A lifeline for AIG

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Sep 17th 2008 | NEW YORK
From Economist.com

America’s government comes to the rescue of a giant insurance company

AP/Shutterstock
AMERICAN finance has a new, if reluctant, kingpin: the government. In a dramatic move on the evening of Tuesday September 16th the Federal Reserve agreed to provide American International Group with a loan of $85 billion to help it stave off bankruptcy. In return, either the Fed or Treasury will take effective control of the company, which until recently was an icon of private-sector capitalism. In the space of nine days, the government has found itself having to take charge of both the country’s largest insurer and its two giant mortgage agencies, Fannie Mae and Freddie Mac. The move comes two days after Lehman Brothers, a big investment bank, filed for bankruptcy after being denied federal help, and Merrill Lynch, another Wall Street giant, fled into the arms of Bank of America for fear of being swept away by the hurricane battering global financial markets.

As well as writing general-insurance policies all over the world, AIG plunged disastrously into the market for derivatives linked to housing and credit. Its exposure to the murky credit-default swaps market alone is a notional $441 billion, enormous by anyone’s standards. As the market value of these derivatives fell, the firm found itself strapped for capital, and was forced last weekend to approach the Fed, cap in hand. The central bank initially demurred, instead nudging JPMorgan Chase and Goldman Sachs to try to help AIG raise the money from private sources, such as other banks, private-equity firms and sovereign-wealth funds. Those efforts failed, however, and AIG’s predicament worsened on Monday when the big rating agencies downgraded its debt, forcing it to post more than $13 billion of extra collateral with trading partners. At that point officials performed a U-turn and began negotiating an emergency rescue.

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They may have had no choice. Markets did not completely fall apart after Lehman’s bankruptcy, as some had feared, but they were highly agitated. The rate that big banks charge each other for short-term money jumped to three times the level in June, and the cost of protecting against their default broke records. Officials worried that the collapse of AIG, with its $1 trillion balance sheet and operations in 130 countries, could send the financial system into a tailspin. Its CDS counterparties, mostly banks, would have had to write down their positions, straining their capital ratios at the worst possible moment.

The AIG bailout shows how hard it is for America’s financial authorities to steer a straight course through a crisis that is piling one systemic threat onto another. Bear Stearns had been helped in March for fear of chaos in derivatives markets, in which it was a leading player as a prime broker. And, in taking on Fannie and Freddie, they were belatedly making explicit the implicit government guarantee that the twins had long enjoyed in the eyes of investors. In allowing Lehman to go bust when competitors balked at taking it on, Hank Paulson, the treasury secretary, attempted to draw a line in the sand. But AIG was considered simply too big to fail.

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Its deep reach into consumer finance also played a part in the decision to intervene. Had AIG gone bust, its millions of customers would have been left wondering if their car and home insurance policies were still valid, at a time when consumers are already twitchy about the safety of their bank deposits. Underlining the risk that the credit crisis poses to small investors, a money-market fund “broke the buck” on Tuesday—that is, its net asset value fell below $1—the first time this has happened since 1994.

The government has, at least, demanded a lot for stepping in. It will receive warrants entitling it to a 79.9% stake in AIG. The two-year loan, secured against AIG’s insurance businesses, carries an interest rate of LIBOR plus 850 basis points (hundredths of a percentage point). The government will install new management and will have veto power over all important decisions, including asset sales and payment of dividends.

AIG will raise money to repay the loan by selling assets. The expectation is that the group will be broken up and sold, bit by bit. This would mark an extraordinary end for a company that as recently as last year enjoyed a market capitalisation of more than $170 billion. The company insists that it is illiquid, not insolvent, but the size of the loan suggests that its problems go beyond a short-term cash crunch.

The question that hangs over the rescue—apart from whether taxpayers will get their money back—is whether the government can continue to deal with tottering financial companies in an ad hoc manner. Pressure is likely to grow for the creation of a more formal mechanism for handling the sick, akin to the Resolution Trust Corporation that took on bad assets from the savings and loan crisis of the 1980s. That, at least, would make the hospitalisation process more transparent. After the historic events of the past fortnight, who would bet that AIG will be the last lumbering giant to need resuscitation?