There’s no way to understate the enormity of what happened yesterday evening, ladies and gentlemen. Yesterday morning, I wrote in this space that it was the first day of the rest of Wall Street’s life.
But then, the Federal Reserve rebooted the financial world. Today is the first day of a brand new life.
The events of the past four days have been so momentous and so unprecedented that they need a name. Let’s call it The New Trade.
The United States acquired AIG Incorporated, the largest insurance holding-company in the country, and an entity regulated not by any Federal body, but by the State of New York.
An enormous amount of anger has already been expressed in the few hours since the deal was announced. I’m going to refrain from adding to that.
It’s as if you woke up to find the sun rising in the west rather than the east, in a sky that’s green instead of blue. It’s hard to be angry about a change like that. I’m still trying to grasp the full dimensions of what has changed.
So rather than tell you what I feel, I’m going to tell you what actually happened, to the best of our knowledge, and hopefully give you a perspective you won’t get anywhere else.
The Biggest Insurer
AIG has 116,000 employees. As of June 30, the company’s balance sheet shows total assets of $1.05 TRILLION, against liabilities of $972 billion. They had lost more than $18 billion in the three quarters to June 30, and almost certainly were on track to report some evil results for the quarter that will end on September 30.
Maybe this will give you a different perspective: AIG was number 13 on the Fortune 500 list of the biggest American companies.
AIG contains a great many very healthy, very well-capitalized, very profitable businesses, and it generates enormous cash flow. And yet, it was on the edge of filing for Chapter 11 bankruptcy last night (as the far-smaller investment bank Lehman Brothers had done the day before).
I and many others fully expected that the Federal regulators would allow AIG to file the bankruptcy, in light of the fact that they let Lehman enter a largely-unassisted death agony, and of their multiple statements that they would not be committing public money to bail anyone out anymore.
Going into yesterday, the situation facing AIG was this: because of the money they had lost on their portfolio of investments and credit products derived from mortgages, they had suffered several downgrades from the ratings agencies.
They were already under pressure to either sell assets or raise new capital because of their ongoing losses. The rating-downgrades increase the interest rates that AIG must pay on the money it borrows to run its businesses. That deterioration makes everything worse, fast.
And AIG had made a large business of writing credit-default swaps, which are like insurance policies for fixed-income securities. If their capital position continued to deteriorate as the market for mortgage-backed securities fell, they could conceivably be forced to surrender the collateral that secured their borrowings, their swaps, and their other obligations.
That would have had the effect of dumping a lot of distressed assets onto a market that is already reeling from the bankruptcy of Lehman Brothers, on top of the stress from over a year of credit crisis.
This is the “systemic risk” that the federal regulators obviously became deeply frightened about, sometime yesterday. The more picturesque word for it is “meltdown,” as asset prices would fall precipitously across all markets in the whole world.
What AIG needed was a bridge loan, a commitment of capital that would allow them to meet all of their obligations with confidence, while they continued the process of finding an equity partner or someone to buy their assets.
Let me repeat that: AIG had to find some new money, because they had lost so much already. This means that, regardless of how it happened, the company was going to get smaller, or create losses for its shareholders, or both. This wasn’t a business-as-usual situation.
They spent the last several days looking for about $75 billion, according to various reports, from a combination of sources: Wall St. firms, banks, foreign entities, and the Fed itself.
No one bit. And that really matters a lot, because it shows you that AIG couldn’t find a way to make the deal attractive to anyone. This point will come back when we discuss the impact on taxpayers.
At some point yesterday afternoon, it became clear that AIG wasn’t going to get bridged. And it also became clear to Treasury and Fed officials that they didn’t want to see an 11 filing, with technical defaults all over a $1 trillion asset portfolio.
What I badly wish I knew was this: did the regulators know this would happen late last week, when they decided to tell Wall St. that they were going to let Lehman Brothers die? Or were the regulators blindsided?
Think about it. If you know you’re going to create the mother of all bailouts, do you do two of them in a row (three if you count Merrill Lynch)? Or do you act tough on the ones you’re not worried about, so you can bail out the one that really scares you?
