THE BASIS POINT

AIG Bailout Overview (part 2): Subprime Fed Loan Could Protect Tax Dollars

 

Here’s a more detailed version of the Fed’s AIG bailout to follow up our previous post. Quick review: On Monday it was thought that AIG, the world’s largest insurer, needed about $40 billion to meet a wave of claims on credit default swaps and other obligations. The logic went that this would be a bridge loan to cover them while they sold some of their trillion dollars in assets to raise money. But the claims causing their short-term cash crunch were obligations that needed to be settled within days, lest it start a domino effect of counterparty defaults on all kinds of derivatives throughout the global financial system. And it would have taken weeks or months for AIG to sell assets to raise money.

Later Monday, the New York State government authorized AIG to raise $20 billion from its own subsidiaries and later still the Fed asked JP Morgan Chase and Goldman Sachs to step in with a liquidity facility of up to $75 billion. With the required bridge loan funds ballooning by the hour, CNBC’s David Faber joked that it was the Bridge Loan to Nowhere. Like a clever VP campaigner who might be hiding something, JPM and Goldman said ‘thanks but no thanks’ when asked to help (a tacit admission of the true short-term weaknesses throughout the banking system). The Fed was left to figure it out. They extended an $85 billion liquidity facility to AIG so it could meet its short term obligations.

Our understanding is that it will behave like an $85b line of credit. They can draw on for 2 years at a rate of 3mo LIBOR + 850 basis points. Right now 3mo LIBOR is 2.81%, so that’s an 11.31% rate (side-note: 3mo LIBOR has averaged 4.59% January 1990 to present). Assuming AIG drew the whole $85b and repaid it in 2 years, below are the terms of the AIG bailout loan:

Loan Amount = $85,000,000,000
Rate = 11.31%
Term = 2 years
Monthly interest-only payment = $801,125,000 (with full $85b due in 2yrs)
Principal increases 2.5% (or $2.125b) each quarter past 2yrs it’s not repaid

Under this scenario (if it is correct), this would yield $19b in interest income for the Fed over 2 years. This is not a bad deal, since AIG is ultimately a good credit risk if they really can move some of their trillion in assets as they claim they can. Remember the Fed-to-Bank Discount Rate for short-term emergency loans is 2.25%, so this loan to AIG is at a 9.06% premium over the Discount Rate.

The Fed also gets a 79.9% in AIG’s stock. The act of the Fed stepping in dilutes those shares, but that’s also a potential source of longer-term return if we’re understanding this correctly. Not as clear on these stock terms.

Government and taxpayer involvement is certainly not how an open market should function, but the open markets are broken despite what John McCain said Monday. So this seems to be the only way.

Good News: If AIG makes good, taxpayer money could be OK.

Bad News: The terms and rate on this loan behave almost exactly like a subprime residential mortgage loan. Those loans were all 2 or 3 year terms, had LIBOR plus at least 5% rates, and had extremely harsh terms after the initial term expired. This proves what NYU economics guru Nouriel Roubini has been saying:

“Reckless people have deluded themselves that this was a subprime crisis,” he told me. “But we have problems with credit-card debt, student-loan debt, auto loans, commercial real estate loans, home-equity loans, corporate debt and loans that financed leveraged buyouts.” All of these forms of debt, he argues, suffer from some or all of the same traits that first surfaced in the housing market: shoddy underwriting, securitization, negligence on the part of the credit-rating agencies and lax government oversight.

“We have a subprime financial system,” he said, “not a subprime mortgage market.”

Basis Point of Disclosure: The Basis Point is doing the best we can to keep up with unprecedented changes in the markets and do our best to fact check the items we discuss, but we may not be getting all of this correct. Please chime in with corrections if you see errors. Thanks.

 
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