The Overpayment Begins

Way back in the heady days of September, we criticized the original version of TARP because it seemed designed to ensure the government would overpay for toxic assets. Instead, we recommended splitting the transaction into two parts: (a) buy the assets at market (cheap) prices, and (b) explicitly recapitalize the banks. In mid-October, Treasury committed $250 billion to explicit recapitalization, but to all intents and purposes seems committed to using some of the other $450 billion to buy those same toxic assets – at what price is still unclear. (Why they would still bother doing this is also unclear, for that matter.)

Until now.

Today’s government re-re-bailout of AIG (WSJ article; Yves Smith commentary) can be hard to follow, but one provision is the creation of a new entity with $5 billion from AIG and $30 billion from the government to buy collateralized debt obligations (CDOs). The goal is to buy CDOs that AIG insured (using credit default swaps), because if those CDOs are held by an entity that is friendly to AIG, that entity will no longer demand collateral from AIG. The theory is that in the long run these CDOs will not default and that the new entity will make money on the deal.

The rub is that this entity is planning to pay 50 cents on the dollar for these CDOs. This has two problems. First, 50 cents is almost certainly more than these CDOs are worth on their own (hence the title of this post). If they were really worth 50 cents on the dollar, AIG wouldn’t be having the problems it is having posting collateral; like the original TARP plan, this is an unfounded bet that the market is mispricing these assets. Second, and more bafflingly, the CDS contract is presumably separate from the ownership of the CDO; that is, buying the CDO from the counterparty doesn’t eliminate AIG’s obligation to pay if the CDO defaults, and hence doesn’t serve its stated purpose. If, on the contrary, the CDS contract is contingent on the counterparty holding the CDO, then the CDO is worth a lot more than 50 cents to the counterparty, because it is insured for 100 cents by AIG – and we all know the government isn’t going to let AIG default on those swaps. And no sane counterparty would sell for 50 cents.

Supposedly Treasury had enough time to think about how AIG should be bailed out and this is a better bailout than the original. If it is, I must be missing something.

4 thoughts on “The Overpayment Begins

  1. “November 10, 2008, 5:16 pm

    More A.I.G.
    By Floyd Norris,
    New York Times
    The most interesting part of the American International Group bailout today is the securities lending part, which I will get to later. It is happening because A.I.G. gambled with collateral that it was expected to put in safe investments. Having lost the gamble, it turns to Uncle Sam.

    Before we get to that, I need to correct something from my previous post on A.I.G. In it, I wrote:

    It appears that the government may end up with a lot of dubious paper, since it has limited A.I.G.’s risk in purchasing some dubious collateralized debt obligations that the company insured. A.I.G. seems to think the owners of those C.D.O.’s will sell them at a discount, but when asked why they would do that — given the insurance — there was no real answer. This plan could flop in the market.

    I’ve now gone through documents, and talked to people briefed on the bailout, and I think I understand it better. The first sentence is accurate. But the rest of the paragraph is misleading or wrong. The inability of company executives to answer the question is appalling. This deal will appeal to everyone in the market. It is only the government that is at risk.

    Here is how the C.D.O. deal will work. A.I.G., in many cases, has already had to put up in cash the decline in market value of the C.D.O.’s. Say that is 50 percent of the original value. The new special purpose vehicle will buy the C.D.O. for the remaining 50 percent. The holder gets par — keeping the cash he already got from A.I.G., and the rest from the new vehicle.

    This is supposed to cost $35 billion to buy $70 billion of paper. The new vehicle will get $30 billion from the government and $5 billion from A.I.G. If all goes well, A.I.G. will earn three percentage points over Libor on that $5 billion, with the possibility of additional profits. The government will get just one percentage point over Libor on its investment, although it will be repaid first, if all goes well. If somehow there are profits, the government gets two-thirds, and A.I.G. the rest.

    If there are losses, A.I.G. will take the first $5 billion, and the government the rest.

    For A.I.G., this limits the possible losses from the venture.

    These are C.D.O.’s, by the way, that are called multi-sector because they were made up of securities from various mortgage backed securities — subprime, Alt-A, home equity lines of credit and commercial.

    A.I.G. guaranteed they would pay off. This makes good on the guarantee, courtesy of the taxpayers.

    Now for the securities lending business.

    A.I.G.’s insurance companies, like many other institutional investors, lend out the corporate bonds and stocks they own. The borrowers of the securities, who need them to deliver on short sales, or for other purposes, put up collateral of a little over the value of the securities.

    Normal institutional investors put that money to work in short-term money markets. There they earn perhaps 30 basis points over the interest rate they are paying to the borrower who put up the collateral. If the money market does not blow up, it provides a low but safe profit.

    That was not good enough for A.I.G. It took the money and used it to buy residential mortgage-backed securities (R.M.B.S.). They paid much higher interest rates, so A.I.G. could report higher earnings.

    Now, however, the R.M.B.S. have plunged in value, and are hard to sell at any price. As the normal securities are returned, the borrowers want their cash back, and A.I.G. does not have it.

    The process will be similar, A.I.G. will put up cash to cover the decline so far in market value and the new special purpose vehicle — financed with $1 billion from A.I.G. and $22.5 billion from the government, will then buy the securities at that market price. Again, all will make money if the market price is low enough. They will lose if it is not low enough to cope with future defaults.

    Much will depend on whether the market values are fair or not. A.I.G. will calculate them, under government oversight.

  2. pillip: Thanks for pointing that out. Floyd Norris’s initial interpretation – which he realized is wrong – was the same as my initial interpretation – which was based on the WALL STREET JOURNAL article. Which means that AIG managed to give the wrong information to both the Times and the WSJ. Wow.

    The new version makes more sense in some ways and less sense in others. It makes more sense because now we understand why the counterparty would sell. Essentially AIG is settling the CDS as if the CDO defaulted – it is paying 100 cents on the dollar to the counterparty and getting the CDO in return. (This assumes that the amount to be paid is not 50 cents across the board, but whatever in addition to the already-posted collateral will come to 100 cents.) Then the government and AIG are left holding the CDO.

    But it makes less sense because the government is putting $30 billion into an entity that will buy $35 billion worth of CDOs, where the government faces most of the downside (AIG takes the first $5 billion of risk, but we get all the rest) and only one-third of the upside. Who negotiated that deal?

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