The Bailout of AIG - Assignment Example

The bailout of AIG made news because it was the highest recipient of the Federal funds that were made available under the TARP or the Troubled AssetsRelief Plan that was passed by the Federal government. The point of contention in bailing out AIG was that it was too big to fail and hence needed all the support that the Federal Government could extend. The Federal Reserve extended an $85 billion loan to American International Group to be paid back as AIG sells off some business in the biggest government takeover so far in the ongoing credit crisis. The deal is designed to let the Fed unwind AIGs hugely complex business in an "orderly manner, with the least possible disruption to the overall economy." The government will take a 79.9 stake in the firm, along with the right to suspend dividends. The terms for lending are steep—the Libor overnight rate banks lend to each other, plus an extra 8.5 percent—and will last for two years. Robert Willumstad, AIGs CEO, will be replaced by Edward Liddy, former chairman of Allstate Corp. The deal should reassure investors worrying over an untold amount of counterparty risk in the financial system And comfort the market, given the governments guarantee that AIG wont default. Thats the good news. The downside is we still dont know how to value the CDS and mortgage securities that got us into this mess in the first place. Also, with AIGs bailout coming just two weeks after the government takeover of Fannie Mae and Freddie Mac, its still not apparent that credit markets are recovering. Further out, taxpayers are now on the hook for a few more of Wall Streets bad bets (though AIG will very likely pay off much of the balance), and the Feds unprecedented help could result in a coming wave of equally unprecedented regulation of the financial services industry. The U.S. government seized control of American International Group Inc. -- one of the worlds biggest insurers -- in an $85 billion deal that signaled the intensity of its concerns about the danger a collapse could pose to the financial system. The step marks a dramatic turnabout for the federal government, which had been strongly resisting overtures from AIG for an emergency loan or some intervention that would prevent the insurer from falling into bankruptcy. Just last weekend, the government essentially pulled the plug on Lehman Brothers Holdings Inc., allowing the big investment bank to go under instead of giving it financial support. This time, the government decided AIG truly was too big to fail. The U.S. negotiators drove a hard bargain. Under terms hammered out, the Fed will lend up to $85 billion to AIG, and the U.S. government will effectively get a 79.9% equity stake in the insurer in the form of warrants called equity participation notes. The two-year loan will carry an interest rate of Libor plus 8.5 percentage points. (Libor, the London interbank offered rate, is a common short-term lending benchmark.) The loan is secured by AIGs assets, including its profitable insurance businesses, giving the Fed some protection even if markets continue to sink. And if AIG rebounds, taxpayers could reap a big profit through the governments equity stake. "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 Fed said in a statement. It puts the government in control of a private insurer -- a historic development, particularly considering that AIG isnt directly regulated by the federal government. The Fed took the highly unusual step using legal authority granted in the Federal Reserve Act, which allows it to lend to nonbanks under "unusual and exigent" circumstances, something it invoked when Bear Stearns Cos. was rescued in March. As part of the deal, Treasury Secretary Henry Paulson insisted that AIGs chief executive, Robert Willumstad, step aside. Mr. Paulson personally told Mr. Willumstad the news in a phone call on Tuesday, according to a person familiar with the call. Mr. Willumstad will be succeeded by Edward Liddy, the former head of insurer Allstate Corp. AIGs bailout caps a tumultuous 10 days that have remade the American financial system. In that time, the government has engineered rescues that insert it deep into the housing and insurance industries, while Wall Street has watched two of its last four big independent brokerage firms exit the scene. The U.S. on Sept. 6 took over mortgage-lending giants Fannie Mae and Freddie Mac as they teetered near collapse. This Sunday, the U.S. refused to bail out Wall Street pillar Lehman Brothers, which filed for bankruptcy-court protection and is now being sold off in pieces. That same day, another struggling Wall Street titan, Merrill Lynch & Co., agreed to sell itself to Bank of America Corp. The AIG deal followed a day of high drama in Washington. The Treasurys Mr. Paulson and Federal Reserve Chairman Ben Bernanke convened in the early evening an unexpected meeting of top congressional leaders. Late in the trading day Tuesday, anticipation that the government might assist the insurer helped propel the Dow Jones Industrial Average to a 1.3% gain. In bailing out AIG, the Federal Reserve appeared to be motivated in part by worries that Wall Streets financial crisis could begin to spill over into seemingly safe investments held by small investors, such as money-market funds that invest in AIG debt. Indeed, the $62 billion Primary Fund from the Reserve, a New York money-market firm, said it "broke the buck" -- that is, its net asset value fell below the $1-a-share level that funds