AIG Bailout 2: Why?

The WSJ has details of AIG Bailout II:

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.)

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.

Let’s do a quick back-of-the-envelope calculation here. Libor is now at 2.29%, so $85 billion at Libor +850bp works out at $9.17 billion per year. Meanwhile, $60 billion at Libor +300bp works out at $3.17 billion per year, and the 10% coupon on $40 billion of preferred shares is of course $4 billion per year, for total interest payments under the new plan of $7.17 billion. That’s a savings of $2 billion a year for AIG. Against that, AIG has to put $6 billion in cash into two new special-purpose vehicles, designed to help sort out many of the problems at the insurer’s CDS and securities-lending business.

The article does shed some light on just how spectacularly incompetent AIG has been when it comes to securities lending:

A second vehicle would be set up to solve the liquidity problems in AIG’s securities lending business. The business involves lending out securities to short sellers or others and investing the collateral for gains. The strategy for many has lately backfired as once-reliable credit investments have seized up…

Under the new plan, the government would inject about $20 billion into the securities lending vehicle and AIG would put in $1 billion. The vehicle would then buy the illiquid securities the AIG unit holds, known as residential mortgage-backed securities, for about 50 cents on the dollar.

Securities lending is meant to be a no-risk operation. In a repo operation, the long-term owner of a stock — in this case, AIG — will sell it to someone who wants to short it, and charge them interest. They then subsequently buy back the stock at the price they sold it for; the interest is pure profit.

AIG, however, seems to have gotten spectacularly greedy. It took the proceeds from the stock sales, and instead of putting it somewhere safe, invested it in RMBS. Which are now worth 50 cents on the dollar.

This is in a way worse than AIG’s misadventures in the CDS market. When AIG Financial Products wrote credit protection, it thought the chances of default were minimal. But investing $42 billion of repo collateral in RMBS? There’s no good reason to do that: it’s not your money, you can’t afford to lose it, so you put it somewhere safe.

The silliest bit of this plan, however, is the idea that AIG will be able to cancel out its CDS exposure by buying the underlying securities. The WSJ explains how improbable this scheme is:

The government may be betting that federal involvement will encourage the counterparties to sell the assets to the AIG vehicle.

Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted back the contracts…

However, the agreements may be difficult to work out. Some banks 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 and Canadian 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 and Canadian banks demanded collateral from Merrill which in turn demanded collateral from AIG.

None of this makes sense to me. If AIG wants to unwind its CDS exposure, all it needs to do is negotiate with its counterparties to pay them an up-front sum in return for their tearing up the contract. CDS are derivatives: you don’t need to do anything with the underlying securities in order to cancel them out.

But of course if AIG simply made those kind of payments and took its losses, the government wouldn’t end up with any assets, and wouldn’t be able to tell the public that it was still possible that AIG might make a profit on the deal.

So this looks like an exercise in face-saving to me, rather than something with any real economic logic behind it. But at least the Troubled Asset Relief Program finally gets to buy itself some Troubled Assets, even if there isn’t a reverse auction involved. Maybe that’s why Treasury’s going along with this plan; I can’t think of any other reason. Here’s how the WSJ parses the logic:

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.

How does transferring billions of dollars of contingent liabilities from AIG to Treasury in any way help the taxpayer’s ability to recoup the money that has been pumped into the insurer? I don’t get it. And I don’t see the systemic risk which this plan is meant to head off. Without that systemic risk, I see no reason why AIG should get any bailout at all.

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