Insurer's plan to ease its swaps problem raises more questions than it answers.
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American Intl Group, Inc.
Sun Nov 16 2008 04:46 EST
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American International Group has a plan to undo some of its most unprofitable financial missteps. Problem is, the company can't explain exactly how its approach is supposed to work, and not only is the government-controlled insurer using its own taxpayer-owned assets to pay for some of the program, the Federal Reserve is joining in with even more federal dough.
AIG seems to be planning to risk more than $70.0 billion to extricate itself from a sticky situation involving exotic bond and insurance products. That's nearly half of the $150.0 billionthe government is paying to bail out the insurer.
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The plan revolves around insurance contracts American International Group (nyse: AIG - news - people ) wrote on multi-sector collateralized debt obligations, a kind of slice-and-diced bond product that is at the heart of the worldwide credit crunch. These CDOs are mostly filled with subprimemortgage-backed securities that have plunged in value since sketchy U.S. borrowers began defaulting on their home loans in recent months.
The credit default swaps on this kind of CDO account for the lion's share of AIG's problems with default insurance.
The market for the CDOs has evaporated, even for issues that don't have any known problems. Nobody wants to buy them, which means, for now, they essentially have a value of $0. Some prudent investors, and some cynical speculators, bought insurance called credit default swaps from companies like AIG if the CDOs failed to pay off as they were supposed to. When these investments buckle, AIG either has to make a payment or buy the bond, depending on the terms of the specific deal.
On the face of it, the company's approach to its problem is sensible. It wants to buy the CDOs it insured and cancel the swaps. The bonds are almost certainly worth more than nothing, and they might be worth something close to their face value.
So far, so good, but this is where the complications set in.
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• How many of the investors who bought the insurance actually own the protected CDOs? Beats AIG.
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• What price is AIG planning to pay for the CDOs? If it's close to face value, why not just pay off the insurance? The story changes.
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• If it's not close to face value, why would an investor who bought insurance be willing to give AIG a break? All will be revealed.
The insurer has changed its story since it revealed the plan on Monday.
Initially, it seemed the company would try to low-ball investors into parting with their AIG-backed securities for a fraction of face value. But by Thursday, Nick Ashooh, a spokesman for AIG, said a $35.0 billion companyset up by the insurer and the Fed to resolve the issue would pay face value for the securities. Approximately half will be in cash and the other half will be collateral that AIG had to post with the insurance buyers as the value of their CDOs eroded.
This generous bent certainly doesn't jive with what AIG management said on a Monday conference call with analysts. There, they made it sound like the company would offer a fraction of face value and that the Federal Reserve would lean on the buyers -- many of which are banks that it regulates -- to accept what was on the table.
Chief Executive Edward Liddy said, "The Federal Reserve and its rather substantial influence will be the driver of the negotiations with the counterparties and we would expect that they will have substantially more success with those discussion thanwe have."
Scott Frost of HSBC asked, "So the CDO holder is not being made whole here. Is that correct? You're essentially buying the CDO for 50 cents on the dollar? Is that what you expect to have happen here?"
To which David Herzog, AIG's chief financial officer, replied, "No, Scott. Let's be clear. The CDO is being purchased at a negotiated rate, and I think Ed commented that the Fed is involved, heavily involved in that negotiation."
Frost pressed the point: "What is the motivation of the CDO holder to accept less then? Is it because you're saying look, I'm going to offer this to you, take it or leave it and if the CDO holder says I'll leave it, what do you do about it?"
Herzog: "Yes, well they can also tear the credit default swap up. So I think there again, I think there's, the structure has been designed in a way that's balanced in terms of the various stakeholders' motivations and incentives. So we believe this structure will be successful in accomplishing the restructuring and the de-risking of the AIG portfolio in this regard."
Frost suggested the approach might be too much stick and not enough carrot. "Is it fair to say then that there's going to be some kind, a little bit of execution risk here in your ability to get the holders of the CDOs to accept what you're offering them? Is that -- that's a fair, is that accurate?"
Herzog: "We're optimistic that we think this structure will be successful."
By the mid-week, that optimism had faded, and AIG is now offering what amounts to the full face value.
But what if the swap was sold to a third party, say a hedge fund that figured the bond would default? These prescient investors have no logicial reason to forfeit their profitable positions. This practice as rampant in recent years though difficult to quantify because the market is unregulated and the deals are private.
AIG contends that it can void the insurance by simply purchasing the CDO: "If a CDO changes hands, then the attached swap is terminated," Ashooh said.
Lawyers said this is unlikely to be the case.
Zachary Rosenbaum, a partner at New York law firm Lowenstein Sandler, said, "At first blush it makes a lot of sense if AIG is buying the CDO and the swap counterparty is also the asset owner. Where it starts to not make sense is when AIG is trying to terminate a swap where the counterparty is not the owner of the asset, which is often the case."
If AIG can really just buy up the assets it insured and nullify the swaps, why then would someone would someone have paid for protection in the first place?
"You'd have to ask the CDO and swap holders," Ashooh said. "The only way to answer the question is to know their motivation. We can’t tell you that."
AIG doesn't "really know" who owns the swaps but it thinks "in the vast majority of cases our counterparty could get the bond if they don’t directly own it. All that matters is that we buy the CDO and then the swap terminates."
What seems more likely is that only a portion of AIG's most troublesome swaps can be wiped out by buying the protected asset.
Ashooh said he had been limited in what he could say about the matter by the Fed.
http://www.forbes.com/markets/2008/11/15/...-cx_md_1110markets24.html |
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