AIG's $150B bailout (cont.)
We won't leave it entirely, though, because the RMBS turned out to be connected by tunnel to the netherworld called securities lending. For many years, the AIG operating companies, like many other large holders of fixed-income securities, have lent these to banks and brokers that have reasons for needing them - maybe clients wanting to sell short. For this service, the lenders had received cash collateral that slightly exceeded the value of the bonds. Over the years, AIG's companies had invested this short-term money in conservative, liquid investments and thus been always ready to repatriate the collateral if their customers wanted it back.
But this strategy didn't make much money. So in the middle of this decade, the AIG companies began both to greatly increase the amount of securities lending they were doing - the total hit about $90 billion in the third quarter of 2007 - and to invest the collateral in longer-term, seemingly safe AAA securities that offered good yields. The main choice for investment was, you guessed it, RMBS. That bit of elegant selection left AIG's operating companies not only using short-term money to invest long, which is known folly, but also putting this money into impenetrable securities poised to both tumble in value and establish new records for illiquidity. When news of AIG's problems spread in 2008, the banks and brokers came tearing back to redeem their cash collateral, and the AIG companies couldn't hand it over, because it was tied up in unsalable RMBS. This was a second vise that tightened around AIG. One company insider calls this whole investment plot "just one of the dumbest things I've ever seen." (Fortune was refused an interview with AIG's head of investments, Win Neuger, who was one of the executives on Herzog's kill list. A Neuger lieutenant also on the list, Richard Scott, has left, as noted earlier.)
Unfortunately for AIG's restructuring plan, the RMBS - greatly marked down during 2008 - sat at crisis time on the balance sheets of life insurance companies that AIG has since determined to sell. But what buyer wants to take on billions of tainted, impossible- to-value mortgage securities? Enter the government's troops: RMBS having a face value of $39 billion, marked down to $19.8 billion by AIG, have just been helicoptered out of the war zone into a new off-balance-sheet financing vehicle. This vehicle has received a six-year, extendable $19.5 billion Fed loan and $5.1 billion in equity from AIG. If the loan is paid back and the RMBS meanwhile gain in value, the Fed and AIG will share in the gains, with the Fed getting the lion's share.
A similar split of eventual gains, if there are any, will apply to another special-purpose vehicle set up to sweep most of AIG's multisector CDS risks off the company's financial statements. The Fed has made a $30 billion loan to this vehicle, and AIG has contributed $5 billion in equity. To cut through the details of this labyrinthine transaction, the $35 billion total, plus collateral that AIG's counterparties held, is intended to make these parties whole on about $65 billion par value of CDOs. Meanwhile, AIG will be freed of its swap obligations on these securities. That will not rid AIG of direct risk on multisector CDS. It will continue to wrestle with $9.5 billion of swaps that were sheer speculations, rather than insurance-like contracts, and that the government's rescue program is not taking over.
The two new entities will test the theory - widely admired by people who own mortgage securities - that there is good value in these if they are held to maturity. This opinion is indeed endorsed by Rodney Clark, the lead AIG analyst at Standard & Poor's, who thinks that the recoveries on AIG's mortgage securities could be "potentially significant" and that it is regrettable that AIG has given up so much of the upside to the government. Clark's opinion in effect frames a can't-win proposition for the feds: If they make money on the RMBS, that's good for the taxpayer. But because AIG will share so little in the gains, these won't do much to get the company off the government's hands.
Let's sum up the components of the government's largesse: There are three elements that lean on Fed loans: a $60 billion credit line, and two financing vehicles, one providing a $19.5 billion loan, the other $30 billion. Alongside is the Treasury's holding of $40 billion of AIG preferred stock, paying a 10% dividend. Grand total: $149.5 billion, which through history will be rounded off to $150 billion. And that does not take into account the possibility that down the road Plan B will be revealed as inadequate and a Plan C will have to be announced, which will make hara-kiri swords mandatory at the press conference.
The CEO who put AIG financial products into the ill-fated multisector CDS, Joe Cassano, 53, is no longer with AIG. He "stepped down" with AIG's "concurrence" last February, just as the company reported more than $11 billion of 2007 unrealized losses on the $80 billion of multisector CDS then outstanding. These losses (not to mention another $23 billion that came later) trashed the confident statements that Cassano had been making about the CDS. A famous one, from an analysts' meeting in August 2007: "It is hard for us, without being flippant, to even see a scenario ... within any kind of realm of reason that would see us losing $1 in any of those transactions."). One remarkable fact: A retired AIG director says that a few years ago Cassano was on the short list of candidates to succeed Hank Greenberg as boss of AIG in its entirety.
Today FP has a brand-new interim head, Gerry Pasciucco (pa-SHOE-co), 48, who came in November from Morgan Stanley, which is an advisor to the New York Fed and is more or less lending Pasciucco, a capital markets expert, to FP. Pasciucco knows his mission as if it had been engraved on the inside of his glasses: He is to "de-risk" FP and wind it down with all due speed. Says Liddy: "We are not going to be in that business. I've made that declaration. I want to get us out."
