sheet. At the moment the govt has decided it does not want to consolidate the balance sheets, for political reasons mainly, but that should not mislead us with regard to the underlying economics. AIG was insuring CDOs, so now the government is insuring CDOs. My information is that for the most part AIG was insuring the highest tranches, not the lowest. Now that AIG and the monolines are no longer writing such insurance, the market in the underlying is frozen. Maybe that is the underlying motivation for government action? Or am I being too charitable.
Yves-
I suspect the reason for sweetening the deal is because the TARP has created a new ceiling in terms of punitive measures (i.e. anyone that needs bailout will get terms at least as sweet as the initial bailouts under TARP), and there will soon be a race to the bottom for sweeter and sweeter terms as deals get negotiated.
I wonder though: when the govt hits the $700bil ceiling — which it will reach very soon at its current burn rate — it will be forced to choose between two options: 1) ask Congress to raise the limit, or 2) sell the assets on its balance sheet in order to free up cash.
I’m not sure Congress is willing to raise the limit since the election is now over and also since they’re drafting new fiscal stimulus plans themselves, although the stupidity, recklessness, and cravenness of the current Congress shouldn’t be underestimated.
If that’s the case, the Fed will need to start selling the assets on its balance sheet. Will we at that point finally have the open sales that so many people have been calling for? After all, who has the cash available to give the govt an artificially high price? And will that finally constrict the Fed from paying astronomical prices for junk? After all, if the Fed buys all this crap for 50c/$, but is forced to sell it next month on the open market and only gets 5c/$, we’ll finally have a true price.
If the Fed doesn’t sell assets because it knows the prices will be stunningly low, then they will be forced to cease their bailouts (again, assuming Congress can’t be hit up for another trillion or two), meaning banks which need cash will have to sell on the open market again.
In other words, there might be a silver lining yet, Yves, albeit one costing $700bil :-) After exhausting $700bil, there is no one left to bailout the Fed (assuming congress stands firm, a big if), which means we might finally see asset sales at true market values with no tinkering or manipulation from side parties.
Matt Dubuque is right to suggest reading the actual statement. Look at the two new facilities being created.
The first one especially seems to be nothing more than a consolidation of the joint balance sheet. AIG has apparently been borrowing Treasury securities from the Fed, using RMBS as collateral. Now that the govt owns AIG, it is eliminating the loan and taking the collateral, nothing more.
The second one does involve purchasing CDOs, but only CDOs on which AIG has already written CDS, which means that the price paid for the CDO has no balance sheet consequences. If you pay a high price, then there is less insurance payout; if you pay a low price, then there is more insurance payout.
Matt,
Curious on what an innovate housing program looks like. Mcuh as the alchemy of wall street has convinced people that assets prices are a function innovation, they are not. They are a function of underlying fundamentals. And the idiotic idea postulated by CBS dean hibbard to refi everyone into a fixed rate at X is more of the same. Asset prices clear when they become aligned with wages – see Yves pwrite up on stangant wages and the debt plug.
So while the populists would have you believe that there are all these victimized home owners, it would interesting to hear how much equity in total these people collectivily had at risk. i doubt very much frankly, but that is a hunch.
Frankly the route that seems most ammenable to the government at this point is a bond insurance like solution that buys time and is capital light. The American way. So now we have the GSEs to buy the debt and the governement through its wholey owned sub AIG now inures the mortgages/restructurings.
Volker is on record repeatedly saying this is the worst and most complicated thing he has seen in his lifetime. he ahas sauid there is a fundamental mispricing across asset classes that has been ongoing for a long time.
it would be reassuring for people to stop ataliking about propping asset prices to save banks. The irony is this is populism. perhaps if we spent less money propping up failed business models like GS, allowed bondholders to eat cake there would be plenty of cash available to ringfence depositors. While they are at it abolish the Fed and let interest rates fuind their own level.
