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What really happened in the $85 billion bailout of A.I.G.
November 24, 2009 12:19 PM

Neil Barofsky, the special inspector general for the government's $700 billion financial bailout program (SIGTARP), has filed a report detailing what happened with the government bailout of the insurance giant, A.I.G. in the fall of 2008. The story is pretty amazing on many different fronts and begins here (original .pdf):

In September 2008, multiple U.S. financial institutions had failed or were on the brink of failure as a result of an escalating crisis in the financial markets. By September 2008, bankruptcy loomed for AIG, in part because AIG was unlikely to be able to raise the capital needed to meet additional calls for large collateral payments in the case of an anticipated downgrade in its credit rating by credit rating agencies. On the afternoon of September 15, 2008, the three largest credit rating agencies -- Standard and Poor's Financial Services, Moody's Investors Service, Inc., and Fitch Ratings Ltd. -- downgraded AIG. On September 16, 2008, because of concerns that an AIG bankruptcy could cause systemic risk to the entire financial system and the American retirement system, the Federal Reserve Board, with the support of Treasury, authorized the Federal Reserve Board of New York (FRBNY) to lend up to $85 billion to the firm. Despite this initial Government assistance, AIG's financial difficulties continued, and there were concerns that a further downgrade was forthcoming. Additional downgrades, among other things, could trigger requirements for AIG to make additional collateral payments (referred to as "posting collateral") to AIG's counterparties. The downgrades could thus exacerbate the liquidity drain and the payments to swap counterparties.

Thus began all the fun (so to speak):

The Federal Reserve Board authorized FRBNY to create a special purpose vehicle ("SPV") called Maiden Lane III and to lend it up to $30 billion to buy collateralized debt obligations ("CDOs") underlying the credit default swaps from AIG's counterparties.
Essentially, what this meant was that taxpayers would be buying the $30 billion of toxic assets from AIG's counterparties that AIG was insuring in the event that those toxic assets would become worthless. AIG is a big insurance company, not unlike Allstate or Geico that insures automobiles. When you buy insurance on your automobile, and you get in an accident, Geico is obligated by the contract you signed with them to pay the expenses to fix your car. Likewise, AIG insured these toxic assets (equivalent to the car) that its counterparties purchased. The counterparties bought these assets and then bought insurance from AIG in case the toxic assets (CDO's) became worthless. As these CDOs became worth less and less, AIG was obligated to pay out more and more on these insurance contracts it had issued to its counterparties, thereby bleeding money, which led to downgrades by the credit agencies, which would lead to further bleeding of cash, and so on into bankruptcy.

And who exactly were these counterparties? The eight largest were: Societe Generale, Goldman Sachs, Merrill Lynch, Deutsche Bank, UBS, Calyon, Barclays and Bank of America. A complete list of these counterparties can be found here. And this page gives the timeline leading up to the creation of Maiden Lane III.

As AIG's financial condition was deteriorating, FRBNY was monitoring the situation because they knew that if AIG failed, it would be a far bigger disaster for the economy. Lehman Brothers had just gone bankrupt, and it was clear that the repercussions of that failure were ringing far and wide, and Lehman Brothers only had about $8 billion in commercial paper that was exposed. By contrast, AIG had $20 billion in commercial paper outstanding that was owned by institutional investors and money market funds that would likely have taken losses had AIG failed. In fact, one of the biggest ramifications of the Lehman bankruptcy was that mutual funds that were supposedly risk-free suffered when their holdings in Lehman bonds and commercial paper went to zero:

Federal Reserve and Treasury officials discussed whether a default on AIG's commercial paper could lead to further "breaking-of-the buck" for money market funds. Money market funds are considered among the safest investments and maintain a net asset value of $1 per share. When the fund falls below $1 per share, it is known as "breaking the buck," an event that had not occurred in many years. After Lehman filed for bankruptcy, the Reserve Primary Fund, the oldest money market fund in the United States, was forced to write off debt issued by Lehman (about $785 million). As a consequence, on September 16, 2008, the Reserve Primary Fund dipped below $1.00 per share, thereby "breaking the buck," which further aggravated the credit crisis