Do you see my point? If the feds had bailed out a pair of broker-dealers and the thirteenth-largest business in America in one weekend, there would simply have been no end to it. Especially with a Democratic Congress and maybe a Democratic President coming up next year. Bailing out GM and Ford Motor would have been nothing compared to this, and there would have been no answer to: “Well, you took care of them, so take care of us too!”
So maybe they said something like this: “Let’s show everyone we’re not afraid to draw blood. After all, the world can survive without Lehman Brothers and Merrill Lynch. Then we have some cover to deal aggressively with a problem that the world would not be able to easily survive.”
Or maybe they were surprised as hell yesterday when they saw just how bad the AIG situation was. As I said, I wish I knew.
So according to the Fed’s terse statement released last night, this is what went down:
The New York Fed will create a special credit facility for AIG. It will last for 24 months, during which time AIG may borrow up to $85 billion, at an interest rate of three-month dollar LIBOR plus 850 basis points.
That’s about 14% or so at the moment. You need the interest rate to be a penalty rate, to force AIG to use other capital sources in preference. The new facility is only for use as a last resort. Otherwise AIG would have an overwhelming, unfair competitive advantage. It's quite likely that AIG will end up never borrowing from the $85 billion credit line at all.
AIG’s borrowings will be collateralized by all of the assets of AIG, including stock and assets held in non-insurance subsidiaries. This means that, with everything hypothecated, AIG has no more balance sheet to expand its businesses with.
It’s expected that the company will use the 24 months to sell off its assets and pay its obligations as they come due, becoming a continually-smaller company in the process. I’ll come back to this point.
In return for extending the credit, the United States will take a 79.9% ownership stake in AIG, and has the right to veto the payment of dividends to existing shareholders.
Have you ever negotiated a venture-capital bridge under adverse conditions? I have, and that’s what this reminds me of. It’s the bridge loan from hell.
It’s completely unclear this morning how the New York Fed will finance the credit line to AIG. There’s been some speculation that there will be massive new issuance of Treasury debt, but no one knows yet.
Are You Angry About the Bailout
Why all the anger? Because to the naked eye, it looks like a lot of people at the top of AIG made out like bandits and will escape punishment for their mistakes.
Let’s put that in perspective. For one thing, the shareholders are well and truly screwed. They will lose everything. For another thing, the senior management of AIG will be swept out with the trash and replaced with a new team.
I’ve already described the systemic risk that the regulators were trying to avoid, which would have been the result of a disorderly failure. Bankruptcy does not defease a financial company’s obligations to meet margin or collateral calls to their counterparties. And in any case, such failures would have resulted in a chain-reaction of failures in otherwise-healthy companies.
Add to that the insurance policies and annuities that AIG has written all over the world. You yourself may own some of them.
You may be angry about the bailout. But if there had been no bailout, would you have been angry about the sudden cancellation of your homeowner’s insurance after you paid your premiums, or about losing all the money in your retirement savings account?
And what if the financial tsunami had wrecked the stock market, triggered a massive recession, and caused you to lose your job?
Still feeling angry?
The Impact on Capitalism
There’s one more key thing I want to say, which reflects the fact that the AIG bailout is one of the most unprecedented things the government has ever done in peacetime.
The United States must not remain in the insurance business.
We’ve embarked, on one day’s notice, on precisely the path that free-market advocates consider a nightmare scenario. The largest insurance company in America is now owned and operated by the government, and has nearly unlimited access to cheap capital by virtue of the credit-quality enhancement provided by the Fed line of credit.
If you were one of AIG’s competitors, wouldn’t you be feeling a little bit like Tokyo when Godzilla is in town?
That’s the great hazard faced by the government now.
The only permissible course of action is for the feds to explicitly and openly put AIG on a path to liquidation.
They must NOT plan to operate the company as usual. Instead, they must lay out concrete plans and monthly targets for a wind-down of all of AIG’s businesses. This needs to be done so as to minimize the impact on asset values, the stability of the ongoing businesses as they transition to new ownership, and on the employees who make their livings at AIG.
And meanwhile, from this day forward, the sun will rise in the West and set in the East.