Asset prices are a function of income and prospects not the other way around. Didn;t hoover try this with inflating wages to keep up consumption?
My big things in the anti-Obama tax/economic rants has been these people need to pay attention to what is happening now rather than what has not yet happened.
The future may well lead to whatever feared financial/economic/big gov policy, but right under their noses everything they fear is already happening.
Yves, after reading your post I got a bleak vision of the Indonesian mud volcano: Created by humans that should have known better than drilling there. But so far nobody was able to plug the hole to stop the mud flow. Now you have a post-apocalyptic countryside with villages sunk in black muck. In case you need a new metaphor, maybe some of these photographs will do? http://mudflow-sidoarjo.110mb.com/
Thanks for the detail. With the news today, AIG looks worse and worse. It’s ridiculous that they’re allowed to do this.
I voted as a Republican in early voting but the actual election day came and I found myself actually regretting. The Democratic Congress held off on approval of this bail-out and all the others until they received intense scrutiny by the public and President Bush to move forward or else. Now Obama has to deal with all of the mistakes made in the last 4 years and it is am impossible task. Our debt can only be reduced by all of us being taxed higher and that is not his fault. We must pay for the bailouts under a Republican President and his spending. While I am a Republican, I am embarassed to say it out loud because we are in this mess during a Republican’s reign and Republican’s are against capitalism and nationalism and here we are. This cannot be pinned on the Democrats. They held back and now we will all reap what we have sown! This mortgage mess started during Bush’s first 4 years and now has imploded and caused markets around the world great problems. If Obama can even do anything during his 4 years except keep the country positive it will be a miracle.
Mrs Smith,
your post is delightful, and your indignation is absolutely appropriate.
But, I do not agree with the last sentence: ” When the TARP was announced, we called it “Mussolini-Style Corporatism in Action.” “
I think that Mussolini made a lot of good things BEFORE linking himself and Italy to the nazis. And, above all, I’m sure that you really do not need to search examples abroad if you want to explain how a country is looted to the benefit of the few and well connected and to the expense of all the ordinary people.
Haven’t follow AIG extensively, but even a superficial understanding comes up with at least 3 material misrepresentations/ errors in this rant.
1. The CDO’s backed by AIG that the Fed is buying are NOT “across all tranches” since AIG only insured the super senior portion by definition. The idea is for the Fed/ AIG vehicle to buy the CDO’s insured by AIG and release AIG from the obligation to post collateral. Putting this off balance sheet makes sense since it is part of the TARP and by definition not a liquid trading security with market values.
2. AIG stopped writing insurance on CDO’s at the end of 2005. The earlier CDO’s are more sound. So a comparison with Merrill’s sale at $.22 is complete nonsense. Merrill ramped up its underwriting of trash debt into 2006 and 2007. The dirtiest trash from the later years that Merrill couldn’t sell is what Lonestar bought at $.22.
3. Regarding the Loanstar sale, characterizing the price paid by Lone Star as “contingent on performance” is silly. Lone Star paid in equity (25%) and borrowed the rest (75%) from Merrill. Still lone star is on the hook for the first loss.
Based on these observations, it’s not clear that $.50 on the dollar is too high a price to pay for the asset- a supersenior CDO tranche from 2005 and earlier.
This is still a good deal for AIG. Regardless, the government owns 80%, so 80% of the benefit from reducing the interest rate accrues to the government.
Squeezing another 10% out of AIG could very well be counterproductive if customers continue to flee AIG’s core businesses. Or you could nationalize the thing and let Congress run it, with the treasury guaranteeing all debt. I doubt either scenario would produce higher returns for the 80% government shareholder.
The government is going to make a killing off of AIG, even with this “sweetheart deal”.
Rather reminds me of Grand Theft.