This was the single-most significant (and terrifying) moment of the financial crash of 2008:

The resulting market anxiety contributed to a run on the Reserve Primary Fund in which investors attempted to withdraw their money quickly. In addition, large-scale redemptions caused money market mutual fund companies to hoard cash rather than invest in funding markets, such as commercial paper and certificates of deposit. In the final analysis, the Federal Reserve and Treasury believed that the risks of not rescuing AIG outweighed the risks associated with rescuing the troubled insurance company, and on September 16, 2008, the Federal Reserve Board authorized an $85 billion credit facility for AIG.

The report then takes a step back from there and analyzes the private efforts to rescue AIG that were being orchestrated by the FRBNY. It shows that many of these so-called "expert" financial gurus had no idea what the true underlying value of the CDOs really were. In fact, AIG had previously retained BlackRock Solutions (BRS) to evaluate AIG's swap portfolios and underlying CDOs, because they weren't sure what these things were actually worth. To make matters worse, the FRBNY had no idea what the true value of these toxic assets were. When the private consortium opted not to bail out AIG and the FRBNY stepped in with their decision to rescue AIG, they hadn't even developed a plan for the bailout and had to rely on the BlackRock plan!

When the consortium declined to assist AIG and the three largest credit rating agencies downgraded AIG on September 15, 2008, the Federal Reserve and Treasury made the decision, within a matter of hours, that FRBNY would provide $85 billion in financing to AIG. FRBNY did not develop a contingency plan in the event that the private financing did not go through and did not conduct an independent analysis regarding the appropriate terms for Government assistance to AIG; instead it used in substantial part the economic terms of the private sector deal, albeit for $85 billion instead of the $75 billion prepared by JPMorgan Chase for the unsuccessful private sector solution.

So, FRBNY had no contingency plan and they had no idea what these CDOs were worth. So what did they do?

A senior vice president of FRBNY confirmed with SIGTARP that BRS's knowledge of the portfolio and their analytical work were important to FRBNY's efforts to rescue AIG. As a result, FRBNY decided to hire BRS to assist FRBNY in its evaluation of AIG's liquidity needs. A BRS managing director noted that AIG's swap exposure was complicated for two reasons:
First, each swap contract had a different credit event that would trigger a collateral posting under the contract. Second, the counterparties had different mark-to-market valuations for the underlying CDOs than AIGFP, therefore making the swap exposures difficult to track. For example, AIGFP could have marked a CDO at 85 cents on the dollar while the counterparty could have marked the CDO at 70 cents on the dollar on its own books, which, among other things, created potential disputes with the counterparties as to the amount of collateral owed. In late September, FRBNY asked BRS to help them analyze a portfolio of multi-sector CDOs that would eventually become Maiden Lane III.

In addition to the complexities of valuing these multi-billion dollar CDOs, the original terms of the $75 billion private consortium bailout that the FRBNY adopted from JPMorgan and BlackRock included an onerous 11% interest payout from AIG to the government. It became quickly evident that those terms would increase the likelihood of AIG going bankrupt:

An FRBNY official told SIGTARP that, by September 17, 2008 -- the day after FRBNY provided initial assistance to AIG and two days after AIG's downgrades -- it was clear that the rating agencies were planning another downgrade of AIG because of the deteriorating financial condition of the company and the impact the $85 billion FRBNY loan could have on AIG's capital structure, including the high interest rate payments AIG would have to make to FRBNY. FRBNY's General Counsel emphasized in an interview with SIGTARP that FRBNY "inherited the bank consortium deal," that the interest rate was too high, and that FRBNY recognized the need to restructure the deal by making it less onerous to AIG soon after the agreement was signed.

