I am not even going to attempt to go into detail about the enlarged and much sweetened government bailout package with A.I.G. that is being reported today. Yves at Naked Capitalism has a beautiful point-by-point dissection of what is going on, and I encourage everyone to read it.
For those who get lost in the technical jargon, I'll just do a short summary here.
- The initial AIG rescue package was: a $85 billion 2-year loan, interest rate at Libor + 8.5%, and loan is secured by assets of AIG. In return government gets 79.9% stake in AIG.
- Early in October, the government lent AIG an additional $37.8 billion, gets nothing in return.
- This weekend, the government has promised AIG another $27.2 billion (for a total of $150 billion). In addition, the terms of the $150 billion are being entirely rewritten (as compared to the initial AIG package) and will now look like this (bold to show what has changed from original terms):
- $60 billion will be a 5-year loan, interest rate at Libor + 3%
- $40 billion will come out of TARP, and government will get preferred shares, with 10% annual dividends.
- $30 billion will go into a separate entity that will buy up the collateralized debt obligations which AIG had been giving guarantees (via credit default swaps) on. (AIG will contribute $5 billion into the entity.) See below discussion.
- Though I can't find this last bit, I'm assuming the last $20 billion will go into a second entity that will do similar securities purchases.
- The government will continue to own a 79.9% equity stake in AIG.
I have such a violent reaction to the government investment in the special entities that I feel this urge to throttle the current administration with my bare hands. This is what is going on. First, the reason that AIG is in such bad shape is because they were guaranteeing some of these very bad asset backed securities that we've all been hearing about, in this case, collateralized debt obligations (CDOs). What this means is that if you bought one of these guarantees from AIG, IF the CDO defaults, you have the right to collect the face value of the CDO from AIG (I've written about this previously at MOMocrats). This has been problematic for AIG because the premium they were collecting to insure these CDOs was magnitudes less than the obligations they've now taken on (remember, this is all because these banker brainiacs believed that never in a million years could such CDOs default, so the premiums were, in their minds, free money).
Now that many of these CDOs are on the verge of collapse, things are extremely problematic for AIG.
What the government proposes to do, with these special entities, is to buy some of the most vulnerable and worst performing CDOs underlying AIG's guarantees. And they propose to buy them at 50 cents to the dollar across all tranches. What does this do? Well, by purchasing the CDOs, the government is effectively preventing the possibility of their default, and therefor, preventing AIG from ever having to make good on its guarantees.
Why is this a problem??? As Yves notes, "Recall that in Merrill's not-all-that-long-ago sale of its super-senior CDOs (the very best tranches) it got a nominal price of 22 cents on the dollar... [and the] hedge fund Lone Star paid only 25% of that amount (or 5.5 cents) in cash, the rest was contingent on performance. So Merrill might have sold the CDOs for as little as [5.5 cents on the dollar]."
In the best case scenario, the government is paying twice the amount that Merrill was able to get on its super-senior tranches of CDOs, in the worst case, the government is paying 10 times that amount.
For a super long time, the pro-business, rah-rah TARP people have been pointing out that the government bailouts are not handouts per se, as they were all structured as loans or government purchase of common or preferred shares. There's been a lot of talk of government getting the "upside" or economic recovery.
I'm sorry, but at this point, I'm struggling to see how the government can expect to "recover" anything on their "investments". In an incredibly short amount of time (2 months), the AIG loan has gone from a libor +8.5% over two years to libor + 3% over five year, reflecting the all too precarious situation AIG is in (they can't even afford to make interest payments on the very cheap money they're getting). In addition, if the Merrill CDO numbers are correct, you're going to have to see a 10 fold correction of the CDO prices before the government will net even on the purchase of CDOs, let's not even talk about the disappearing possibility of getting to any upside.
On a complete aside, I think this is an interesting approach for dealing with the CDS problem for PRIVATE financial enterprises. One of the biggest problems with the CDS market is that there were people who did not hold the underlying security and were still buying the guarantees. (Which is why the CDS market is estimated to have a nominal value upwards of $60+ trillion (under dispute).) This means that even though you never bought a CDO (for example) you could still collect the full face value of the CDO from the guarantor if that CDO defaults. And since you paid only pennies on the dollar for the guarantee, you could make out like a flamin' bandit.
So if I was an issuer of CDSs, I would totally take any last pots of money I had and buy out the CDOs (or whatever ABS, RMBS, etc... that I had enhanced) from their holders. Most of these instruments are dirt cheap right now, and beats paying out the full value times however many CDS contracts I have outstanding.
J and I had a big fight about this last night, with him saying that he finds this strategy completely unfair, since it would be interference with fulfilling a contract. I called bullshit on him, pointing out that interference is problematic in contracts only when you prevent the counterparty from fulfilling their obligations under the contract, not when you do whatever is possible on your side to prevent triggering a payout event (like under an insurance contract). J kept doing the "I can't believe you're so stupid," hands over his despairing eyes thing that he does.
Yeah, we have fights about these things. Whatever, this blog isn't called Wonkess for no reason.
Update: William Buiter has a post up at the FT asking that question to end all questions - is it time to let AIG fail? My favorite parts:
No doubt a lot of CDS contracts written on AIG debt would be activated by a default, but the aftermath of Lehman’s filing for bankruptcy protection demonstrated that the process of unwinding and settleing the CDS claims was remarkably orderly and much less destructive than feared.
and
Here we run again into the incomprehensible fact that, almost 15 months after the start of the crisis, the US Federal authorities have not yet created a special resolution regime (SRR) with prompt corrective action (PCA) powers that would allow a duly appointed Administrator or Conservator to take any systemically important institution into Administration/Conservatorship before the normal tests for insolvency (balance sheet insolvency or liquidity insolvency) have been met. The Conservator would replace board and management and suspend the voting rights and other decision rights of the shareholders. No dividends, share repurchases or other transfers of resources to the old shareholders could take place while the Conservatorship is in effect. The Conservator should be able to impose charges (haircuts) on all unsecured debt holders and other unsecured creditors, regardless of seniority. The Conservator would also be able to impose mandatory debt-to-equity conversions on all unsecured creditors and debt holders, with or without first extinguishing the equity of the old shareholders. The Conservator would have full authority to sell assets and to restructure the balance sheet and the activities of the business in any way deemed appropriate and lawful. Finally, the Consevator would have the power to liquidate the company.
Update (2): More white hot anger from Interfluidity and Clusterstock.
Ok, so I'm going to have to read this tomorrow when my brain is less fried, but I just had to say I am relieved to know there ARE couples out there who argue about these things & not the dishes. You guys are officially brainiacs.
Posted by: hoppytoddle | November 11, 2008 at 12:20 AM