This is all to fishy. AIG is not worth saving.
doc holiday said…
It seems to me that AIG should have to provide something in this exchange like performance or cash flow, or I don’t know … seems like some restrictions or terms should be kinda connected to the loan they were given and … ahhh, well, yah know, some accountability, some thread that connects the loot to the pirates — otherwise this would actually be stealing and someone like Paulson could end up in prison, for the rest of his life, where he can have lots of time for writing about the explanation as to why he thinks he can subvert The Constitution and distort the powers of The treasury and usurp power from Congress …
—
Yes, the taxpayers
have the “moral right”
to know how there tax
dollars are spent…
By the way, in Canada
we sometimes have
commissions of
inquiry presided over
by a Federal judge with
a mandate (or terms of
reference) given by the
Prime Minister. It’s
the same as roughly
as court proceedings,
but there are no
penalties; only a report by the Commissioner . It’s good
and the UK has them too.
Finance Ministers of
the G20 less the US
have met in Sao Paulo,
Brazil. The British
and Europeans are
pretty much all agreed
that more regulation is
needed in the financial
markets. The G20
Heads of State will
meet Nov 15 in
Washington, D.C .
regards,
anon
Matt D…
As J K Galbraith famously stated…’Finance does not lend itself to innovation’. Imo, he was right.
As evidence I submit that innovation is the reason we are riding in this train that is involved in a slow motion crash.
More of the same is unlikely to stop the wreck.
Fantastic article Yves.
How AIG is soaking up billions which could be put to far better use is outrageous. Imagine $140bn invested in green post-oil energies, nationwide free broadband, Medicare, anything would be better.
If this “bailout” of AIG occured in a fictional story 2 years ago. Then the only nuttier addition possible would be to reveal the Illuminati secretly in charge of the Fed – and AIG in secretly in charge of the Illuminati!
I’m holding my breath for this news :-)
Just a guess, but considering what happened to GS stock price today, I think what this deal means to AIG’s supersenior CDS counterparties is the following: You can treat the collateral you have received so far as all you’ll get. Take it and shut up or we’ll put you on Geithner’s undesirable list.
Maybe the Fed’s even planning to play hardball and tell the counterparties whatever collateral you had at the time of the first bailout is the limit — or we take it out of your hide in other ways.
This show is getting interesting.
All very interesting. I could make a far stronger argument for saving the US auto industry than i can for the financial industry. With Financials, if an entity goes under, another can take it's place almost immediately – the main disruption will be to the financial companies' shareholders and employees. They deserve the disruption in any event, due to mis-management by employees, and inattention by investors.
The industrial sector is something else. While equally mis-managed, having GM go out of business would be a much bigger issue for the US. First, a significant amount of "plant&equipment" would immediately go to seed – and would likely take a long while (if ever) to get re-started. The ripple effect of employees, suppliers, dealers, and so on, would be much greater than even AIG failing completely.
I've been swimming against the tide for years on the point of manufacturing – but it remains true that only in manufacturing is true value added and wealth created.
I would vote to take back all of the $700Billion (or whatever number it is) from financials, and if we must use it – recreate the manufacturing sector.
I’m the “bad” anonymous poster from above…..
“A price of 50 cents on the dollar for CDOs across all tranches, particularly when the objective is to buy the dreckiest dreck (the ones where AIG’s losses on its CDS guarantees would be greatest) is simply breathtaking. It’s a wet dream for anyone who owns them.”
I don’t think this is what is happening. I think they are buying them at 100 cents on the dollar.
http://media.corporate-ir.net/media_files/irol/76/76115/reports/Nov%2010%20Investor%20Presentation%20FINAL%2011%2009%201050%20PM.PDF
If you go down to page 5 and look at multi sector CDO’s you will see that they are planning on buying all $70 billion of them back from the “insureds” for lack of a better term. Financing Entity #2. AIG puts up ALL their collateral $35 billion. AIG puts up another $5 billion. FRBNY loans $30 billion.
They offer to “settle up” with the insureds and if they have them, the “insureds” will just tender the CDO’s to the Entity. If they don’t have them, they will have to do something – either buy an identical CDO, agree on a similar CDO, or come up with some sort of cash settlement price.
