Tuesday, September 16, 2008 4 comments ++[ CLICK TO COMMENT ]++

AIG Essentially Nationalized by the Federal Reserve

The Federal Reserve is a private bank so I guess they technically can't nationalize anything. But if it were like central banks in other countries and was controlled by the government, you would have just seen the largest nationalization possibly in US history (and maybe world history). The media will consider it neither to be a "conservatorship" nor a nationalization but if the FedRes takes 79.9% ownership of a company that's basically owning them.

It's a weird nationalization in that bondholders were made whole, while preferred and common shareholders end up losing nearly everything. This is a bizarre turn of events. I used to have respect for Ben Bernake but I really think they have no idea what they are doing. They should get the Treasury to bail out AIG, not the Federal Reserve. I guess Congress and Senate are not going to approve a Treasury bailout but now the FedRes balance sheet is weakened considerably (it depends on if they will provide more money or not.) They are taking on enormous responsibility and I am pretty sure the Federal Reserve has very little expertise running an insurance company, let alone any private company.

I really don't like this move at all. The Fannie and Freddie takeover makes sense because they were quasi-government entities and the market assumed it was always backed by the government. AIG, in contrast, has nothing to do with the government. The government should either (i) provide a loan at a high price (say 15% plus LIBOR) or (ii) they should let AIG go into run-off (with parent going bankrupt.) The repercussions from AIG failing would be quite bad but the current move is going to cause severe harm for the following reasons.

The bondholders who facilitated the leverage will keep doing what they have done in the past because, well, they will never learn their lesson. I'll bet the same bond investors will be investing in a similar outfit in 2 years. It makes little sense to wipe out preferred and common shareholders while bondholders keep on profitting.

Secondly, this is a bizarre situation where the government is the majority owner now but AIG will still continue to operate as it always has, with a few cosmetic changes with the executives. Am I the only one that thinks the government is going to end up doing a worse job running this behemoth? A liquidation would be orderly and get rid of this failed risk taker. I'll bet that G will be spun off from the government in 10 years (if it isn't liquidated) and we will end up with the same problem again.

What worried the Federal Reserve bankers was clearly the fact that AIG was a big derivatives dealer. Well, what message does this send? All it does is to tell the market that it makes perfect sense to become a big player in derivatives without any understanding of risk because the government will always prevent a collapse.

AIG's failure due to illiquidity (not talking about the failure due to mortgage loss) is largely due to management. They should have known that downgrades would require collateral to be posted and sold off their assets many months ago. Instead, they didn't even want to sell the aircraft lease operation and others because it was worth holding. What sort of idiotic strategy is that? Being an insurance operation with problems arising from their CDS insurance of mortgage bonds, they clearly should have kept up with the monoline bond insurers such as Ambac and MBIA, who were also in a similar business and went through a similar rating downgrade process before. I hope that the executive doesn't get a bonus or any excess payment like John Thain's $50 million for selling off Merril Lynch after it dropped 50%+ during his tenure. Even if the job is complex, no one deserves millions in compensation for running down the firm. Even if you only took the job 5 or 6 months ago, it is crazy when you realize that management never grasped how the need to post collateral will bring down a $50 billion (formerly $200 billion) firm. Even with the mortgage losses, the company should be worth $20 billion or more (probably more like $50 billion) to existing shareholders. Not close to zero.

After that rant you might think I have a big holding in AIG. Nope. It's just that this is ridiculous, both from an investor point of view, and from a hypothetical taxpayer point of view (I say hypothetical because I'm Canadian and won't be footing the bill for the Treasury and FedRes actions.) I also don't like the fact that they bailed out bondholders. How is any other firm that is cash strapped going to raise capital with such actions? It will be almost impossible to issue preferred or common shares now. I guess it'll all be down to junk bonds now (although that's not equity capital.) Maybe Bill Gross, Mohamed El-Erian et al can profit from all this. They have Alan Greenspan on their team after all.


4 Response to AIG Essentially Nationalized by the Federal Reserve

September 17, 2008 at 8:13 AM

My read is that the AIG subsidiaries will be sold overtime to cover the $85B hole/bridge loan.

That $85B may wipe out AIG's existing preferreds and common _anyway_ -- remember, AIG's _book value_ was no where near $85B.

Assuming the $85B wipe out AIG's existing equity, and the gov't gets its bridge loan paid back, The gov't would _then_ get the rights to 80% of the remaining recapitalization.

The existing common will get NOTHING if the $85B hole is enough to wipe out AIG's existing capital base.

September 17, 2008 at 8:15 AM

This is the same reason why Phoney and Fraudie's common is currently trading cents on the dollar even though the gov't "only" obtain righst to 80% of the two GSEs.

September 17, 2008 at 10:31 AM

AIG didn't lose $75 billion. It's not a loss. They just need to collateralize their assets. Their assets will still be worth something so it isn't as big of a problem as it seems. That's probably why the common stock is still trading around $2 today, which pegs it at a market cap of around $5 billion--larger than many small or medium-sized firms.

AIG's book value was $78 billion in June (according to Yahoo Finance numbers). They can probably raise around $20 billion by selling their valuable subsidiaries.

What will make the common worthless, and possibly the preferreds as well, is the government dilution. Shareholders are looking at instantaneou 80% dilution.

Fannie and Freddie are a different situation for a number of reasons. They threat is actual insolvency (although I think it's overblown) whereas AIG is simply a liquidity crunch. For instance, it would be almost impossible for anyone to show that book value for AIG is negative; for Fannie and Freddie, the govt seized it claiming book value was negative...

September 17, 2008 at 4:11 PM

As with Fan & Fred the high interest on the .Gov "help" will eat up cashflow (I agree with Synchro! remarkable) and .Gov also takes 80% of the remainder. Close to a wipeout for shareholders.

If the story is true that management rejected an offer from PE firms to inject a lot of capital because it would have involved transferring control to the PE guys management deserves to be sued into bankruptcy for gross negligence. Almost any deal would have been better for shareholders then this. (in case anyone wonders, no, I have no AIG long or short)

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