The overriding question is just how fast that can happen. Liddy himself, speaking to analysts in early October, said it would take a while. And for an "instructive prior situation," he referred the analysts to Warren Buffett's experience in extricating Berkshire Hathaway from General Re Securities, a derivatives operation originally modeled after AIG FP. The notional value of Gen Re's derivatives, however, was only about $1 trillion at the peak, vs. AIG's $2 trillion.
Buffett's experience is indeed instructive - "Even to me," the Berkshire CEO cracks. After buying Gen Re in 1998, he tried unsuccessfully to sell the derivatives business and then, in 2001, began to wind it down. Buffett says he told Gen Re's management to be patient at getting the job done, because he knew its difficulties. Derivatives, he presciently told Berkshire's stockholders then, are a little like hell: "easy to enter and almost impossible to exit." That's because if the aim is to terminate all your contracts - tear up the tickets, as they say - you must conduct negotiations with all your counterparties, most of whom will be interested in exacting a pound of flesh.
Four years later, in early 2005, Buffett gave his shareholders an update: Gen Re Securities had started with 23,218 contracts and had worked those down to 2,890. The aggregate losses on this endeavor, he said, had been $404 million. The settled contract that stood out, he added, was one that had "a term of 100 years!"
Gerry Pasciucco says FP has between 40,000 and 50,000 contracts. The preponderance of those are swaps, and a small part are options. The options are a particular problem in today's volatile markets because they require "dynamic hedging," which means they must be repeatedly hedged as prices swing. Some of Pasciucco's 380 employees are wrestling with that bear, and a raft of others are trying to settle contracts. Many of these stretch out for years, because from its start FP knew that contracts beyond, say, 20 years in length attracted the least competition and therefore were odds on to be moneymakers. Pasciucco doesn't know of any 100-year contracts in the shop. But there is one, he says, that runs to 2080.
Pasciucco has divided FP business into 23 segments - for instance, commodities is a segment - and says he is intent on winding these down in a very organized way. At his office in Wilton, Conn. (the other of FP's big offices is in London), he sometimes gets thoughts about the creditworthiness of counterparties from Fed officials who are based on the premises. He says those observers recognize the need to balance the competing objectives of speed, careful use of cash, and getting maximum value out of FP's business.
Pasciucco will not say how long he's slated to stay around FP, but it is clear he's thinking more like one year than five. The business, he says, will gradually get wound down, and then AIG will be left with a relatively small number of contracts (which is in fact Buffett's situation) and what insurers call a "tail" that extends residual risk into future years.
It's not easy to believe it's going to be that simple. Nothing about derivatives is, and FP is hardly a routine player. Another party sensing there may be a lasting issue here is Moody's, which in December said of FP's wind-down: "The costs and duration of this process are difficult to estimate and could be substantial."
Liddy, however, presents himself as an optimist about AIG. He sees the company selling its properties and regaining strength to the point that it can talk to the government about ways to cut down that 79.9% ownership. All that he says on this point is very vague: "There's just more thinking that needs to be applied to that." Meantime, he says AIG has a good "partnership" with the government. He treats this partner like the gorilla it is: "Whenever you want to do anything that requires shareholder approval," he says, "you have to go spend some time with them."
Not all parts of the world are as cheerful about AIG's future, partly because the company's stock price - under $2 a share - suggests a waif hanging on by its fingernails. In December, a financial Web site, 24/7 Wall Street, actually listed the company as one that wouldn't be around at the end of 2009. That seems extreme, if only because it is not easy to imagine the government walking away from the $150 billion it already has on the table. On the other hand, appearing on Meet the Press right after AIG was saved from bankruptcy, Hank Paulson dared to use the L-word, saying the government had put up its funding facility (then $85 billion) "to allow the government to liquidate this company...." And then he left the thought unfinished, as he referred to avoiding "a real catastrophe in our financial system."
Among the less sanguine AIG experts around is Hank Greenberg, who hangs on every move the company makes. Speaking recently in the quiet Park Avenue offices of C.V. Starr & Co., which he heads and which is AIG's largest shareholder after the government, he talked about the people who call to tell him they are leaving AIG and about the poor insurance results it reported in the third quarter. The unspoken subtext in everything he says is that things would be different if he were there.
Meanwhile, he clearly does not approve of the way Uncle Sam is treating its guest. "The government," he says, "should realize that its purpose is to get paid back, not wring every dollar of income it can out of the company today." He doubts that AIG is viable unless there's a Plan C - some lightening of the burden that interest and dividends place on the company and some move by the government to be more generous in sharing gains it extracts. Whether or not Greenberg is right about the need for the government to alter its approach, it seems clear that AIG will be dining at the taxpayer table for years to come.