That part could get interesting.
Anyway, when it is done, then AIG will own the CDO and the first $30 billion will go back to the NYFRB. If they actually draw the $30 billion.
The stuff is totally gone from AIG’s balance sheet and most of it (if not all) of their $40 billion has been written off.
Either way, it is totally gone from AIG.
The CDO’s will likely sit in the entity until they mature and the cash is whatever it is. $70 billion in CDO’s is gone from the financial system.
That’s the way I read it anyway —
Pretty much a nothingburger.
They insured the entire CDO’s — 100 cents on the dollar. They get the CDO’s and the FRBNY owns whatever they loan (up to $30 billion) subordinated by AIG’s $40 billion.
If this isn’t it, then maybe someone else can explain it.
The very top management was replaced (and realistically, only limited housecleaning would be possible given the specialized nature of many of their businesses).
Fine. We conscript them just like soldiers. They work for board and keep until all the money is paid back and just like soldiers, there is no quitting without a firing squad. I’m just progressive at heart.
Good find on that presentation. I don’t understand the “cash collateral” portion though…where does it state that that collateral is being put up by AIG, and why would that be purposefully separated from the “Investment from AIG” part?
If you want to see why Lehman was allowed to fail, but AIG could not be, look no further than their CDS positions. Lehman was a market maker. For the most part, it bought contracts from Bob for ‘x’ and sold them to Frank for ‘X+.’ When Lehman disappeared, Bob and Frank were, in many cases, able to pair off the trade and face each other. A lot of such netting was done over the weekend as Lehman was going kaput.
AIG, on the other hand had convinced themselves they were “writing insurance,” when in fact all they were doing was writing puts on crap bonds. But they were short default protection tot he tune of $440bn. If they had ceased to exist as a counterparty, that wouldn’t have netted out so good. The AIG bailout is not a bailout for AIG per se, its a bailout for the bank counterparites who have CDS trades on with them, Goldman Sachs chief among them. The banks are being allowed to raid the Treasury to extract their winnings on trades with AIG, when the banks themselves cleary failed to do their counterparty risk homework.
One last point, the Fed, in ‘loaning’ $30bn to the LLC which will be buying garbage CDO, is effectively undertaking the activity that was supposed to be carried out by the Treasury Dept. under the TARP legislation. But because treasury is pissing through the $700bn liek there’s no tomorrow, by pouring it into the bottomless pit of financial system capital losses, the Fed has stepped in to do the garbage collection, er “troubled asset” purchases, which will effectively be monetized
I agree with Briangobosox, in that Goldman had a vested interest in the survival of AIG – they had approximately $20 billion in exposure to trades with AIG. And, all forms of risk assessment were tossed out the window by every player in this pathetic drama – along with lending standards, of course. SplendidMarbles
worker,
If the WSJ piece is correct, your assertion is wrong. The purpose is to unwind the CDO. To do that, you need at least a majority, in some cases 2/3 or 3/4 of ALL the tranches to effect an unwinding.
In addition, a recent New York Times story discussed the AIG swaps unit at great length. It did not start reporting losses until late 2007 and its head was presumably fired this year. Although the story does not give exact dates, it is pretty clear that the head of the swap unit was active at least through the middle of 2007. Your assertion that they quit writing business in 2005 looks badly counterfactual. They cut back their involvement with Merrill, but there were PLENTY of other CDOs being written (n fact, London, where the group was located, was a far bigger center anyhow, and the worst stuff was sold into Europe in 2006 and 2007).
As I recall the discussion of the Lone Star deal, I recall reading reports (not here) that they payment of the debt WAS contingent. Those reports may have been in error, but Yves did not make this up. I saw it as well.
worker, this is 8:05 again.
