As markets tumble, all eyes on AIG

Dow nears 12-year low as U.S. makes fourth attempt to shore up ailing insurer with further $30-billion

SINCLAIR STEWART March 3, 2009

NEW YORK -- If investors didn’t quite grasp the implications of Washington’s initial effort to rescue American International Group Inc. last fall, the message surely sunk in yesterday when lawmakers mounted their fourth attempt: The reeling insurer is the financial equivalent of a time bomb, and its collapse could pose a greater threat to the economy than a major bank failure.

The U.S. government quickly pledged an additional $30-billion (U.S.) in aid to prop up the company after it revealed a $62-billion quarterly loss, the largest in corporate history.

AIG had already received $150-billion in taxpayer-funded support before this latest rescue package: triple the $50-billion in emergency financing U.S. officials have earmarked for troubled Citigroup Inc. and more than three times the $45-billion handed to Bank of America.

Yet even with this intervention, North American stock markets continued to plummet. The Dow Jones industrial average fell almost 300 points to 6,763.29, its lowest level in almost 12 years. The panic spilled over into Canada, where the benchmark S&P/TSX composite index dropped nearly 5.4 per cent to 7,687.51, amid the deepest economic contraction since 1991.

Several sectors, including commodities, contributed to a gut-wrenching fall in Toronto.

But many observers insist stock markets around the world will remain in freefall until the Obama administration can stabilize the U.S. financial industry, the locus of the economic crisis.

Investors are still unsure which banks will fail, or how a vaguely worded proposal to strip the most toxic assets off of bank balance sheets will work, and this uncertainty has contributed to a general sense of panic.

The Treasury Department and Federal Reserve acknowledged this shattered confidence yesterday, and said they had no choice but to inject more money into AIG, given the extent of its business dealings with policy holders, municipalities and many of the country’s largest banks - all of which could suffer even more if the insurer was to fail.

"The potential cost to the economy and the taxpayer of government inaction would be extremely high," they warned in a joint statement, noting AIG’s potential for infecting the economy with "systemic risk."

AIG is at the epicentre of the "shadow banking system," which helped to incite the mortgage-fuelled credit crisis. This is a largely unregulated world populated by complex derivative products like credit default swaps, a kind of insurance policy AIG offered to protect investors who own securities backed by pools of mortgages or other assets.

AIG was a crucial linchpin because its policies allowed banks to minimize the capital they needed to keep on hand; this, in turn, freed these banks to buy ever larger amounts of mortgage-backed securities and fuel the rapid expansion of the market.

Say a bank bought a group of securities, but was worried that the mortgages backing them would decline in value: It could buy a credit default swap from AIG for a fee, and basically receive a policy that guarded against any downside. As of the end of last year, AIG still backstopped about $300-billion worth of these securities.

AIG’s biggest mistake was an apparent gamble that housing prices would continue to climb - or at the very least, that they would remain stable. Yet when housing prices fell sharply in 2007, the insurer had to pay billions of dollars worth of collateral to its customers to bridge the shortfall.

As the severity of these capital calls continued over last summer, AIG found itself in serious trouble, and approached the government for help. Washington, fearing a debilitating ripple effect throughout an already fragile banking system, stepped in with an $85-billion loan offered at a high interest rate. A month later, as problems mounted, the government added $38-billion, and then, in November, restructured the entire aid plan by committing cash to help buy some of the securities that AIG insured.

Yet none of that has been enough for several reasons.

When the value of the securities it insures declines, AIG’s customers can make a "collateral call" and demand a payment. AIG also has to write down the value of these contracts on its own books, which hurts the company’s capital position and can precipitate credit rating downgrades. This, in turn, compounds the problem: in many cases, customers can demand collateral calls if AIG’s debt rating is cut.

The self-reinforcing nature of AIG’s woes has thus far defied Washington’s costly bailout effort. Yet the government has acknowledged AIG is "too big to fail" and there is a possibility it may have to inject even more cash into the company before all is said and done.

If AIG were to fall, its insurance contracts would be nullified and banks would have to take massive writedowns of their own, further imperilling the financial system. There would also be the logistical nightmare of untangling such a large and complex web of counterparty relationships.

"They are trying to protect the global financial system from a complete meltdown," said Phillip Phan, professor of management at the Johns Hopkins Carey Business School in Baltimore.

The government already owns almost 80 per cent of AIG, and yesterday’s deal will see it become more deeply entrenched - although it is relaxing the interest rates on the company’s loans.

In addition to giving AIG a new $30-billion loan, which will help guard against another debt rating downgrade, the government is exchanging $40-billion of preferred shares for a different type of preferred share that will help buttress AIG’s capital position. These new shares don’t pay dividends, easing the company’s financial burden - but depriving taxpayers of that income.

AIG said it has used about $38-billion out of a previously announced $60-billion loan program. Instead of paying that back, however, AIG will now give the government stakes in two subsidiaries.

AIG chief executive officer Edward Liddy, who was parachuted into the job last fall by the government, told analysts yesterday the company is "too complicated, too unwieldy and opaque" to remain a single business.

He added that AIG is pursuing sales of some divisions, and there is the possibility it might spin off one unit into a publicly traded company.

A LONG SLIDE

The S&P/TSX composite fell 5.4 per cent yesterday, a steeper decline than most major or global markets.

Sept. 1 to Oct. 10

The sharp drop for the S&P/TSX begins as the mortgage market in the United States melts down. The U.S. government takes over Freddie Mac and Fannie Mae, and in the coming weeks AIG is nationalized and Lehman Brothers files for bankruptcy.

Nov. 4 to Nov. 20

As the market searches for direction, oil continues to plunge, down 60 per cent from its highs set only four months prior.

Jan. 1 to present

Hopes of a commodities-based recovery shore up the index, but a constant barrage of weak economic indicators - culminating with yesterday’s report of a 3.4-per-cent GDP contraction - drag the index down.

Close:7,687.51

Down:435.51

NINIAN CARTER/THE GLOBE AND MAIL.. SOURCE: BLOOMBERG

AIG revised rescue package highlights

New equity capital commitment

Up to $30-billion (U.S.) equity line from the $700-billion Troubled Asset Relief Program, with a five-year term.

Terms of Treasury’s $40-billion preferred investment eased

The new deal increases equity content of the preferred stake and reduces the annual cost of servicing dividends by more than $4-billion.

AIA & Alico

Foreign life operations American International Assurance (AIA) and American Life Insurance Co (Alico) will be put in special-purpose vehicles. The New York Federal Reserve will get preferred stock in the vehicles in return for a reduction in the outstanding balance by up to $26-billion of its $60-billion credit line.

Life insurance securitization

AIG plans to give the Fed securitization notes of up to $8.5-billion, representing the embedded value of some U.S. life insurance businesses, to further reduce government debt.

Credit facility

The total amount available to AIG under the facility will remain at least $25-billion. Interest rate cut

The Libor floor on credit facility to be removed, saving AIG about $1-billion a year. AIU Holdings Inc.

A new general-insurance holding company with AIG’s Commercial Insurance group, Foreign General unit, and other property and casualty operations to be formed. AIG plans to sell a minority stake in AIU. A source with direct knowledge of the matter said earlier that up to 20 per cent of the business might be sold to public, and over time it could be sold off in its entirety.

Reuters