Monday, November 10, 2008

Time to pull the plug on AIG?

(Willem Buiter @ FT) AIG, the walking-dead insurance giant, is reported to have gone through $81 bn or so of the $122.5bn worth of financial facilities provided by the Fed since September 2008, first through an expensive (850 basis points over 3-month Libor) 2-year $85 bn facility and soon after through a rather cheaper (as far as I can tell) $37.5 supplementary facility. Not only is AIG seeking additional Federal assistance. It is also arguing that the original $85 bn facility is unfairly expensive, compared to the 5 percent plus some warrants charged by the US Treasury for its capital injection into nine large US commercial banks.

AIG is correct in noting and complaining about the inexplicable discrepancy between the cost of official funds charged to the nine banks and that charged to AIG. The unfairness, indeed the outrage, however, lies in the US Treasury injecting equity into the nine US commercial banks on sweetheart terms, way below what these banks ought to have paid for the money, and way below what it would have cost them to raise the money in the markets, whether from Warren Buffett or from Qatar.

AIG’s current modus operandi and business model is obviously not sustainable. Indeed it is not viable even in the short run. What if the US authorities reduce the cost of the existing facilities and dole out a further $200 billion or so to see them through to Thanksgiving? AIG will no doubt be back for another $200bn when the turkeys have been digested, to see them through to Christmas. This is getting very silly indeed.

There are two viable options. The first is to put AIG into receivership immediately. It has quite a lot of viable businesses (anything that did not touch CDS and complex structured products). The currently commercially viable bits could be sold off severally or jointly or re-launched as going concerns. The rest could either be liquididated or taken into public ownership and operated that way until a decision can be made about the private commercial viability of the publicly owned bits when order returns to global financial markets, in a year or two.

The authorities (the State of New York Insurance Department is the regulator of this global insurance giant!) have had at least a couple of months to prepare for a possible bankruptcy protection filing by AIG, so this should not come as a surprise and there should be a contingency plan ready for use.

The size of AIG’s balance sheet ($ 1 trillion at its peak, probably rather less now) looks less awesome now that governments all over the world are guaranteeing private liabilities and funding capital injections worth multiple hundreds of billions and even trillions of dollars at the drop of a hat.

No doubt a lot of CDS contracts written on AIG debt would be activated by a default, but the aftermath of Lehman’s filing for bankruptcy protection demonstrated that the process of unwinding and settleing the CDS claims was remarkably orderly and much less destructive than feared. The Conservator for AIG (or whatever the Administrator of AIG’s insolvency regime is called) should be given a public mandate not to liquidity assets in a hurry, so as not to intensify the vicious spiral of illiquid asset fire-sales, further asset price declines, margin calls, further forced liquidations of assets and further price declines and deepening market illiquidity and funding illiquidity.

The second viable option is to take AIG completely into public ownership. The government already has 79.9 percent of the equity. I believe that any increase in that government ownership share would trigger a technical default on some of the outstanding CDS taken out against an AIG default. It such is the case, so be it. It may seem that, with the government already owning almost 80 percent of the equity, the orginal $85 bn facility is largely the US Federal Reserve making an expensive loan to the US Treasury. That, however, is incorrect.

By keeping AIG technically solvent, the bond holders and other senior unsecured creditors of AIG are kept current on interest and principal. AIG’s debt sells at a steep discount relative to US Treasury bills and bonds, reflecting the market’s perception of its fragile solvency. If the government were to nationalise AIG now, while it is still technically solvent and a going concern, the senior unsecured creditors would all be made whole - AIG’s debt would effectively become US Treasury debt. Saving AIG’s unsecured debt holders and other unsecured creditors would be unfair. It would also be a terrible distortion of future incentives, by encouraging reckless lending to large financial institutions - institutions deemed to large, to interconnected or too politically well-connected to fail. It would be the mother of all moral hazard.

Here we run again into the incomprehensible fact that, almost 15 months after the start of the crisis, the US Federal authorities have not yet created a special resolution regime (SRR) with prompt corrective action (PCA) powers that would allow a duly appointed Administrator or Conservator to take any systemically important institution into Administration/Conservatorship before the normal tests for insolvency (balance sheet insolvency or liquidity insolvency) have been met. The Conservator would replace board and management and suspend the voting rights and other decision rights of the shareholders. No dividends, share repurchases or other transfers of resources to the old shareholders could take place while the Conservatorship is in effect. The Conservator should be able to impose charges (haircuts) on all unsecured debt holders and other unsecured creditors, regardless of seniority. The Conservator would also be able to impose mandatory debt-to-equity conversions on all unsecured creditors and debt holders, with or without first extinguishing the equity of the old shareholders. The Conservator would have full authority to sell assets and to restructure the balance sheet and the activities of the business in any way deemed appropriate and lawful. Finally, the Consevator would have the power to liquidate the company.

No SRR with PCA powers was in place for investment banks. So we were treated to the disgraceful spectacle of Bear Stearns’ last-minute sale to JPMorgan. Bear Stear’ demise took place 7 months into the crisis, so perhaps the authorities had not yet woken up to the fact that an SRR for investment banks might be a good idea. No such excuse was on offer, however, when Lehman Brothers hit the wall in September 2008, more than a year after the start of the crisis. The Treasury, the SEC and the Fed have failed miserably to get the appropriate regulatory framework in place. And we know what an SRR ought to look like: the FDIC has adminstered one for years for the federally insured commercial banks.

When it became obvious that AIG too was too large or too interconnected to fail, the SRR net should have been extended to AIG also. Surely someone in a position of responsibility in Washington must have a little list with the names of the systemically important financial institutions? There has to be an SRR with PCA powers for all these institutions. There is no excuse for the absence of such a regime for all financial institutions except for commercial banks.

In the absence of a proper SRR for AIG, nationalisation of AIG threatens to make all unsecured creditors whole. That would be disastrous for medium and long-term financial stability. I very much hope a way will be found to impose a charge/haircut on all unsecured creditors if AIG gets nationalised completely. I also hope that, if the authorities decide not to nationalise AIG completely at this stage, they will still succeed in making the senior unsecured debt holders and creditors of AIG pay a hefty price for this undeserved financial support.

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