Sunday, November 9, 2008

Government, AIG Near a Pact To Scrap Original Rescue Deal

The U.S. government was near a deal last night to scrap its original $123 billion bailout of American International Group Inc. and replace it with a new $150 billion package, according to people familiar with the matter said. While the proposed arrangement would considerably ease terms on the faltering insurer, it would give the government an unprecedented role as an actor in financial markets. It could also spark a political backlash, especially from congressional Democrats, because the Treasury, while adding to its AIG obligations, has thus far refused to extend a hand to the struggling Big Three auto makers. Details of the revised deal could be announced as soon as Monday -- when the company is expected to report third-quarter earnings -- but remained in flux. Under the terms being discussed late Sunday, the government would give AIG more money, including $40 billion from the U.S. Treasury's $700 billion Troubled Asset Relief Program. It would also demand less interest than on the bulk of the original loan, while freeing AIG from exposure to some of the risky financial instruments that nearly caused it to file for bankruptcy protection. The $150 billion in government aid consists of a $60 billion loan, a $40 billion preferred stock investment and $50 billion in capital largely to buy and backstop distressed assets in two special financing vehicles. The plan is a tacit acknowledgment that the original $85 billion rescue in September, combined with an additional $37.8 billion made available to the company last month, together haven't come close to stabilizing AIG. The giant insurer employs more than 100,000 people world-wide and touches business and finance at innumerable points throughout the global economy. The changes follow widespread criticism from some large shareholders of the original rescue plan, which would have required AIG to quickly sell assets in a declining market while also paying steep interest rates on its loans from the government. That plan also failed to adequately address the main challenge facing the insurer -- how it was hemorrhaging billions on credit default swaps and other financial instruments -- as it posted collateral to nervous trading partners. AIG Chief Executive Edward Liddy, appointed in mid-September with the support of the government, has scrambled to resolve the insurer's problems under the original bailout framework. Edward Liddy AIG laid out a far-reaching plan in early October for selling off assets to pay back the first loan the government extended, which was for up to $85 billion. But the turmoil in the markets is making it difficult for potential buyers to get funding, and is also lowering what a whole range of assets may be able to fetch. The revised structure is designed to improve both AIG's ability to sell assets for a decent price and the taxpayer's ability to recoup the money that has been pumped into the insurer. It also transfers to the government many of the risks once absorbed by AIG, potentially exposing the government to billions of dollars in future losses. Under the terms being finalized on Sunday night, the government would replace its original $85 billion loan with a two-year duration with a $60 billion loan with a five-year duration. Interest on the loan would drop from 8.5% plus three-month Libor interest-rate benchmark to 3% plus Libor. (Libor, the London interbank offered rate, is a common short-term benchmark.) In addition, the government would tap the $700 billion Troubled Asset Relief Program to inject $40 billion into AIG in return for preferred shares. Those shares would carry 10% annual interest payments. The government's equity interest in AIG would remain at 79.9% following the changes. The government's initial intervention was driven by concern that AIG's failure to meet it obligations in the credit default swap market would create a global financial meltdown. (A credit default swap, or CDS, is essentially an insurance policy on a bond acquired by investors to guard against default. AIG wrote tens of billions of dollars worth of these contracts.) Under the revised deal, AIG would transfer the troubled holdings into two separate entities that would be capitalized by the government. The first such vehicle would be capitalized with $30 billion from the government and $5 billion from AIG. That money would be used to acquire the underlying securities with a face value of $70 billion that AIG agreed to insure with the credit default swaps. These securities, known as collateralized debt obligations, are thinly traded investments that include pools of loans. The vehicle would seek to acquire the securities from their trading partners on the CDS contracts for about 50 cents on the dollar. The securities in question don't account for all of AIG's credit default swap exposure but are connected to the most troubled assets. Most of the trading partners AIG would seek to acquire the assets from are other financial institutions. The government may be betting that federal involvement will encourage the trading partners to sell the assets to the AIG vehicle. Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted back the contracts. The total collateral at stake is about $30 billion. It may also have some unintended consequences across the markets. For the plan to work, AIG's trading partners -- the banks and financial institutions that are on the other side of its credit-default-swap contracts -- may have to agree to any changes in the terms of their agreements with AIG. Such changes could cause those partners, which have pried billions of dollars worth of collateral from AIG over the past year, to return some or much of the collateral. That could be a costly exercise for some financial institutions, because the cash they received from AIG has in recent months been a cheap source of funding for many banks. The agreements may be difficult to work out. Some financial institutions that face AIG in credit-default swaps don't actually hold the physical securities on which they purchased protection. Merrill Lynch & Co., for example, previously sold many mortgage CDOs it underwrote to European banks. Through a complex set of transactions, Merrill took back the credit risk of some of those assets and hedged that risk by buying credit-default swaps from AIG. When the securities fell in value, the European banks demanded collateral from Merrill which in turn demanded collateral from AIG. A second vehicle would be set up to solve the liquidity problems in AIG's securities lending business. The business involves lending out securities to short sellers or others and investing the collateral for gains. AIG has scrambled to unload illiquid assets in order to give back the collateral it accepted. AIG's exposure to this market forced it to seek a $37.8 billion lending facility from the government to cover its commitments. Under the new plan, the government would inject about $20 billion into the securities lending vehicle and AIG would put in $1 billion. The vehicle would then buy the illiquid securities the AIG unit holds, known as residential mortgage-backed securities, for about 50 cents on the dollar. AIG would use the proceeds to shut down the $37.8 billion lending facility which is has not yet fully tapped. Still, the challenges facing AIG are enormous. With so much uncertainty about its future, it is battling to retain some key business customers as well as valuable employees in its operating units. A crucial goal is improving AIG's capital structure to give the property-casualty-insurance units a better chance to remain profitable and avoid punishing ratings-agency downgrades. The company's ratings have been under review at most of the major ratings firms.

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