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Fed Reserve Vice Chairman Says Risks Great in Not Rescuing AIG


Posted on 05 Mar 2009

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In remarks prepared for a hearing of the Senate Banking Committee, Federal Reserve Board Vice Chairman Donald Kohn said that while the decisions to rescue American International Group Inc. have been “difficult,” the costs of withholding aid to the insurer would be “unacceptably large.”

“The disorderly failure of systemically important financial institutions during this period of severe economic stress would only deepen the current economic recession,” Kohn said today. “We have been and will continue to work alongside the Treasury and other government agencies to avoid this outcome.”

Kohn’s comments, building on remarks this week from Fed Chairman Ben S. Bernanke, indicate the government may commit more funds to avoid an AIG failure. Bernanke told another Senate panel on March 3 that AIG’s collapse “would be devastating to the stability of the world financial system” and jeopardize taxpayer investment in the firm, now totaling $163 billion.

The government provided a revised rescue this week, adding a $30 billion line of capital, as the New York-based company reported a $61.7 billion fourth-quarter loss. The Fed warned that AIG may need more aid if markets don’t recover.

“Extreme financial and economic conditions have greatly complicated the plans for divestiture of significant parts of the company in order to repay the U.S. government for its previous support,” Kohn said. The new plan will “provide longer-term stability to AIG” while “maximizing likelihood of repayment to the U.S. government,” Kohn said.

First Infusion

In its first infusion of cash, the federal government provided AIG in September with $85 billion and took an 80 percent stake. The bailout swelled to $122.8 billion and then $150 billion as the government sought to prevent losses at banks that did business with the insurer.

The bulk of AIG’s losses, which totaled more than $100 billion in the past five quarters, stem from credit-default swaps sold to investors to protect them from the declining value of financial assets.

“These have entailed very difficult and uncomfortable decisions for a central bank,” Kohn said. “These decisions were particularly difficult and discomforting because they involved addressing systemic problems created largely by poor decision- making by the company itself.”

This week the U.S. agreed to accept a lower interest rate on loans to AIG and to exchange $40 billion in preferred stock for new non-cumulative preferred shares that resemble common equity, the Treasury and Fed said.

More Borrowing

The company also had borrowed about $14 billion through the Fed’s Commercial Paper Funding Facility as of Feb. 18, Kohn said.

Kohn said that the Fed’s team of 15 employees, led by senior officials, maintains oversight of AIG and that the central bank “routinely” tells AIG of its views on “key issues, such as major incidents of corporate spending and executive compensation.” The Fed worked with AIG to restrict executives’ salary and bonuses for 2008 and 2009, Kohn said.

AIG will pay down the federal loan, pegged at about $38.9 billion at yearend, partly by turning over its two largest international life insurance units valued at about $26 billion.

AIG Chief Executive Officer Edward Liddy replaced Robert Willumstad in September as part of the government rescue. Liddy said on a conference call this week that the five-year $30 billion capital commitment from the Treasury is a “backup facility,” and the company has plenty of cash. AIG is focused on protecting policyholders and paying back the government, Liddy said.

Declining Values

The insurer will probably need more government funds to cover contract liabilities and declines in asset values, according to Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania. At the end of December, AIG had $27 billion in unrealized losses on swaps, options and forward contracts and $25 billion in pretax gross unrealized losses on bonds and equity securities. Credit-rating downgrades on structured finance products may also boost losses, Egan said.

“We expect the U.S. will continue to support AIG until it is no longer too big to fail,” Egan wrote in a March 2 report.

Troubled assets on AIG’s books lost about $10 billion in value in the weeks before the bailout in November. The losses were on about $100 billion of assets acquired by two government- supported entities set up by the Fed.

The company’s woes are also driving away potential customers. General insurance net premiums written slumped 16 percent in the fourth quarter to $9.2 billion. Within that business, premiums for commercial insurance fell 22 percent to $4.4 billion, AIG said.


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