And hence we get to the second core part of this story: The Federal Government had in place ZERO oversight of this conglomerate, they knew nothing about these toxic assets, and were therefore completely and woefully unprepared to deal with this monstrosity. The FRBNY didn't "inherit the bank consortium," they simply had no plan of their own!

FRBNY had not purchased these toxic assets yet, but it was clear that as they were decreasing in value, the amount that AIG had to cough up to pay their counterparties on their insurance policies that they had purchased was going to drive AIG into bankruptcy. And it became very clear, after repeated efforts by FBRNY to re-negotiated the terms of these insurance policies with AIGs counterparties wer rebuffed, that the only solution was for FBRNY to purchase these toxic CDOs (thereby creating Maiden Lane III) and to terminate the insurance policies. And this is where the valuation issues came into play.

The counterparties (Goldman, Society General, Merrill Lynch, et. al) refused to take less than 100% on the dollar of their insurance policies. They wanted AIG to make them whole - the same as if your car was totaled and GEICO said that they couldn't reimburse you for the value of the car, you would just say, "no, I'm entitled to 100% of the value of my car." If GEICO went bankrupt, you'd be out of luck, right? It was the same with AIG going out of business, except that its counterparties knew that they held the upper hand. They didn't have to negotiate with the government because they knew that the FBRNY would never let AIG go bankrupt, as that would lead to the complete cratering of the entire economy.

Now, according to the Barofsky report (starting here), the government did try to negotiate with the counterparties to settle on some value whereby they would take a loss on the insurance policies they purchased from AIG in exchange for taking those toxic assets off their hands. All but one gave a big fat middle finger to the government, and the only one that didn't - UBS - said that they would only be willing to take a measly 2% haircut (loss) on their insurance policies. What did the FBRNY do? They decided to compensate them effectively at Par Value - thereby making all of them whole on their insurance policies - an incredible outcome considering that the company they purchased insurance from was basically bankrupt (think GEICO going bankrupt the day you total your car and the government steps in and pays you 100% of the value of your now-worthless automobile).

On November 6 and 7, 2008, FRBNY assistant vice presidents, vice presidents, senior vice presidents, and executive vice presidents contacted eight of AIG's largest counterparties (Societe Generale, Goldman Sachs, Merrill Lynch, Deutsche Bank, UBS, Calyon, Barclays and Bank of America) by telephone. They described a proposal under which each counterparty was asked to accept a haircut from par. Seven of the eight counterparties told FRBNY officials that they would not voluntarily agree to a haircut. The eighth counterparty, UBS, said that it would accept a haircut of 2 percent as long as the other counterparties also granted a similar concession to FRBNY. FRBNY officials told SIGTARP that their concerns about credit rating downgrades limited the time available for negotiation about reductions in payments. According to an FRBNY senior vice president, the counterparties that FRBNY approached that resisted being paid anything less than the equivalent of par in exchange for terminating their credit default swap contracts cited several reasons for this (which can be found here).

For instance:

Goldman Sachs had approximately $22.1 billion of notional amount of outstanding credit default swap contracts with AIG, approximately $20 billion of which were against an underlying portfolio of CDOs. According to Goldman Sachs, it had one telephone conversation with FRBNY staff in which the possibility of concessions was mentioned. Goldman Sachs has since explained that it did not agree to concessions because it would have realized a loss if it had.

