Tuesday, November 17, 2009

Audit: A 'Backdoor Bailout' of AIG's Counterparties?

When the New York Fed renegotiated its original $85 billion deal to bail out AIG last year, it "effectively" transferred tens of billions dollars of cash from the federal government directly into the coffers of the AIG’s counterparties, according to an audit by TARP Inspector General Neil M. Barofsky. The New York Fed pursued a negotiating strategy that failed to get the counterparties to accept anything approaching market value for the toxic assets taken off their books by the deal. This raises the question of whether or not this was a “backdoor bailout” of the counterparties, the audit suggests.

By Robert Stowe England
November 17, 2009

By November 2008 the emergency rescue of the giant insurance company AIG, engineered by the New York Fed two months earlier, was in trouble.

Timothy Geithner, President of the New York Federal Reserve Bank, had played a leading role in that rescue, authorized by the Federal Reserve’s Ben Bernanke and then Treasury Secretary Hank Paulson, a former chairman of Goldman Sachs.

By early November, it had become clear that the September 16 deal was going to have to be restructured.

This presented a serious test of the ability of the New York Fed to both negotiate a new and better deal that would stick this time and also to protect the government from further potential losses.

The New York Fed, however, entered this effort in the belief that it was handicapped. As a result, it fell victim to pressure from AIG counterparties to pay 100 percent of the dollar for toxic assets that were worth far less, according to an audit released today by the Office of the Special Inspector General for the Troubled Asset Relief Program (TARP), headed by Neil M. Barofsky.

“After limited efforts to negotiate concessions from the counterparties failed, [the New York Fed] decided to pay AIG’s counterparties at what was effectively face or “par value . . . for the collateralized debt obligations (CDOs) underlying [AIG’s] credit default swap (CDS) portfolio,” the audit concludes.

The CDOs were mostly toxic mortgage assets held by the counterparties. AIG had entered into the swap agreements to guarantee payment of the cash flows from those assets if and when underlying mortgages went bad.

According to the audit, the New York Fed felt it was dealt a bad hand. The agency “was confronted with a number of factors that it believed limited its ability to negotiate reductions in payments effectively, including a perceived lack of leverage over the counterparties because the threat of an AIG bankruptcy had already been removed by [the New York Fed’s] previous assistance to AIG.”

The audit also concluded, not surprisingly, that the original terms of federal assistance to AIG on September 16, as it so gingerly put it, “inadequately addressed AIG’s long-term liquidity concerns.”

In other words, the original deal was fatally flawed and by failing to work out a proper deal on September 16 the New York Fed now had to do it over.

Further, the audit concluded, the New York Fed’s “negotiating strategy to pursue concessions from counter parties offered little opportunity for success, even in light of the unwillingness of one counterparty to agree to concessions.”

The failure of the New York Fed’s negotiating strategy, combined with the structure of the deals, “effectively transferred tens of billions of dollars of cash from the Government to AIG’s counterparties, even though senior policy makers contend that assistance to AIG’s counterparties was not a relevant consideration in fashioning assistance to AIG,” the audit stated.

There were 16 counterparties from around the globe. The top six, however, represented reimbursement that totaled nearly 86 percent of the total $62.1 billion either paid out as a purchase of the assets or retained collateral that has been posted by AIG to the counterparties.

The amounts break down as follows:

• Societe Generale, 16.5 billion ($6.9 billion, Maiden Lane III; $9.6 billion, AIG collateral
• Goldman Sachs, $14 billion ($5.6 billion, Maiden Lane III; $8.4 billion, AIG collateral)
• Merrill Lynch, $6.2 billion ($3.1 billion, Maiden Lane III; $3.1 billion, AIG collateral)
• Deutsche Bank, $2.8 billion ($2.8 billion, Maiden Lane III; $5.7 billion, AIG collateral)
• UBS, $2.5 billion ($1.3 billion, Maiden Lane III; $3.8 billion, AIG collateral)
• Calyon, $2.5 billion ($2.5 billion, Maiden Lane III; $3.1 billion, AIG collateral)

The entire audit report can be found at this link: http://www.sigtarp.gov/reports/audit/2009/Factors_Affecting_Efforts_to_Limit_Payments_to_AIG_Counterparties.pdf

The Challenge for the New York Fed

What exactly was the problem for the New York Fed? Quite simply, the credit rating agencies – who were late in recognizing the credit quality of trillions of structured securities they had rated AAA – were considering making further credit downgrades to AIG.

Those potential downgrades were contemplated in large part because the value of toxic mortgage derivative assets held by counterparties to the credit default swap (CDS) deals were continuing to fall in value as the number of foreclosures rose and the economy hurtled toward recession.

Lower credit ratings would mean lower values for the toxic assets, which would mean that AIG would have to post higher collateral with the counterparties against default. Posting that collateral would, in turn, would push AIG back towards a disorderly bankruptcy once again, with all the attendant systemic risk – even with the $85 billion loan from the New York Fed and a 79.9 percent federal government stake in the company.

