Here are 4 items regarding the AIG bailout that are worth thinking about:
1) AIG is the world’s biggest insurer. AN uncontrolled bankruptcy would have dramatically exacerbated the current recession — possibly turning it into a depression;
2) The NY based firm was also a huge Credit Default Swap insurer/underwriter. The tems of CDS require collateral to be posted, depending upon such factors as credit rating and credit spreads;As home prices fell, spreads widened, and companies went down, AIG’s collateral requirements went up significantly.
3) Hence, this is more of a liquidity problem than an actual insolvency. This is the first bailout that adhered to Walter Bagehot’s dictum “Central Banks should lend freely at a penalty rate;”
4) Moral Hazard, successfully avoided in the Lehman Brothers bankruptcy, was put aside given the massive size of AIG — if any firm was TBTF — too big to fail — it is AIG.
The Federal Reserve released:
The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.
The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.
The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.
The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.
The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.
Here’s a few excerpts from major media —
The U.S. government agreed to lend as much as $85 billion to American International Group Inc. in exchange for a 79.9 percent stake to save the country’s biggest insurer from collapse.
The Federal Reserve “determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance,” the Fed said.
The agreement, supported by the Treasury Department, will keep New York-based AIG in business, averting a failure that could have threatened more financial companies and added to chaos in world markets. Losses industrywide could have totaled $180 billion if AIG collapsed, according to RBC Capital Markets. AIG needed the loan after its credit ratings were cut and shares plunged 79 percent since Sept. 11.
That the government would prop up AIG financially offers a stark indication of the breadth of the insurer’s role in the global economy. If it were to have trouble meeting its obligations, the potential domino effect could reach around the world.
For one thing, banks and mutual funds are major holders off AIG’s debt and could take a hit if the insurer were to default. In addition, AIG was a major seller of “credit-default swaps,” essentially, insurance against default on assets tied to corporate debt and mortgage securities. Weakness at AIG could force financial institutions in the U.S., Europe and Asia that bought these swaps to take write-downs or losses.
AIG’s millions of insurance policyholders appear to be considerably less at risk. That’s because of how the company is structured and regulated. Its insurance policies are issued by separate subsidiaries of AIG, highly regulated units that have assets available to pay claims. In the U.S., those assets can’t be shifted out of the subsidiaries without regulatory approval, and insurance is also regulated strictly abroad.
If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, which in turn would have reduced their own capital and the value of their own debt.
“It would have been a chain reaction,” said Uwe Reinhardt, a professor of economics at Princeton University. “The spillover effects could have been incredible.”
Financial markets, which on Monday had plunged over worries about A.I.G.’s possible collapse, reacted with relief to the news of the bailout. In anticipation of a deal, stocks rose about 1 percent in the United States on Tuesday and were up about 2 percent in early trading in Asian markets Wednesday morning.
To give you an idea of how interconnected AIG is with the rest of the financial universe, Bloomberg reports that “Lehman Brothers Holdings Inc.’s London landlord, Songbird Estates Plc, said rent payments on the bank’s offices in the Canary Wharf financial district are insured by American International Group Inc.
The AIG news is unprecedented, and will likely dominate tomorrow’s trading. Futures are up only now down modestly.
Previously: Bloomberg Video: AIG Earnings http://bigpicture.typepad.com/comments/2008/08/bloomberg-video.html
Sources: Federal Reserve News Release on AIG http://www.federalreserve.gov/newsevents/press/other/20080916a.htm
Fed’s $85 Billion Loan Rescues Insurer EDMUND L. ANDREWS, MICHAEL J. de la MERCED and MARY WILLIAMS WALSH NYT, September 16, 2008 http://www.nytimes.com/2008/09/17/business/17insure.html
AIG Gets Up to $85 Billion Fed Loan; Cedes Control Craig Torres and Hugh Son Bloomberg, Sept. 16 2008 http://www.bloomberg.com/apps/news?pid=20601087&sid=aAkvusf5Ld7M&
U.S. Plans Rescue of AIG to Halt Crisis; Central Banks Inject Cash as Credit Dries Up $85 Billion Loan for Giant Insurer Aimed at Averting Collapse; Historic Move Would Cap 10 Days That Reshaped U.S. Finance; Fed Says AIG Will Sell Businesses in Orderly Manner MATTHEW KARNITSCHNIG, DEBORAH SOLOMON and LIAM PLEVEN http://online.wsj.com/article/SB122156561931242905.html
A.I.G. Is Still Profitable, With a Wide Array of Enterprises JONATHAN D. GLATER NYT September 16, 2008 http://www.nytimes.com/2008/09/17/business/17aig.html
Originally published at The Big Picture and reproduced here with the author’s permission.