So far the tab for government rescues is $900 billion:
- There is $200 billion for Fannie Mae and Freddie Mac. The Treasury will inject up to $100 billion into each institution by purchasing preferred stock to shore up their capital as needed. The deal puts the two housing finance firms under government control.
- $300 billion for the Federal Housing Administration to refinance failing mortgage into new, reduced-principal loans with a federal guarantee, passed as part of a broad housing rescue bill.
- $4 billion in grants to local communities to help them buy and repair homes abandoned due to mortgage foreclosures.
- The latest, $85 billion loan for AIG, giving the Federal government a 79.9 percent stake and avoid a bankruptcy filing for the embattled insurer.
- There will be at least $87 billion in repayments to JPMorgan Chase for providing financing to underpin trades with units of bankrupt investment bank Lehman Brothers. U.S. Treasury Secretary Henry Paulson said over the weekend he was adamant that public funds not be used to rescue the firm.
- $29 billion in financing for JPMorgan Chase's government-brokered buyout of Bear Stearns in March. The Fed agreed to take $30 billion in questionable Bear assets as collateral, making JPMorgan liable for the first $1 billion in losses, while agreeing to shoulder any further losses.
- At least $200 billion of currently outstanding loans to banks issued through the Fed's Term Auction Facility, which was recently expanded to allow for longer loans of 84 days alongside the previous 28-day credits.
The Government Comes to AIG’s Rescue
According to the Fed’s official press release, the government is lending AIG up to $85 billion through a secured loan designed to protect it and the taxpayer. The credit facility lasts two years and has an interest rate of three-month LIBOR plus 850 basis points, or a high rate of 11.3%. The Fed Board felt, according to its release, that allowing AIG to fail would “add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.” The decision the Fed made was to allow the insurer to unload assets without causing great disruption to the overall economy.
“…The [Fed] loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets.” In return, “the U.S. government will receive a 79.9 % equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.”
AIG gets a two-year loan at an interest rate of 11.3%, with a $19 billion interest payment due at the end of its term, as the Fed has exercised, within its purview, a loophole in the law that lets it lend to non-banks in “exigent” circumstances. And with the credit facility comes a nearly 80% equity stake in AIG, now owned by US taxpayers.
The government in its official statement wants to ensure the public that what it did with AIG is not what occurred with a Fannie Mae-Freddie Mac, which is guaranteeing a company’s debt. The message to taxpayers is that it not guaranteeing anything else at AIG, and that the government will profit from the AIG rescue.
AIG: Too Big, Important to Go Under
AIG insures everything from cars to homes to businesses and families and other carriers. Its guarantees sit behind mutual funds and money funds, pension funds owned by government workers, 401 (k) holdings, and annuities.
Despite the Fed’s intervention, already a flight out of money funds to US treasuries is underway, driving yields down to record lows, due to the loss of confidence and upon news that the money fund Reserve Primary saw its net asset value drop below $1. The three-month t-bill has plunged to rate levels not seen since 1954, to as low as 0.23%.
As AIG is a huge player in the $62 trillion credit default swaps market, and a bankruptcy would have ignited massive write-downs around the globe. Banks around the country have counted these swaps as part of their regulatory capital cushions they are required to hold to support their businesses. If the swaps go down in value, banks could face more write-downs and have to raise more capital, if, in the form of equity raises, diluting existing shares.
CDSs are basically insurance against defaults on derivatives. A swap is essentially debt insurance companies buy on their credit derivatives, whereby AIG would have to pony up money if the assets underlying the derivatives belly flopped.
Swaps are basically AIG’s promise that it would make good on any losses to holders of asset-backed bond securities, including mortgage-backed and commercial real estate-backed bonds. With the housing and credit bubble bursting, one estimate of AIG’s exposure here reached half a trillion dollars, but no one actually knows the amount.
Just look at the swaps swirling around Fannie and Freddie alone.
The Fannie and Freddie Factor
As economist Edward Yardeni points out: “Dealers in the CDS market are now working to settle billions of dollars of such contracts” now amounting to as much as $500 billon on the $1.6 trillion of Fannie and Freddie debt.
Yardeni adds that, “although the debt is regarded as safe after the US government effectively nationalized the two gigantic mortgage companies, their move into ‘conservatorship’ counts as the equivalent of a bankruptcy in the credit derivatives market.” That remains to be seen.
Yardeni points out that, in the 9/11 edition of the Financial Times, Aline van Duyn, one of the smartest business columnists in the world, reported that the recovery value of the Fannie and Freddie CDS is currently expected to be about 95 cents on the dollar, leading to a potential 5% loss for insurance companies or banks who offered protection against a default.
If their CDS contracts total $200 billion to $500 billion, as some have estimated, the losses would come to $10 billion to $25 billion.
Read Between the Fed’s Lines
Note how, as CreditSights, a research firm points out in a special report, the Fed’s press statement and dictums governing the AIG rescue do not use the words “default, receivership, conservatorship.”
Those words would let counter-parties break trades involving AIG credit defaults swaps around the globe. That would create even more write-downs around the world.
As the housing and credit bubble burst, AIG already has seen massive defaults on these derivatives as well as dramatic plunges in values of other securities it owned, triggering more than $40 billion in write-downs and record losses.
The Fed in Reactionary Mode
With the Fed's bailout of AIG, "the money supply has just been expanded by $85 billion,” says David Rosenberg, a top economist at Merrill Lynch. “With this move the Fed and Treasury have blinked in the face of market pressure once again.”
Rosenberg adds: “They continue to react to situations rather than getting in front of them and now they have created uncertainty about what firms qualify for bailouts and which do not. Until that goes away, markets will continue to test their limits and that is not good news for markets going forward.”
Additionally, it means more inflation, as the government needs to print money to solve these problems, sending the dollar lower.
After-the fact refereeing is extremely costly to taxpayers. Is the free market now a regulatory free-for-all too?