Not only did they not want to incur a loss, they claimed that they had already hedged their exposure and couldn't lose anymore, so hence, they didn't need to negotiate with the government. The facts don't bear this argument out, though:

Notwithstanding the additional credit protection it received in the market, Goldman Sachs (as well as the market as a whole) received a benefit from Maiden Lane III and the continued viability of AIG. First, in light of the illiquid state of the market in November 2008 (an illiquidity that likely would have been exacerbated by AIG's failure), it is far from certain that the underlying CDOs could have easily been liquidated, even at the discounted price of $4.3 billion. Second, had AIG collapsed, the systemic implications on other market participants might have made it difficult for Goldman Sachs to collect on the credit protection it had purchased against an AIG default, although Goldman Sachs stated that it had received collateral from its counterparties in those transactions. Finally, if AIG had defaulted, Goldman Sachs would have been forced to bear the risk of further declines in the market value of the approximately $4.3 billion in CDOs that it transferred to the Maiden Lane III portfolio as well as approximately $5.5 billion for its credit default swaps that were not part of the Maiden Lane III portfolio; Maiden Lane III removed any risk for the $4.3 billion within that portfolio, and continued Government backing of AIG provided Goldman Sachs with ongoing protection against an AIG default on the remaining $5.5 billion.

So why didn't the FRBNY intervene and make them take a haircut? They cite 7 main reasons listed here, two of which were:

As a policy matter, FRBNY was unwilling to use its leverage as the regulator for several of the counterparties to compel concessions, in part because in the negotiations it was acting as a creditor of AIG and not as the counterparties' primary regulator.

Also as a policy matter, FRBNY was uncomfortable with violating the principle of
sanctity of contract.

Do these two reasons hold up under further scrutiny,let alone the other five?

While there can be no doubt that a regulators' inherent leverage over a regulated entity must be used appropriately, and could in certain circumstances be abused, in other instances in this financial crisis regulators (including the Federal Reserve) have used overtly coercive language to convince financial institutions to take or forego certain actions. As SIGTARP reported in its audit of the initial Capital Purchase Program investments, for example, Treasury and the Federal Reserve were fully prepared to use their leverage as regulators to compel the nine largest financial institutions (including some of AIG's counterparties) to accept $125 billion of TARP funding and to pressure Bank of America to conclude its merger with Merrill Lynch. Similarly, it has been widely reported that the Government, while arguably acting on behalf of General Motors and Chrysler, took an active role in negotiating substantial concessions from the creditors of those companies.
The table located here outlines the exact amount paid out to each AIG counterparty, including $16.5 billion to Societe Generale, $14 billion to Goldman Sachs, $6.2 billion to Merrill Lynch (now Bank of America), $8.5 billion to Deutsche Bank, $3.8 billion to UBS, and so on.

There's one last chapter to this saga which is important to note. The Federal Reserve for many months refused to reveal the identities of the firms listed above who received the bailout vis a vis Maiden Lane III:

On March 5, 2009, Federal Reserve Vice Chairman Kohn testified before Congress about the decision to pay effectively par value to the counterparties, but refused to reveal the identities of the counterparties or payments made. Kohn expressed his judgment that "giving the names would undermine the stability of the company and could have serious knock-on effects to the rest of the financial markets and the government's efforts to stabilize them."

Ten days following the Senate hearing, and approximately four months after the first of Maiden
Lane III's payments to counterparties, AIG, in consultation with the Federal Reserve, released
the identity of the counterparties, as indicated in Table 2.


What happened? Did the markets react to this news? Was there any harm done to these firms at all?

It does not appear that the disclosures had any of the negative consequences that Vice Chairman Kohn anticipated on AIG or on the markets generally.

At the end of the report, it details what comprises these toxic assets and how the value of this $20+ billion portfolio has changed in the past year:

** As of December 31, 2008, the fair value of the portfolio was $27.1 billion. ** As of March 31, 2009, the fair value of the portfolio was $20.7 billion. ** As of June 30, 2009, the fair market value of the portfolio was $22.4 billion. ** As of September 30, 2009, the fair market value of the portfolio was $23.5 billion.

And according to the report, as of September 30th, the balance of principal and interest owed to FRBNY was $19.9 billion, while the portfolio was worth $23.5 billion, netting a profit so far of $3.6 billion to tax payers. Not bad, but will we get our money back? The report says that if all goes well, and Maiden Lane III continues to pay back the loan at the same rate, it will take another 4-5 years to repay us taxpayers.