The Federal Reserve and the Treasury decided to move quickly to avoid the credit downgrade with a restructuring of its assistance to AIG. They authorized the New York Fed to set up a special purpose vehicle (SPV) called Maiden Lane III and for the New York Fed to lend it $30 billion to purchase the toxic CDO assets held by AIG’s counterparties.

As part of the deal, AIG’s counterparties agreed to terminate the troublesome swaps that threatened to topple the company in return for retaining the collateral AIG had already posted.

Then only decision now left was how much Maiden Lane III would pay for the toxic assets held by the counterparties – whose identities were still not publicly disclosed.

The New York Fed then entered into negotiations with the counterparties to determine how much it would pay for the toxic CDOs. When the dust had settled, the price paid of $62.1 billion represented 100 percent of pay value for the counterparties.

In the aftermath of the deal, the value of the CDOs dropped precipitously while some of the counterparties were bailed out with Treasury funding under TARP.

This all raises “questions,” as the audit put it, of “whether these counterparty payments may also effectively have been paid using Government funding as a ‘backdoor bailout’ of these counterparties.”

The second AIG bailout was almost as pricey as the first one, and this time it was even more favorable to AIG. For example, Treasury purchased $40 billion of newly-issued AIG preferred shares.

This $40 billion, the audit reports, “went directly to [the New York Fed] to pay back a portion of the funds provided by [the New York Fed] and permitted [the New York Fed] to reduce the total amount available under the credit facility from $85 billion to $60 billion."

The New York Fed in turned was authorized “to create and lend up to $30 billion to Maiden Lane III” to buy the toxic CDOs from the AIG counterparties.

Maiden Lane III was funded with $24.3 billion from the New York Fed in the form of a senior loan and a $5 billion equity investment from AIG.

Of the amount Maiden Lane III paid for the toxic CDOs, $27.1 billion was paid to the counterparties and $2.5 billion went to the New York Fed.

The counterparties were allowed to keep the $35 billion in collateral that been posted by AIG prior to the deal. The $35 billion was funded, in part, from the original $85 billion line of credit, the audit helpfully explains.

As a result, AIG’s counterparties received $62.1 billion or full face value for the toxic assets. The top six counterparties received 85 percent of that or $53.3 billion.

The audit also points out that New York Fed initially chose not to reveal the names of the counterparties – or to reveal they had paid 100 percent value for the assets. On March 5, 2009, however, Federal Reserve Vice Chairman Donald L. Kohn testified to a Senate panel that the New York Fed had paid par but refused to identify the counterparties.

Ten days following the Senate hearing, AIG, in consultation with the Fed, released the names of the counterparties and on April 28, 2009, the New York Fed provided further information on its Website, the audit notes.

Details of the Negotiations

The audit details the efforts of the New York Fed to negotiate concessions with eight of the counterparties in return for tearing up the swaps and removing the toxic assets from their balance sheet.

The eight counterparties were Societe Generale, Goldman Sachs, Merrill Lynch, Deutsche Bank, UBS, Calyon, Barclays, and Bank of America.

Here are some of the highlights:

• The Commission Bancaire in Europe said that absent a bankruptcy, Societe Generale and Calyon could not accept anything less than par under existing law.
• Goldman Sachs said they could not take a concession because they would have to report a loss.
• Merrill Lynch rejected concessions without direct approval by ceo John Thain.
• Four more counterparties refused to accept a haircut.
• Only one – UBS – offered a haircut, 98 cents on the dollar.

The audit reports the concerns of Timothy Geithner and the New York Fed at the time of the negotiations as follows.

• The leverage of a threatened AIG bankruptcy had been removed.
• A threat of an AIG default might introduce doubt in the marketplace about the resolve of the U.S. government to follow through on its commitment to financial stability.
• There was fear that the credit rating agencies would view negatively any effort to threatening not to support AIG. The New York fed was unwilling to use its leverage as the regulator, in part because it was acting as a creditor of AIG in the negotiations.
• The New York Fed wanted to uphold the sanctity of contracts.
• The refusal of the French banks to negotiate concessions meant the New York Fed by exacting concessions from other players would not be treating all parties equally.
• The New York Fed did not have legal mechanisms in place to deal with the counterparties.

Perhaps the only upbeat note from the audit is that Barofsky believes that the market value of the CDOs held by Maiden Lane III are worth more than the amount of money it owes to the New York Fed.

The audit reports a $23.2 billion market value on November 2, 2009 for the CDOs held by Maiden Lane III. The loan balance owed by Maiden Lane III to the New York Fed stood at $19.3 billion.

But even this bit of positive news has to be tempered because the true cost of the AIG bailouts remains very much in question. For example, it ignores the loss to AIG (and the government as 79.9 percent equity owner) of the $35 billion AIG posted as collateral with the counterparties, which they were allowed to keep in the deal worked out by the New York Fed.

“While [the New York Fed] may eventually be made whole on its loan to Maiden Lane III, it is difficult to assess the true costs of the Federal Reserve’s actions until there is more clarity as to AIG’s ability to repay all of its assistance from the Government,” the audit concludes.

Copyright © 2009 by Robert Stowe England

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