AIG Bailout Hurting The U.S. Taxpayer

American International Group, or AIG (AIG), has been one of the financial sector companies tied up in the heart of all of the chaos in the past couple of months. AIG’s problems continue to escalate without a clear solution in sight. AIG is in the midst of a liquidity crisis, on a scale that has never been witnessed before. It has experienced a viscous cycle of credit downgrades, management changes, and government injections which have resulted in the American tax payers taking an 80% stake in the quickly failing company.

Leading up to the Bailout

AIG looked as if they successfully turned their company around after a series of fraud investigations by the SEC and other government agencies. The investigations surrounded AIG’s former CEO, Maurice “Hank” Greenberg, in regards to an accounting scandal which ultimately led to the end of Mr. Greenberg’s leadership of AIG in early 2005. Succeeding Mr. Greenberg was Martin Sullivan, who led the company until he was fired in June 2008 because of AIG’s large financial losses and falling stock price. Mr. Sullivan was then replaced by Robert Willumstad, who was ultimately replaced by Edward Liddy in mid September of 2008.

AIG’s share price is down over 90% from their 52-week high of over $70. For the first half of the year, AIG had write offs of over $13 billion stemming from poor financial assets. The financial losses plaguing the company resulted from bad bets in their Financial Product division. The company decided to get involved in insurance contracts on collateralized debt obligations, or CDO’s. These insurance contracts are also known as credit default swaps, or CDS’. These CDS’ that AIG wrote protected investors against the possibility of a default on various CDO’s. A more in-depth explanation on credit default swaps can be found in my previous article. The insurance contracts that AIG wrote have become detrimental to the company’s financial strength, as they have been forced to pay back clients who purchased the protection. The underlying CDO’s were often made up of the worst tranches of sub-prime residential mortgages. These sub-prime loans have plunged in value due to homeowners defaulting on their loans. A lot of the CDO’s have virtually zero value because there are no buyers in the market. Originally, AIG secured over $440 billion worth of AAA securities, of which $57 billion were structured around sub-prime assets.

Lehman Brothers was forced to declare bankruptcy on September 15^th, sending the financial markets into a tailspin, which I don’t think we have recovered from or will recover from for a long time. This historic failure, which was the largest ever in U.S. history, had more effects than many people thought. AIG’s management knew that they had to do something quickly in the face of the market conditions. It was later noted in an article by The New York Times that AIG had valued its Alt-A and sub-prime MBS at 1.7 to 2 times the rates that Lehman used. Originally, the Federal Reserve shot down the idea to lend AIG money. AIG’s stock price fell over 60% that Monday because of the deteriorating outlook on the company and the Fed’s denial of funds.

The Original Bailout

The Fed quickly changed their mind after they realized that they had to react quickly to protect against the failure of AIG because of the possible implications that event would have. On September 16^th, the Fed announced that the New York Fed would provide AIG with a 24 month loan, allowing the company to draw up to $85 billion in exchange for warrants for a 79.9% equity stake in AIG. The deal also gives the Fed the right to suspend the payment of credit facilities and freeze dividend payments to common and preferred shareholders. The loan was also collateralized by AIG’s assets and had an interest rate of 850 basis points over 3 month LIBOR. This $85 billion number was staggering at the time, but wouldn’t be enough to help out the troubled insurer. The credit spread of 850 basis points was extremely high and would have placed AIG into a junk credit rating in normal market conditions. The Fed decided to lend the money at this harsh rate to give incentive to AIG to sell off their assets as quickly as possible. Although the credit facility helped them shore up their balance sheet in the near term to pay off clients and meet margin calls from other large financial institutions like Goldman Sachs (GS) and J.P. Morgan Chase (JPM), the terms of the spread did not help the company with selling off their assets. The deal changed potential buyers’ minds, as it signaled that there would be more problems to come.

It was soon realized that the original $85 billion would not be sufficient. AIG drew down over $28 billion within two days of the facility’s existence. The Fed decided to add an additional $37.8 billion in an effort to make sure AIG was adequately capitalized for the time being. AIG was still running through the cash quicker than anticipated and used over $90 billion out of the total $122 billion by October 24^th. Hank Greenberg opposed the deal, describing the bailout as a nationalization of AIG.

The Upgraded Bailout

The U.S. government needed to clean up their mess of the original deal that provided AIG with capital. In my opinion, the deal was haphazardly put together to ensure the financial markets that they would not allow AIG to fail. The positive result from the deal was that AIG did not fail. The negative is that the deal only put a band-aid on a wound that needed surgery. The Fed announced on November 12^th that they have re-structured the terms of the previous deal and set up new facilities to help AIG. The new $150 billion package includes money from the previous deal made in September and adds additional capital to the company. The Fed re-structured the interest rate that AIG has to pay on their loan to around 6% from over 10%. AIG will have to pay 10% interest on the $40 billion capital infusion from the Treasury.

The re-structured deal includes the creation of two new entities that will take some of the garbage assets on their books. The government will buy over $52 billion of distressed assets from AIG to aid in the healing process. This helps AIG by getting rid of these assets, but may hurt them in the long run as they are being forced to sell these securities and will be giving up any potential gains that they could incur.

Earnings

Since the government owns about 80% of AIG, the American Taxpayers took a hit last week when AIG reported a $24.5 billion quarterly loss, or $9.05 per share, and took another $7.1 billion in write-downs on its credit derivatives portfolio. This loss was larger than expected by many analysts on the street, as they didn’t accurately foresee AIG’s deteriorating business conditions.

In their third quarter press release, CEO Ed Liddy stated: “Third quarter results reflect extreme dislocations and volatility in the capital markets and significant charges related to restructuring activities. Reported earnings are not indicative of the underlying core earnings power of our insurance businesses, which remain solidly capitalized. Retention of our customers remains strong and reflects the support and loyalty of our long-term partners, intermediaries and sponsors.”

Outlook

Although the stock is down over 90% from a year ago, the outlook is not positive for AIG over the next 6-9 months. The management shuffles that have taken place over the past year only hurt AIG and their ability to return to profitability. Although the new government plan may seem like a cure-all to the current situation, especially with the two new entities that will buy everything, I still don’t think that this is the end. Over the past year, I have learned that there is no such thing as a “perfect solution” or “last write-down” in the financial sector. The terms of the deal are still much better than the original deal, but will still cause problems for AIG in the short-term. Increased regulation is also likely to come out of all of this, to protect the government and taxpayers to hopefully not have to deal with a similar situation in the future. And lastly, don’t rule out a hostile takeover of some kind (probably management) by Hank Greenberg. He has been in the picture a few times in the past couple of months commenting on AIG. He still has not only ownership interests in the firm but also personal interests.

Disclosure: The mutual fund the author is associated with is long GS and JPM

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