I found it. Yves is correct and you are wrong. The loan was explicitly non-recourse to Lone Star.
http://www.portfolio.com/views/blogs/market-movers/2008/07/30/the-mystery-of-merrills-asset-reduction?rss=true
And I pretty certain you are in error on your second point. The purpose of the exercise is OBVIOUSLY to by the CDOs where AIG’s loss exposure is highest. And while I am not certain how far into 2007 AIG was writing CDS, they were doing so in 2006 and some portion of 2007.
“kfunck1 said…
Good find on that presentation. I don’t understand the “cash collateral” portion though…where does it state that that collateral is being put up by AIG, and why would that be purposefully separated from the “Investment from AIG” part?”
I have no idea why the only place the collateral is mentioned is in the pitch slide. However, it makes sense in that AIG has already written off $30 billion and it was the cash calls that were causing havoc.
If I am correct, the portion of the rant regarding valuation of CDO’s is moot.
There is a lot of information on the AIG web site, and it is clear that AIG has already written this stuff down.
It is also clear that they have posted collateral and are probably having all sorts of issues with their counter parties.
http://ir.aigcorporate.com/phoenix.zhtml?c=76115&p=irol-financialreports
Since the collateral is almost equal to the amount written off, maybe it was thought to be simpler to present it this way.
I see what you’re saying about the cash calls, in that they should net out/be returned in the event that CDO they are collateralizing is purchased. However, it only appears moot if you believe that they wouldn’t be booking future losses on those CDOs. If that was indeed the case, they wouldn’t be moving them off the books to begin with. From the systemic risk angle, this actually appears to be a proper move (if they indeed are systemically risky), albeit likely still an expensive one, and therein lies the rub.
River,
Your mocking of the idea of changing mark-to-market accounting is cliche. I could write book on it but I will try to be succinct. First of all, MTM is applied in rather arbitrary ways. True banks for example do not have to apply it to things they hold in “Held to maturity” portfolios. They can ignore the value of their agency obligations if they fluctuate from par. They still have to report it, but it doesn’t count towards capital requirements. People in the press often say that if there was no MTM then investors would have no idea what the real value was. People who say this obviously have never seen an FDIC call report. The investor gets to see both
cost and fair value and can decide whether the mark matters to them. I don’t think most investors care at all whether FNM or FRE securities fall below par since they know the bank will hold them to maturity.
The key thing is that for true banks, market changes do not lead to erosion of capital requirements leading to a downward spiral. For investment banks and insurance companies, this is not the case. MTM leads to losses in capital which can lead to credit agency downgrades which can lead to liquidity crises. This is a source of instability that true banks do not have to deal with. Why can’t we be consistent?
What really makes MTM into a farce is that is only applies to securities in which there is some trading. What about all of the other assets that do not trade.
For example banks loans or insurance contracts. Why not mark them to market too? I can assure you that if Well Fargo tried to sell their (still accruing) homebuilder loans thy would not get par. Everyone knows that but no one is suggesting that they should mark them to to market. It is not like they can’t get a price. They can if they wanted. It is just that it wouldn’t be a good price. That is because the market for loans is terribly illiquid. For insurance contracts, it is even worse. Heck, why stop there. Why not make every company market every asset to market?
My point is twofold. One, companies that intend to hold assets to maturity should be able to ignore market fluctuations. They should still report the market value (if they can get one) to investors but should not have to treat them as losses. Right now, there are different rules for different kinds of institutions. Commercial banks for example get special treatment. Why not have one set of rules?
Second, there is a continuous spectrum when it comes to liquidity. US treasuries are completely liquid whereas things like insurance contracts and loans are very illiquid. Things like CDOs and CDSs are somewhere in between. Where do you draw the line? It is completely arbitrary. If banks had to mark their loans to market, there would not be a single solvent bank. None would get more 80 cents in the dollar right now and with 10x leverage, that more than wipes out all of the banks equity.