Keep in mind, though, that AIG still had $302 billion worth of exposure in credit default swaps on its books at the beginning of the year. They have been winding down this exposure over 2009, reducing by $96 billion (or 32%), to $206 billion, its exposure to these credit default swaps, most of which aren't nearly as toxic as those that exist in Maiden Lane III. Still, there remains exposure to these swaps, so if the economy were to crater again, we might have to revisit this nightmare with AIG.

The conclusion of this report can be found here and sums up the crux of this matter nicely:

Questions have been raised as to whether the Federal Reserve intentionally structured the AIG counterparty payments to benefit AIG's counterparties -- in other words that the AIG assistance was in effect a "backdoor bailout" of AIG's counterparties. Then-FRBNY President Geithner and FRBNY's general counsel deny that this was a relevant consideration for the AIG transactions. Irrespective of their stated intent, however, there is no question that the effect of FRBNY's decisions -- indeed, the very design of the federal assistance to AIG -- was that tens of billions of dollars of Government money was funneled inexorably and directly to AIG's counterparties.

The intent in creating Maiden Lane III may similarly have been the improvement of AIG's liquidity position to avoid further rating agency downgrades, but the direct effect was further payments of nearly $30 billion to AIG counterparties, albeit in return for assets of the same market value. Stated another way, by providing AIG with the capital to make these payments, Federal Reserve officials provided AIG's counterparties with tens of billions of dollars they likely would have not otherwise received had AIG gone into bankruptcy.

And there we have it, folks! The Fed stepped in and whether they were trying to save the economy or hooking up their buddies at Goldman, et. al, the end result was the same: a massive $30 billion bailout for firms that purchased insurance against losses from toxic assets from a firm that should have gone bankrupt. All because they thought AIG was "Too Big to Fail."

Lessons Learned

In the postscript of the report, we have some very valuble guidance of where to go from here:

First, AIG stands as a stark example of the tremendous influence of credit rating agencies upon financial institutions and upon Government decision making in response to financial crises. In the lead-up to the crisis, the systemic over-rating of mortgage-backed securities by rating agencies was reflected in the similarly over-rated CDOs that underlied AIGFP's credit default swaps. Once the financial crisis had come to a head, the credit rating agencies downgrades of AIG itself and of the underlying securities played a significant role in AIG's liquidity crisis as those downgrades and the related market declines in the securities required AIG to post billions of dollars in collateral. All of these profound effects were based upon the judgments of a small number of private entities that operate, as described in SIGTARP's October 2009 Quarterly Report, on an inherently conflicted business model and that are subject to minimal regulation.

Second, the now familiar argument from Government officials about the dire consequences of basic transparency, as advocated by the Federal Reserve in connection with Maiden Lane III,
once again simply does not withstand scrutiny. Federal Reserve officials initially refused to
disclose the identities of the counterparties or the details of the payments, warning that disclosure of the names would undermine AIG's stability, the privacy and business interests of the counterparties, and the stability of the markets. After public and Congressional pressure, AIG disclosed the identities. Notwithstanding the Federal Reserve's warnings, the sky did not fall.

Indeed, the sky did not fall. Although it sure looked like it would...and it still may.

Post-post script:

Make sure you read the responses of the Federal Reserve and The Treasury to this report. They are almost as important as the report itself. For instance, in The Treasury's response, they write:

Given the size and interconnectedness of AIG, it should never been allowed to escape tough, consolidated supervision at the holding company level. Due to loopholes in the bankholding company act, it was treated as a thrift holding company -- with limited consolidated supervision and no capital requirements at the holding company level.

How did that happen and what's the story behind that one?

A must-read follow-up, as well, is Gretchen Morgenson's take on this report at the NY Times.. She's been following this story like a hawk, so it's always important to get her take on these matters.

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