The US Treasury and Fed gave out two contrasting signals today. One the one hand, they furthered moral hazard by putting up tax payers money to engineer a $85 bn bailout of the troubled insurance giant American Insurance Group (AIG). In complete contrast, by refusing to lower the benchmark Federal Funds rate from 2%, the Fed appears to have come to the conclusion that continuously postponing the inevitable by ever-cheaper borrowing is no longer a solution.
Reversing all brave talk about refusing to use tax payers money to bailout greedy investors and letting Lehman Brothers fall into bankruptcy, Hank Paulson has blinked and announced the bailout that would give the government control of AIG. AIG with business interests across the globe, covering diverse sectors like mortgages and aircraft leases, was refused a $40 bn bridge loan request by the Fed last week. Coming only two weeks after the government takeover of mortgage financing giants Fannie Mae and Freddie Mac, this "nationalization" of AIG is another strong indicator of the fact that big government is back in the financial markets with a bang.
The Fed and Treasury officials were scared of a global financial "chain reaction" given AIG’s role as an enormous provider of esoteric financial insurance contracts to investors who bought complex mortgage backed securities. Faced with a ratings downgrade, AIG was forced to cough up more collateral to cover for the increased riskiness. Its efforts to raise $75 bn private capital debt(including from JP Morgan Chase and Goldman Sachs) to stave off a ratings downgrade failed, leaving a bailout as the only alternative to a collapse.
Under the rescue plan, the Fed will make a two-year loan to A.I.G. of up to $85 billion and, in return, will receive warrants that can be converted into common stock giving the government nearly 80 percent ownership of the insurer, if the existing shareholders approve. All of the company’s assets are being pledged to secure the loan. Existing stockholders have already seen the value of their stock drop more than 90 percent in the last year. Now they will suffer even more, although they will not be totally wiped out.
The credit default swaps (CDS) underwritten by AIG, effectively required it to cover losses suffered by the buyers in the event the securities defaulted. The CDS are not securities and are not regulated by the Securities and Exchange Commission. And while they perform the same function as an insurance policy, they are not insurance in the conventional sense, so insurance regulators do not monitor them either.
If AIG had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, and that in turn would have reduced their own capital and the value of their own debt. Small investors, including anyone who owned money market funds with AIG securities, could have been hurt, too.
Thanks to its acquisition of an 80% share in AIG by investing $85 bn and holding $29 billion in securities once owned by Bear Stearns, the NYT has a new description for the Fed - investor of last resort! It writes, "Instead of just setting monetary policy in its Ivory Tower-like setting, the Fed now must wear several hats — that of insurance conglomerate, investment banker and even hedge fund manager."
Here is a snapshot of the liabilities taken over by the Fed so far.
Freakonomics has this excellent brief on the "most remarkable period of government intervention into the financial system since the Great Depression" by Doug Diamond and Anil Kashyap.