Why AIG was saved
The US authorities were forced to rescue AIG because unlike Lehman its collapse had the potential to threaten the stability of financial markets and produce a sustained disruption to the US economy.
The desperate scrambling by the US authorities to provide American International Group (AIG) with a taxpayer-funded lifeline of extraordinary size is a clear and unsettling signal that they believed its failure would threaten the already parlous stability of the global financial system.
The same authorities who were prepared to let Lehman go, and effectively forced Merrill Lynch into the arms of Bank of America, have agreed today to lend AIG a staggering $US85 billion.
While the announcement of the rescue was short on detail, the Federal Reserve Board said the two-year loan was secured by all of AIG's assets and those of its main subsidiaries.
The Fed said the loan would assist AIG to meet its obligations as they came due and enable it to sell assets in an orderly manner with the least possible disruption to the overall US economy.
It also said the US Government would receive 79.9 per cent of AIG's equity and the right to veto dividend payments – the Government is trying to diminish the level of moral hazard created by the rescue by ensuring shareholders and preference shareholders are punished in the process. The US has just nationalised one of its biggest private sector institutions.
There are two differences between AIG's plight and the decision the authorities faced when they rejected Lehman's pleas for taxpayer assistance.
The sheer size of AIG – it is the world's largest insurer with $U1 trillion of assets – the nature of its entanglements with other financial institutions and, through its more conventional insurance business, the real economy, is one difference.
It is one of the larger counterparties and insurers of financial risk in the global system, with about $US440 billion of exposures to credit default swaps and other derivatives. It has already written down those exposures by $US25 billion.
It is also, it appears, solvent, which is another significant difference between it and Lehman. It raised $US20 billion of new capital only in May and has been given permission by the regulators to shift another $US20 billion of capital from its insurance subsidiaries into the holding company.
Its issue is one of liquidity. It is a compounding issue, as the escalating size of the funding package – it started as a search for $US40 billion, rose quickly to $US70 billion and eventually topped out at $US85 billion – would suggest.
The reason the funding target was moving so quickly is that it was linked directly to AIG's credit rating. When AIG was downgraded on Monday it triggered a requirement for it to put up $US14.5 billion in new collateral against the credit default swap agreements it has entered. It had previously posted $US16.5 billion of collateral.
Another round of ratings downgrades – which would have been inevitable if it couldn't raise the funds – would have triggered requirements for additional collateral and put the group into a death spiral – it couldn't liquidate its assets quickly enough to release the cash that would allow it to maintain its rating.
To put AIG's significance to the global system into context, the various estimates of losses to counterparties if it collapsed range from about $US180 billion to $US200 billion. Total losses from the credit crisis so far amount to about $US500 billion, although there is an expectation they will easily top $US1 trillion – without AIG's 'assistance'.
Another way of looking at the cost of a collapse would be to say that it could wipe out the equivalent of more than half the capital raised by financial institutions globally to fill in the holes torn in their balance sheets by the crisis.
Much of that capital was raised early in the crisis, before the sovereign wealth funds and private equity firms who provided the bulk of it were scared off by the continuing downwards spiral in markets. AIG-related losses would, on top of what is already out there, add perhaps an unbearable and unfinanceable burden to the capital shortage in the system.
That is why, at the end of the day, the US authorities had to save AIG. When they underwrote the sale of Bear Stearns to JP Morgan Chase they did so because they believed at the time that its collapse could jeopardise the continued functioning of the system. They were prepared to let Lehman and probably Merrill go because they didn't.
AIG was, ultimately, too big, too important and too connected to both the system and the real US economy to allow it to fail. It may not be the last big institution to fall into that category.
The same authorities who were prepared to let Lehman go, and effectively forced Merrill Lynch into the arms of Bank of America, have agreed today to lend AIG a staggering $US85 billion.
While the announcement of the rescue was short on detail, the Federal Reserve Board said the two-year loan was secured by all of AIG's assets and those of its main subsidiaries.
The Fed said the loan would assist AIG to meet its obligations as they came due and enable it to sell assets in an orderly manner with the least possible disruption to the overall US economy.
It also said the US Government would receive 79.9 per cent of AIG's equity and the right to veto dividend payments – the Government is trying to diminish the level of moral hazard created by the rescue by ensuring shareholders and preference shareholders are punished in the process. The US has just nationalised one of its biggest private sector institutions.
There are two differences between AIG's plight and the decision the authorities faced when they rejected Lehman's pleas for taxpayer assistance.
The sheer size of AIG – it is the world's largest insurer with $U1 trillion of assets – the nature of its entanglements with other financial institutions and, through its more conventional insurance business, the real economy, is one difference.
It is one of the larger counterparties and insurers of financial risk in the global system, with about $US440 billion of exposures to credit default swaps and other derivatives. It has already written down those exposures by $US25 billion.
It is also, it appears, solvent, which is another significant difference between it and Lehman. It raised $US20 billion of new capital only in May and has been given permission by the regulators to shift another $US20 billion of capital from its insurance subsidiaries into the holding company.
Its issue is one of liquidity. It is a compounding issue, as the escalating size of the funding package – it started as a search for $US40 billion, rose quickly to $US70 billion and eventually topped out at $US85 billion – would suggest.
The reason the funding target was moving so quickly is that it was linked directly to AIG's credit rating. When AIG was downgraded on Monday it triggered a requirement for it to put up $US14.5 billion in new collateral against the credit default swap agreements it has entered. It had previously posted $US16.5 billion of collateral.
Another round of ratings downgrades – which would have been inevitable if it couldn't raise the funds – would have triggered requirements for additional collateral and put the group into a death spiral – it couldn't liquidate its assets quickly enough to release the cash that would allow it to maintain its rating.
To put AIG's significance to the global system into context, the various estimates of losses to counterparties if it collapsed range from about $US180 billion to $US200 billion. Total losses from the credit crisis so far amount to about $US500 billion, although there is an expectation they will easily top $US1 trillion – without AIG's 'assistance'.
Another way of looking at the cost of a collapse would be to say that it could wipe out the equivalent of more than half the capital raised by financial institutions globally to fill in the holes torn in their balance sheets by the crisis.
Much of that capital was raised early in the crisis, before the sovereign wealth funds and private equity firms who provided the bulk of it were scared off by the continuing downwards spiral in markets. AIG-related losses would, on top of what is already out there, add perhaps an unbearable and unfinanceable burden to the capital shortage in the system.
That is why, at the end of the day, the US authorities had to save AIG. When they underwrote the sale of Bear Stearns to JP Morgan Chase they did so because they believed at the time that its collapse could jeopardise the continued functioning of the system. They were prepared to let Lehman and probably Merrill go because they didn't.
AIG was, ultimately, too big, too important and too connected to both the system and the real US economy to allow it to fail. It may not be the last big institution to fall into that category.
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