Washington

|

Federal Reserve officials woefully underestimated the potentialcost of bailing out American International Group, according to areport issued by the Office of the Special Inspector General forthe Troubled Asset Relief Program.

|

Because of that, and also because it acted more as a creditorthan a regulator in stabilizing AIG in September 2008, the Fedwound up paying more than it should have to close out thecollateralized debt obligations underlying AIG's huge loss-riddledcredit default swap portfolio, the report concluded.

|

The issues involved in the report concern funds in excess of the$85 billion in original monies that the Fed provided AIG on Sept.17, 2008 in return for 79.9 percent of the company's stock.

|

Among the reasons the Fed was hamstrung was that in order to getthe original deal done quickly, AIG accepted a proposed privatedeal that fell through.

|

The failed transaction negotiated by J.P. Morgan called for an11 percent interest rate on a $75 billion loan. According to thereport, the Fed "inherited the deal" and just added another $10billion to that. It didn't realize until later that the interestrate was punitive and that the deal would have to be renegotiated,the report said.

|

The report dealt with $72 billion worth of CDOs sold tocounterparties by AIG's Financial Products unit without holding thereserves that would be required of a regulated insurancetransaction of an equivalent amount, according to the report.

|

The report also concluded that the AIG CDS debacle indicated theimportance of transparency when the government interacts with aprivate firm, and said the government underestimated "the enormousimpact" that rating agencies had on the AIG bailout.

|

At the same time, the report indicated that Fed and TreasuryDepartment officials believed a failure to bail out AIG "posedconsiderable risk to the entire financial system and would havesignificantly intensified an already severe financial crisis andcontributed to a further worsening of global economicconditions."

|

Officials were mostly concerned about the impact on the Americanretirement system, the report said, "and determined that AIG'sfailure would have a global retail impact," notably on stable valuefunds and variable rate annuities.

|

The report explained that stable value funds are paired or"wrapped" with insurance contracts to guarantee a specific minimumreturn. The AIG Financial Products unit had written approximately$38 billion of stable value fund wrap contracts held by more than200 wrap contract counterparties that would have been at risk ifthere would have been no bailout, the report said.

|

These counterparties included trustees and investment managersof company retirement plans and 401(k) plans. Companies citedincluded Fidelity, Vanguard and the company retirement plans forAT&T, DuPont, Wal-Mart, Bank of America and other U.S.companies.

|

Also at risk was approximately $20 billion worth of commercialpaper issued by AIG that was owned by institutional investors andmoney market funds "that would likely have taken losses had AIGfailed," the report said.

|

By contrast, in May 2008, Lehman Brothers had $8 billion incommercial paper outstanding–an amount that decreased in the monthsleading to Lehman's bankruptcy, the report said.

|

The decision to bail out AIG itself limited the Fed's ability toobtain haircuts–negotiated repayment discounts–in closing out thecounterparty deals, the report acknowledged.

|

"The Federal Reserve Bank of New York was confronted with anumber of factors that it believed limited its ability to negotiatereductions in payments effectively, including a perceived lack ofleverage over the counterparties because the threat of an AIGfailure had already been removed by the FBNY's prior assistance toAIG."

|

The report also said that officials of the Federal Reserve Bankof New York who negotiated the deal with AIG counterparties believethat the government will ultimately be made whole despite the weakhand the Fed perceived it had in negotiating to close the CDSportfolio during that period.

|

Specifically, the report said, as of Sept. 30, 2009 the currentfair market value of the portfolio the Fed purchased from AIG'scounterparties is $25.3 billion compared to a loan balance of $19.3billion.

|

The FBNY decided to buy out the counterparties to the CDS "inthe fall of 2008″ under terms favorable to AIG's bankcounterparties, when the counterparties demanded a high interestrate to continue holding onto the CDS in the face of a potentialdowngrade of AIG's CDS portfolio by rating agencies, the reportsaid.

|

The structure and effect of the FBNY's assistance to AIG–bothinitially through loans to AIG and through asset purchases inspecial financing vehicles–"effectively transferred tens ofbillions of dollars of cash from the government to AIGcounterparties, even though senior policy makers contend thatassistance to AIG's counterparties was not a relevant considerationin fashioning the assistance to AIG," the report noted.

|

Special Inspector General Neil Barofsky said in his report that"while the FBNY may eventually be made whole on its loans to thespecial financing vehicle, it is difficult to assess the true costsof the Fed's actions until there is more clarification as to AIG'sability to repay all of its assistance to the government."

Want to continue reading?
Become a Free PropertyCasualty360 Digital Reader

  • All PropertyCasualty360.com news coverage, best practices, and in-depth analysis.
  • Educational webcasts, resources from industry leaders, and informative newsletters.
  • Other award-winning websites including BenefitsPRO.com and ThinkAdvisor.com.
NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.