So the people who mock challenges to MTM need to do some more research. It is not so black and white. You can easily report both cost and fair value but you should be able to buy assets that you intend to hold to maturity and not suffer so much from market fluctuations especially during times like these when the market has no rationality.
“One, companies that intend to hold assets to maturity should be able to ignore market fluctuations.”
And they do. Its only when a company decides that something that was previously held as AFS is changed to HTM that a problem arises. You’ve just converted a liquid or cash-equivalent asset into a long-term, non-cash equivalent. This is a direct and dramatic impact on current ratio and a company’s ability to pay short-term debt. Loans aren’t marked to market because they aren’t expected to be liquidated to meet liabilities (unless maybe that institution becomes insolvent); CDOs, CDS, and MBS are almost exclusively AFS, and they are marked accordingly.
“Right now, there are different rules for different kinds of institutions. Commercial banks for example get special treatment. Why not have one set of rules?”
You can apply this to almost any facet of life, let me know when you figure out the right balance of specialization and favoritism, and I’ll notify the Swedes so they can award you your Nobel prize.
kfunck1,
Banks get to choose AFS versus HTM but other financial companies cannot. Why not give this option to the other levered financials?
Anyway, I don’t mean to excuse companies like AIG. They knew the rules that applied to them and chose to ignore the liquidity risks. It was an act of hubris. But in the future, we can do better. We should make sure that a good company cannot be brought down simply because a liquid market turns illiquid. One simple way of doing that is allowing them access to HTM accounting options.
There was a time when banks could fail by people pulling out their deposits in blind fear. We invented the FDIC to prevent that from happening and it has been amazingly successful. Banks that fail now are generally balance sheet insolvent not just cash flow insolvent. Likewise, we will learn from this and will likely figure out a way to prevent what happened to AIG from occurring again. The people that argue fervently for MTM are like the people who resisted the FDIC and said that the taxpayers should never be on the hook for private institutions. Those people have been proven wrong by history. The banking system is much more stable now and that is better for everyone.
David,
I call you naive. I won’t invest in the financials precisely because after their precious models blew up, most are insisting now that M2M is the cause of all their problems. While M2M has its issues, there is no way anyone can do a discounted cash flow analysis on AIG or any of the banks.
So, instead, we have to take bank value on faith, on CDS, collaterized mortagages, CDMsquared, and the whole pile. Nope. Hold on to your AIG; I’m sure you’ll do well, unless Volcker gets the call and Paulson’s out. Under that scenario, you are scalped and deservedly so.
I am dabbling in energy but the financials have AIDS, with a few exceptions. I’m not smart enough to figure out their value and I seriously doubt you are, based on the comments. You should have sold as soon as AIG signed on the TARP, coerced or not. If coerced, it’s their fault for lacking liquity. And when did CDS’s become central to their business model?
“Banks get to choose AFS versus HTM but other financial companies cannot. Why not give this option to the other levered financials?”
I hate to come off as arrogant, but I stopped reading your post after this comment. Any company with any asset can choose whether they hold an asset long-term or short-term.
http://www.chicagogsb.edu/email/chicago_on/ShootingTheMessenger10.12.2008.pdf
I highly suggest you read this article by Ray Ball, a Univ. of Chicago Accounting professor.
I actually read the conference call transcript and it still isn’t 100% clear. 20% of the questions were on this exact topic. http://seekingalpha.com/article/105101-american-international-group-inc-q3-2008-earnings-call-transcript?page=10
Anyway, it sounds like it will be done like this:
1. AIG settles with the holder — commutes the CDS. This will be done at roughly the amount the CDS’s are currently written down, which is $30 billion.
2. The SIV will then buy the CDO at “market price” which would likely be close to the market price set for the commutation.
3. The SIV will have about $35 billion.
4. They kept skirting around whether the CDS owner would take a haircut or get par from the two transactions == Settlement amount from AIG to get it to market, and then the “market value” purchase by the SIV.
