財經觀察 1509 --- The American Bailout Group- FT Alphaville

FT Alphaville noted yesterday that AIG was hardly an insurance company any longer. Rather, it was a bailout fund: a sump into which the US government was pouring billions to prop up derivative contracts AIG had written on a host of structured financial instruments - in turn propping up the prices on those instruments, and the balance sheets of the institutions holding them.

Floyd Norris at the New York Times blogs it all fairly forcefully:
It is sad to see that the plan is for A.I.G. to stay in business forever. This is a company that should be wound down. Instead, it appears that the government will remain an investor for years and years, helping one insurance company compete with others that are not government-subsidized.

In a second post, Norris goes further, calling AIG’s CDO buyback scheme (or rather, the inability of AIG execs to answer questions on it) “appalling”.

For those unfamiliar with that scheme, the gist of the plan is to use $35bn to buy CDO paper AIG has written protection on. The Federal Reserve Bank of New York providing most of that funding:

…the New York Fed will lend up to $30 billion to a newly formed LLC to fund the LLC’s purchase of multi-sector collateralized debt obligations (CDOs) on which AIG Financial Products has written credit default swap (CDS) contracts. AIG will make a $5 billion subordinated loan to the LLC and bear the risk for the first $5 billion of any losses on the portfolio. In connection with the purchase of the CDOs, the CDS counterparties .will concurrently unwind the related CDS transactions The loans will be secured by all of the LLC’s assets and will be repaid from cash flows produced by these assets as well as the proceeds from any sales of these assets. The New York Fed and AIG will share any residual cash flows after the loans are repaid.

Spot the problems.
Firstly, the first loss tranche on this LLC - the equity portion that AIG will hold - is only $5bn. A lot? Not. The CDOs proposed to be purchased have a par value of $70bn. They have, thus, halved in value. Is it not conceivable their value might deteriorate further? A decline from their notional value of just 7 per cent would wipe out AIG’s first loss stake. That’s an equity tranche thinner than those found on these toxic assets in the first place. All this should tell you that this investment has little or nothing to do with prudence.

AIG’s current exposure is twofold; a liquidity risk through the demands of mark-to-market exposure via collateral posting, and a default risk exposure. Which of these does this bailout solve? Neither.

Indeed, AIG is just crystallising existing losses. According to Norris, CDO sellers will keep any collateral hitherto posted against the CDOs. AIG isn’t getting it back.

[Aside: Are these CDS or TRS?]
Anyway, none of this matters. Because there is an even larger CDO problem at AIG which has gone untalked about: the insurer’s colossal involvement in the synthetic CDO market. AIG has derivative positions against $237bn of synthetic corporate CDOs, according to the company’s results.

And if anything, synthetics are even more sensitive to dramatic declines in value than ABS CDOs, should they see problems with their underlying reference entities.

We are only just entering the opening phase of what is shaping up to be a particularly painful default cycle. If predictions about the fragility of synthetic CDOs prove true, then AIG’s balance sheet could be eviscerated by the unwind, and the Fed will be on call to plug the gaps.

All of that and yet still Liddy insists AIG is on course.
News just in: AIG continues to party like it’s 2006

Regards,