US Treasury Secretary Henry Paulson's decision to inject another US$27 billion
into failed insurer AIG and raise the taxpayers' investment to $150 billion
suggests he is 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% of the
company.
AIG was to pay 8.5% above the benchmark London Interbank Offered Rate (Libor)
for the first $85 billion. The insurer 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 billion 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% above Libor and invest
about another $27 billion in 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 to 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 that 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 US 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 makes monthly tax payments to Washington, AIG
executives bang away at birds on the English countryside.
Peter Morici is a professor at the University of Maryland School of
Business and former chief economist at the US International Trade Commission.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
