It seems that under the terms of the announced deal, the US government will be issued warrants by AIG which, if exercised, would give the government an 80% stake in the company, in return for a two-year loan of $85 billion. The use of warrants is significant, because it enables the government to control the company through the threat of massive dilution without actually aligning it with the interests of the shareholders. The important point is that no plans have been declared for these warrants to be exercised, and the shares are still trading.
Consequently, the governmentÆs economic interest as things stand is limited to ensuring that the $85 billion is repaid. As the warrant structure shows, itÆs not interested in taking a stake in the company, nursing it through the bad times, and withdrawing at a profit once its share price has recovered. (Profits which can then be recycled beneficially through the system).
The deal stipulates quite clearly that the loan will be repaid through the sale of AIG assets. In other words, the company is being broken up and sold for scrap. That means it will be impossible for the company to generate new business. And this is not the only disturbing aspect.
The figure puts an arbitrary floor on the value of the assets AIG has to sell off. Since the government has no stake in the company, it has no incentive in ensure that AIGÆs assets are sold at more than is needed to obtain $85 billion. This should have a depressing effect on AIGÆs assets, an unwelcome addition to all the other deflationary aspects weighing on the deal. This is especially unfortunate because AIGÆs insurance operations are reportedly sound and profitable, but an un-incentivised buyer like the US government has no reason to try too hard to extract their fullest value.
Yet from the governmentÆs point of view, the move must look highly satisfactory. The structure neatly combines two objectives. It avoids declaring a destabilising outright bankruptcy, enables a two-year unwinding of deals with the recapitalised companyÆs $441 billion of credit default swap (CDS) counterparties. The financial commitment and quasi ownership structure will hopefully avoid sending creditors into a panic.
In effect, AIG has been transformed into a quasi-government sponsored enterprise (GSE), which should help minimise systemic shocks. But it also punishes the shareholders (and short sellers) by making it plain the company will be dismantled û just as the government crushed the shareholders of Fannie Mae, Freddie Mac, Indie Mack and Lehman Brothers. The three month Libor plus 850bp interest rate on the gigantic bridge loan will ensure that much of the profit (if any) generated by the company will be going to the government, not to shareholders. That rate could go up even further if liquidity continues to leave the system, since itÆs a floating rate based on three-month Libor. The interest cost, if the loan is fully drawn down, is more than the $7 billion in net income AIG made in 2007. The punitive interest rate makes it obvious that the cash must be raised by asset sales rather than cash flow. The punitive intentions of the government seem clear.
The status of bondholders is not clear û will they be senior to the government's claim? Given that all assets of AIG are expressly collateralised against the government loan, it looks not. And the stringent terms of the loan don't make it seem very likely there will be much cash to spare for bondholders. On the other hand, holders of bond insurance policies written by AIG will presumably be honoured using the loan, since defaulting on those would cause bond prices to shudder.
Overall, some observers have argued that the intervention is vague in its guiding principles. A cash injection should be theoretically aimed at illiquid but solvent institutions. Alternatively, the company is made bankrupt and liquidated with clear levels of seniority. But the government doesn't seem to know what AIG is. It's providing the cash but only under conditions that will destroy the company, and which therefore may not pay out bondholders, let alone equity holders. The lack of bankruptcy proceedings confuses the seniority of claims.
The government is not showing any appetite for cranking up the economic system by this kind of restructuring. Sure, there are some systemic safeguards, but even with the two-year buffer and the avoidance of bankruptcy, who knows how the underlying assets will improve? Until there is a general economic upswing ALL assets will suffer. ThatÆs the iron rule in financial crises. So the deal does not give any encouragement whatsoever that the government is committed to rebooting the economy. And thatÆs a negative for systemic stability. Of course, thatÆs not surprising, given the governmentÆs initial (and absurd) stance against any bailout.
The US governmentÆs actions are in interesting contrast to Japan where the decision was made not to kill off the banks during the reorganisation of the 1990s, but to recapitalise them in the form of government preferred shares. As the broader economy recovered (partly thanks to the banks being able to resume their operations on the back of the recaps but also thanks to government fiscal expansion), the banks began to make modest profits and have now almost all paid off the government. The government has also made a profit and those profits have been recycled to the taxpayers. The Japanese governmentÆs actions were not without their faults: it took them far too long to go ahead with the recaps, raising the overall cost considerably.
In addition, one has to ask if the US governmentÆs punitive streak is not trumping the profit motive. Before Lehman was pushed into bankruptcy, AIG had requested a bridge loan of $20 billion. That loan has now ballooned to $85 billion. The collapse in global asset prices triggered by the governmentÆs actions with Lehman make it seem as if a much larger cash infusion became necessary than was previously the case. So the government has made its point, (but at a much higher exposure to AIG than if it had bailed out Lehman.
As argued in a Tuesday article on FinanceAsia, the government should have prevented these blatant corporate abuses from occurring in the first place. Its current priority should be to maintain the safety of the financial system and encourage wealth creation, not mete out justice or force firms into bankruptcy. The final irony is that the financial deleveraging process going on in the world economy will inflict quite enough pain on bond-and-shareholders of all stripes without any help from the Fed/Treasury.
What is also disturbing is how the US government has identified the shareholders (rather than say, regulators, ratings agencies, politicians or managers who have already left troubled firms) as the culprits who deserve punishment. ItÆs hard to feel too much sympathy for Hank Greenberg, a major shareholder who has personally lost billions of dollars, but he is not the only shareholder. What about all the small shareholders who bought into AIG on the assumption that it was a solid insurance company, properly regulated by the US government? How were they to know that Senator Phil Gramm had ensured that credit default swaps, one of the major causes of the implosion at AIG, were exempt from oversight by the insurance regulators? How are existing shareholders to blame for the fact that AIG was regulated by the state of New York, not by the federal government? Are they to blame for the credit agencies providing triple-A ratings to the supposedly super senior CDO products that AIGÆs Financial Products Team was investing in?
All these failings were long-standing, systemic and cultural: abusing shareholders (and possibly bondholders) now is not helping the recovery of the financial system. It is all very well wanting to punish the culprits, but if the right culprits are not found, it becomes lynch justice.
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