Wall Street Confidential .

AIG Deathstar

April 2,2009

by Edward Jay Epstein

The colossal bail-out of AIG is now so enmired in the muck of conspiracy theories that even Eliot Spitzer, who had to resign as governor of New York after laundering secret payments to a call-girl service through an off-shore account, is back on his moral high horse denouncing
the rescue of AIG as “nothing more than a conduit for huge capital flows to the same old suspects, with no reason or explanation.” Suggesting it was an “inside deal” with Goldman Sachs, he demands to know, “the precise conversation” that took place between Fed Chairman Ben Bernanke, NY Fed President Timothy Geithner, Treasury Secretary Henry Paulson, and Goldman Sachs’ CEO Lloyd Blankfein that preceded the initial loan to AIG in mid September 2008. Failure to answer, he warns, “will feed the populist rage that is metastasizing.”
The question he does not ask, and which goes to the heart of the issue is: what would have happened if the Fed and Treasury had not acted decisively to bail-out AIG after it informed them
it was unable to meets its obligations?
AIG at that time was the world’s largest insurance company. It had over $1 trillion dollars in assets. With operations in 130
countries, it insured much of international commercial transaction (including of most of China’s exports to the United States.) Its
AAA credit backstopped its portfolio of $2.7 trillion in derivative contracts that, for better or worse, had spread throughout the
globalized financial system. Here is what would have happened if AIG
move into bamkuptcy proceedings.
For starters, it would leave the major banks of Europe over one-half dollars
short of their government-mandated capital requirements. AIG, through a French
subsidiary called Banque AIG, had been providing these banks with what it called
innocously “regulatory capital.” These arcane derivative contracts, allowed banks
to report to authorities high capital to debt ratios, so an AIG default that
invalidated them would force these banks to call in hundreds of billions in loans.
In addition to these dominos, AIG had sold hundreds of billions of dollars of
credit default swaps, assuming in the process the default risk on everything from
securitized credit, such as sub-prime mortgages and credit card debt, to the
sovereign debt of countries from eastern Europe to Latin America. Without these
guarantees, these securities would lose their ratings, and banks, pension funds,
trusts, and sovereign investment funds would be forced to unload their holdings at
any price causing havoc.
The municipal bond market would also be thrown into turmoil. Not only was
AIG the second largest holder of municipal bonds, but much of the money from
the sales of municipal bonds– some $12.1 billion– had been temporarily invested
in AIG vehicles called Guaranteed Investment Accounts through which states and municipality earned extra interest until they needed the money for construction
and other purposes. If this money was unavailable, a large number of municipal
bonds would be downgraded or, if they could not make up the short fall, default.
Far more disastrous would be the impact of a default on AIG’s insurers, and
the enterprises it had insured, which would face seizure by regulatory authorities
around the world. The immediate problem was that AIG had loaned out much of
the stock in its insurance companies’ portfolio to banks as part of an interest rate
play through it “securities lending program.” As collateral for the stock, the banks had deposited on a short-term basis $43.7 billion in AIG accounts on which they
earned the money-market rate of interest. AIG, to make a higher rate of interest,
put the money in residential mortgages. But after the collapse of Lehman in
September, the banks demanded their $43.7 billion back, as they entitled to do as
the contracts expired weekly, but, with residential mortgages now almost
unsalable, AIG could not repay them or retrieve the shares backing its insurance
. So What Messieurs Bernanke, Geithner, and Paulson were looking at
on September 15th was financial Armageddon with AIG as the death star. We do not need a transcript of their “precise conversations,” or even to know who else they consulted in or out of government that day, to figure out why they decided to intervene. It was what Geithner meekly called “systemic risk.” In other words, preventing the AIG death star from destroying world financial markets.
Their actions were no secret. They provided AIG with an initial $85 billion
emergency loan that allowed it to meet its pending obligations. This loan was not
a grant. It was collateralized by first call on AIG’s trillion dollars in assets, and
carried a high interest rate– three percent above the London interbank rate. For
making this loan, the US government got 77% ownership in AIG. Nor is there
much mystery to what happened to the money. It is detailed on AIG’s website.
The largest part went to repaying 18 banks the $43.7 billion owed to them in
AIG’s security lending program, which allowed AIG to r get its insurance
companies out of harm’s way by recovering their shares. ( $19.2 billion of this
money came from AIG selling its distressed mortgages to the New York Fed’s
entity, Maiden Lane II). Another $12.1 billion went to pay off its obligations to
states from its Guaranteed Investment Agreements. Finally, $22.5 billion was
initially used to post the collateral at 24 banks holding its credit default swap and
then, in November, used as part of the purchase price of the toxic securities
insured by these swap by another New York Fed entity, Maiden Lane III. By
buying these securities at a heavily discounted price, the Fed relieved AIG of
posting any further collateral. As a result, international and American banks
wound up with money due them from AIG, the government, via Maiden Lane II
and III, took part bank’ toxic assets off their books, and the world’s largest
insurance company was saved from bankruptcy.
While no conspiracy theory is needed to explain why Bernanke, Geithner, and
Paulson pushed the $85 billion panic button in mid September, one may be
necessary to unravel how a world-class insurance company turned into a near
death star. Certainly, AIG needed enablers to so permeate the globalized financial



Questions? Email me at edepstein@worldnet.att.net
This website is still (heavily) under construction. The webmistress can be reached at june@jooon.com