JUST how concerned should American taxpayers be about American International Group (AIG), the insurance company brought to its knees by its escapades in the credit-derivatives market? On November 10th a revised rescue package was announced, comprising $153 billion of capital injections and loans. That is the largest bail-out for any firm, anywhere, during the crisis. Is the government being, as AIG’s new chairman says, “very, very smart”, or has it been taken for one of the most expensive rides in corporate history?
Even on September 16th, when the state first intervened, AIG was a controversial candidate for assistance. Its insurance businesses are ring-fenced by local regulators and individually capitalised, precisely so they can survive a collapse of the holding company. A bankruptcy was avoided only because of the size of the holding company’s book of toxic credit derivatives, which senior executives barely understood. These left AIG so intertwined with other financial firms that its failure was judged by the Federal Reserve and Treasury to endanger the financial system.
Whether that judgment was right remains unknowable. But it is now clear that the original plan was flawed. That may be understandable: panic was in the air, AIG faced crippling collateral calls and Lehman Brothers had just folded. And the authorities lacked the wide powers granted by the Troubled Asset Relief Programme (TARP) approved by Congress in October. Unorthodox options, such as splitting the systemically threatening credit derivatives from AIG, were not under discussion.
As a result, the original plan looked a lot like the traditional remedy for a liquidity crisis at a solvent bank. The Fed offered a two-year, $85 billion loan. AIG would pay a penal interest rate and cede to the state an equity stake of just under 80%. But as collateral calls mounted on the credit derivatives, and AIG admitted to new problems, it became plain that the loan was too small. It was also too expensive: in the first year it would have cost almost as much as AIG’s profits in 2006, its best year ever.
Meanwhile the chances of AIG being able to repay the loan also shrank. In the second quarter, it had only $59 billion of core equity capital (defined here as book equity less goodwill, tax assets and stock ceded to the state). By the third quarter, more losses had cut this to a meagre $23 billion. Worse, much if not all of AIG’s capital sits “stranded” in the ring-fenced insurance units. That makes it hard to funnel it up to a holding company that is otherwise almost certainly insolvent.
The original solution was to sell the insurance operations to raise cash, but with AIG’s competitors also reeling, this looked less and less realistic. The alternative, of AIG tapping credit markets to repay the state, became ridiculous by early November. AIG’s own credit spreads implied that the company was headed for default (see chart). Prospects of even rolling over the $64 billion of non-government borrowing due to mature by 2011 became increasingly bleak.
That forced the hand of the authorities. In one sense the new package does what, with the benefit of hindsight, should have happened all along. The Fed will provide $53 billion of funding for two vehicles which will, in effect, assume AIG’s most toxic credit derivatives and mortgage-backed securities. These positions have been marked to fairly conservative levels.
In an alternative universe the government could then walk away, confident that it had dealt with the worst of the systemically important credit derivatives and that the insurance operations remained safely ring-fenced. But in the real world the state is now the biggest lender to AIG, which has drawn down the bulk of the original $85 billion facility. AIG has Uncle Sam in a bind. As a result, the Treasury, through the TARP, has been forced to recapitalise the insurer by purchasing $40 billion of preference shares. Despite this its economic stake in the firm will remain just below 80%. The Fed will also maintain a loan facility, on more generous terms, of $60 billion. And if AIG struggles to refinance its debts, it is quite possible that the state will provide a formal guarantee.
The Treasury has secured crowd-pleasing concessions; for example limits on executives’ bonus payments. But the real question is whether the preference shares are safe. AIG has a trillion-dollar balance-sheet. There is now a thin buffer of core equity between the taxpayer’s preference shares and any further losses. The hope is still that as markets recover, AIG can sell the crown jewels of its insurance business at a premium to book value. That may well take years. Plenty of time to reflect on how an offer of a temporary loan, to a company that barely made the list of systemically vital firms, spiralled into one of the biggest corporate bail-outs ever.
Source URL: http://www.economist.com/finance/displaystory.cfm?story_id=12607251&fsrc=rss