like this must maintain. Breaking the buck is an extremely rare occurrence. The fund was pinched by investments in bonds issued by now collapsing Lehman Brothers. Money-market funds are supposed to be among the safest investments available. No fund in the $3.6 trillion money-market industry has lost money since 1994, when Orange County, Calif., went bankrupt. A number of money-market funds own securities issued by AIG. The firm is also a big insurer of some money-market instruments. Credit Downgrade AIGs financial crisis intensified Monday night when its credit rating was downgraded, forcing it to post $14.5 billion in collateral. The insurer has far more than that in assets that it could sell, but it could not get the cash quickly enough to satisfy the collateral demands. That explains the interest in obtaining a bridge loan to carry it through. AIGs board approved the rescue Tuesday night. AIGs board said in a statement that the deal would "protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis." The final decision to help AIG came Tuesday as the federal government concluded it would be "catastrophic" to allow the insurer to fail, according to a person familiar with the matter. Over the weekend, federal officials had tried to get the private sector to pony up some funds. But when that effort failed, Fed Chairman Bernanke, New York Fed President Timothy Geithner and Treasury Secretary Paulson concluded that federal assistance was needed to avert an AIG bankruptcy, which they feared could have disastrous repercussions. Staff from the Federal Reserve and Treasury worked on the plan through Monday night. President George W. Bush was briefed on the rescue Tuesday afternoon during a meeting of the Presidents Working Group on Financial Markets. That the government would prop up AIG financially offers a stark indication of the breadth of the insurers 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 of AIGs 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. AIGs millions of insurance policyholders appear to be considerably less at risk. Thats 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 cant be shifted out of the subsidiaries without regulatory approval, and insurance is also regulated strictly abroad. Tuesday afternoon, after the market closed, AIG put out a statement saying its basic insurance and retirement services businesses are "fully capable of meeting their obligations to policyholders." AIG said it was trying to "increase short-term liquidity in the parent company," but said that didnt "include any effort to reduce the capital of any of its subsidiaries or to tap into Asian operations for liquidity." Asia is one of AIGs largest markets. Financial Pain Where the company is feeling financial pain is at the corporate level, even while its insurance operations are healthy. The urgency of federal aid came into stark relief Tuesday as other options fell off the table and pressures continued to build. On Tuesday, AIGs attempt to raise as much as $75 billion from private-sector banks failed. The banks advising the firm concluded it would be all but impossible to organize a loan of that size, making the government AIGs chief hope. As a result of its credit downgrades, the insurer has to post $14.5 billion in collateral to bolster its credit rating. In the debt markets, AIG also has to post additional collateral to investment banks and others it trades with. Adding to AIGs woes, investors continued to pummel the companys stock on Tuesday, pushing the share price down 21%, to $3.75. It was the third double-digit percentage decline in the past three trading days. AIGs shares are now down 94% for the year. AIGs cash squeeze is driven in large part by losses in a unit separate from its traditional insurance businesses. That financial-products unit, which has been a part of AIG for years, sold the credit-default swap contracts designed to protect investors against default in an array of assets, including subprime mortgages. But as the housing market has crumbled, the value of those contracts has dropped sharply, driving $18 billion in losses over the past three quarters and forcing AIG to put up billions of dollars in collateral. AIG raised $20 billion earlier this year. But the ongoing demands are straining the holding companys resources. That strain contributed to the ratings downgrades on Monday. Those downgrades, in turn, ratcheted up the pressure on the company to come up with more cash, quickly. AIG was recently in the news for paying out record bonuses to its executives and this created a furor among the members of the Congress and the public as to how can a firm that received money from the Federal government pay out such huge bonuses to its executives. In my opinion, this is a blatant violation of the trust that the taxpayer has placed upon AIG and the expectation is that the company would use the bailout funds for more productive purposes. AIG management defended the bonuses stating that they were contractually obliged to pay bonuses to their employees and this sparked even more outrage. In my opinion, it is incumbent upon the banks that received the bailout money to use that money judiciously and for getting themselves out of the mess that they have created. Sources AIG: The Biggest Bailout. USNews.com. 17 Sep 2008. 28 Apr 2009. www.usnews.com/blogs/the-ticker/2008/9/17/aig-the-biggest-bailout.html US to take over AIG in $85 Billion Bailout. WSJ.com. 16 Sep 2008. 28 Apr 2009. online.wsj.com/article/SB122156561931242905.html Read More