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The following article was written by Peter Morici, a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.
The Treasury is injecting another $27 billion into AIG and raising the
taxpayers’ investment to $150 billon. Secretary Paulson appears more
intent on helping his pals on Wall Street than protecting taxpayer
interests.
AIG has solid businesses in industrial, commercial and life insurance, but like a lot of financial firms, was attracted to easy profits writing credit default swaps on mortgage backed bonds—so called collateralized debt obligations (CDOs).
AIG received fees to guarantee repayment of those mortgages, or the funds obtained through foreclosures when homeowners defaulted. Like most on Wall Street, AIG executives believed home prices would rise faster than household incomes forever, so these CDOs really bore little risk.
This credit default swap business was outside AIG’s highly-regulated, solid insurance businesses but was backed by the value of those businesses. Essentially, if the CDOs fell too much in value, AIG pledged the value of those businesses.
If an abnormal number of the mortgages failed, the held to maturity value of the CDOs would fall, and obligations would trigger for AIG to post collateral. When that happened in 2007, AIG deposited cash or other liquid assets with the investors holding the CDOs. With the housing market so depressed by the summer of 2007, AIG could not raise enough cash to meet all its obligations.
On September 16, the Federal Reserve provided $85 billion in loans to AIG in exchange for warrants—the right to buy common stock—equal to 79.9 percent of the company.
AIG was to pay 8.5 percent above Libor for the first $85 billion. AIG was to use the loans to honor obligations to holders of the credit default swaps, and AIG was to sell parts of its insurance businesses to repay the loans to the Federal Reserve. That loan proved inadequate, and the Fed advanced another $38 billion on October 9.
The $123 billon was not enough to finance AIG’s short-term credit default swap obligations, and it cannot sell enough pieces of its good insurance businesses to pay back the Federal Reserve in the current environment.
Now, the Federal Reserve and Treasury are agreeing to restructure $60 billion of the original loan, lowering the interest rate to 3 percent above Libor and invest about another $27 billion AIG.
The interest rates on the loans were lowered, in part, because large shareholders complained about heavy handed government action.
The monies will be used to set up two special funds. The first will seek to buy up some of the CDOs that have declined in value for about 50 cents on the dollar, permitting AIG to recoup its collateral paid in cash. This fund will not buy up the most troubled CDOs, whose values are even lower than 50 cents on the dollar.
The second fund will be used to solve liquidity problems at AIG’s securities lending business. It rents securities to short sellers in the stock markets.
This is all folly.
The government assumes greater risks without getting benefits for the taxpayer. Many firms who purchased the original credit default swaps from AIG have used the collateral posted by AIG on the less risky CDOs for other purposes and may not want to sell AIG their CDOs. Also, many of the swaps have been resold to firms that don’t hold the CDOs, as part of complex derivatives transactions.
The short selling business is a whole new headache, and it should make taxpayers ask, what else is lying around at AIG.
If the deal works out, AIG executives get to keep their jobs; but if the plan fails, the U.S. government may get stuck holding the bag on billions of dollars of false promises to pay from AIG. Its warrants may prove not worth very much as AIG’s obligations overwhelm the value of its businesses.
If AIG can’t make it on the money the taxpayers have already apparently squandered, then the Treasury should simply exercise its warrants, take control of AIG, and sell off AIG’s solid insurance businesses for what they are worth. The Treasury can buy back the CDOs for common shares in the company and reorganize the new AIG with more responsible management.
The executives at AIG certainly have not behaved well since the first bailout. They have enjoyed lavish golf retreats in California and luxurious hunting trips in Britain.
While the American taxpayer make monthly tax payment to Washington, AIG executives bang away at birds on the English countryside.
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