Government Steps in to Save Insurer AIG

After declining to step in to rescue Lehman Brothers (“Lehman Files Bankruptcy, Bank of America to Buy Merrill for $50 Billion,” Sept. 15), the government stepped in late Tuesday to provide the financing to keep insurer American International Group, Inc. (NYSE: AIG) afloat.

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend AIG up to $85 billion under section 13(3) of the Federal Reserve Act.

According to the Federal Reserve, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance. 

“The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due,” the Fed said in a prepared statement. “This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.” 

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility. The government will also control a 79.9 percent stake in AIG under the deal.

“The AIG Board has approved this transaction based on its determination that this is the best alternative for all of AIG’s constituencies, including policyholders, customers, creditors, counterparties, employees and shareholders,” the company said in a prepared statement. “AIG is a solid company with over $1 trillion in assets and substantial equity, but it has been recently experiencing serious liquidity issues. We believe the loan, which is backed by profitable, well-capitalized operating subsidiaries with substantial value, will protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis.

“We expect that the proceeds of these sales will be sufficient to repay the loan in full and enable AIG’s businesses to continue as substantial participants in their respective markets,” the statement continued. “In return for providing this essential support, American taxpayers will receive a substantial majority ownership interest in AIG.”

John Jay senior analyst, at Aite Group, told insideARM that several factors contributed to AIG’s problems. The company had gone outside of its traditional insurance business into credit default swaps, very complex and very illiquid derivatives. So when the credit default swaps started unwinding due to the credit crunch, the counterparties demanded more collateral from AIG.

“This is the same thing that happened to Bear Sterns,” Jay said. “Credit default swaps are one of the most complex derivatives out there.”

Due to the complexity, valuations are extremely difficult, according to Jay. The illiquidity means they rise and, more recently, fall in value quickly. As a result of the difficulties with this and other derivatives, Jay expects a trend for financial services and other companies out of complex derivatives and into more plain vanilla investments.