AIG, Brookfield Settle Interest-Rate Swap Dispute for $905 Million

AIG swap settlementAmerican International Group (AIG) will receive $905 million in a settlement agreement that terminates two interest-rate swap agreements and a related lawsuit.

Source: Source: BestWire | Published on August 27, 2013

AIG January 1 renewals

Brookfield Asset Management Inc., the interest rate swap counter party, said it reached an agreement with AIG to terminate two 1990 swap agreements. Brookfield said it will pay AIG $905 million in a single lump sum. The 25-year credit swap agreements, which were to expire in 2015, had been listed as a $1.4 billion liability on Brookfield's books, the company said.

The settlement is not expected to have an impact on AIG's profit or loss. The proceeds from the settlement are expected to go towards the continued wind down of the remaining derivatives portfolio of AIG Financial Products, AIG said in a statement. Attempts to reach the company for additional comment were not immediately successful.

The agreement resolves a 2009 lawsuit that Brookfield and a subsidiary, Brysons International, filed against AIG in U.S. District Court for the Southern District of New York. Brookfield had sought early termination of the swap agreements, saying AIG's inability to pay its bills in the fall of 2008 had triggered default provisions in the contracts.

In a motion to dismiss, AIG said if Brookfield's allegations were true, "it would be inexplicable that not a single other counterparty has sought to assert the same position" as Brookfield, which claims the federal government's bailout of AIG was tantamount to a bankruptcy default.

AIG did experience a severe liquidity crisis in the fall of 2008, and was on the brink of failure when it received a $182.3 billion government bailout.

AIG's crisis stemmed from its financial product unit's involvement in a different form of swaps: credit default swaps backing mortgage-backed securities and collateralized debt obligations. Credit default swaps were triggered when the underlying securities defaulted, and AIG ended up owing more money than it had readily available.

The Brookfield swaps offer a glimpse into the complex financial transactions that AIG was known for.

The Brookfield swaps date back to 1990, when Brookfield's predecessor, Brysons, a successor to Brysons International Bank in Barbados, approached AIG about receiving a $200 million loan.

"Instead of a traditional loan or other standard commercial lending facility, AIG offered financing via a complex structure composed of three transactions: a sale of debentures and two 'fixed for floating' interest rate swaps," according to court papers.

In the first transaction, Brookfield issued and sold its floating rate debentures due October 2015 for $200 million to AIG Financial Securities Corp. Brookfield was required to repay the $200 million in principal on the maturity date plus interest every six months. In 2000, Brookfield repaid the debentures early, and those were not a part of the lawsuit.

The first swap was a "zero-coupon" swap, which meant neither party was required to pay anything until the swaps were terminated 25 years after they were signed. The second contract was a "coupon swap" under which every six months, AIG would pay Brysons a fixed amount calculated on an annual rate of 9.61% on $200 million and every five years, Brysons would pay AIG an amount calculated at LIBOR on $200 million, compounded every six months, according to court documents.

A key aspect of the structure was the final net payment to be made in 2015 on the zero-coupon swap: it was based on the difference between LIBOR and 9.61% over the intervening 25 years. In general, so long as LIBOR remained below 9.61% Brysons would have to pay AIG, but if LIBOR on average moved above 9.61%, then AIG would likely have to pay Brysons.

In its lawsuit, Brookfield says AIG might have suggested the swap structure because unlike a straightforward loan, AIG could take advantage of mark-to-market accounting on the swaps. Under mark-to-market accounting, AIG could book the present value of its expected future profits as immediate income. When applied to an investment with a 25-year term, the difference between mark-to-market and accrual accounting could be significant, because it encompasses the present value of 25 years of profits (or losses). A traditional lender, on the other hand, could book interest income each period only to the extent that interest had accrued to date, according to the lawsuit.

As part of the bailout of AIG, the U.S. Treasury and the Federal Reserve acquired a majority of AIG's stock. As AIG sold assets to repay the federal loans, the federal government gradually sold off its AIG stock. In December, the last of the government-owned AIG was sold, and the Treasury and the Federal Reserve said they had fully recovered the amount they committed to AIG, plus earned an additional $22.7 billion positive return