5. It is possible that there are a number of these where the CDS owner doesn’t have the underlying. I think that the negotiations will be rough on these. They kept saying that they expect the Fed would be involved in the negotiations, which they think will give them some leverage.
6. The Fed involvement in negotiations will mean that holders won’t be able to *not* do a commutation.
7. The SIV will be completely off AIG’s balance sheet. AIG is still adamant that the losses on these “super senior” “multi sector” CDO’s will be much lower then current marks. You can read all about it in their supplemental stuff. I’m not saying I believe it, but one reason they didn’t just try to cram a commutation down the CDS holder is that they don’t want to settle at today’s marks. The fact that they believe it is a factor in all this.
The bottom line is that if someone holds a CDO that is insured by AIG’s CDS, then they should get roughly par.
They made it clear that roughly $30 billion would come directly from AIG and they seem to think think that another $35 billion would be needed, meaning that they squeeze out $7 billion somewhere.
They kept talking about “tearing up” the CDS which means commuting it.
This is all very curious. If they don’t get enough of the super-senior tranche of any deal, I wonder if they can commute the contract. And if these CDOs are held by hedge funds or foreign banks, the Fed may not have the leverage it thinks it has.
Anonymous said…
This is all very curious. If they don’t get enough of the super-senior tranche of any deal, I wonder if they can commute the contract. And if these CDOs are held by hedge funds or foreign banks, the Fed may not have the leverage it thinks it has.
===
If a foreign-based
CDO-holder who has
AIG as a CDS “insurance”
holder posted the
contracts on the
Internet, or gave a
copy to the Press, what
might happen?
thanks
anon
kfunck1,
I read your link. Thanks. I suggest you finish reading my comments. AFS and HTM are technical terms in bank accounting. The difference is that in HTM, market values do not flow through the profit and loss statement. This is simplified but is the main idea. Banks need to choose a category up front and changing categories can be very difficult.
I agree with much of what the professor is saying. No one including myself is entirely blaming MTM. The Professor’s main argument is that the main cause is excessive leverage. That is certainly true. It is the combination of MTM and excessive leverage that brought down the investment banks.
However even with more common leverage ratios of 10 which regulated commercial banks and AIG had, MTM can be a source of instability. Fire sales do exist. If the fire-sale is large enough, if could cause a chain reaction leading to a system wide deleveraging spiral. That is why LTCM was not allowed to liquidate in a fire-sale. AIG was just another example. If AIG had to liquidate their CDS portfolio in a fire-sale, they could have brought down even conservatively leveraged institutions if MTM is not suspended.
I am fully aware of the meaning of HTM and AFS. They apply to any and all organizations with investments, not just banks.
Marked to market accounting did not bring down investment banks, counting securities that were non-transparent and difficult to value, which then became illiquid, is what brought down investment banks. You shouldn’t be holding assets that have such a lethal combination of volatility and illiquidity as anything but trading investments.
FAS 157 very clearly states that “fire-sale” prices do not need to be used to determine fair market value. The very bottom line with this issue is, no one who suggests suspension of FAS 157 has suggested what would replace FV, and please god don’t say historical cost.
“I don’t feel that you are looking at the situation in an unbiased manor.” — David
Of course not. Yves lives in an apartment, not a manor. And certainly not in an “unbiased manor” — WHATEVER THAT IS!
AIG is in league with a criminal CIA group of which Bush Daddy is associated. They all cover for each other, that is why AIG gets special treatment.
I strongly advocate MTM accounting for (most) assets but I think we need a fuller discussion of them.
The assertion that an asset can be “held to maturity” requires at a minimum that no losses can occur that can eat through capital, “available for sale” or other categories. In low risk situations, this is a very good, but not certain, guess.
I’m still not clear how any modern institution can absolutely be solvent with MTM given (a) leverage / fractional reserve lending and (b) the variety of risks that pop up in the real world, whether mispriced off-the-run Treasuries or whatever.