The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.
The Board determined that, in current circumstances, a disorderly failure of AIG could 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 purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.
The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.
The interests of taxpayers are protected by key terms of the loan. The 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. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.
The Wall Street Journal gives a very thorough rundown of all the details.
Opinions are surely going to be divided on whether this is a good thing or not. John Jansen sees the Fed as "careening down a very slippery slope". I have a feeling that most commentators will be against it even though their specific reasons will differ.
Mark Thoma thinks it is a good idea. And while I would have rather seen them tap the private equity market, something had to be done. Recall that AIG has been turning down private assistance for the last couple days because they didn't want to give up control of the company. With the Fed deal, they will surely give up some control, but exactly what the company will look like going forward remains to be seen.
Is it a bailout? Is it a takeover? To me it looks more like bankruptcy by another name. Effectively it gives AIG some time to sell a lot of its assets--more than just the junk--and reorganize itself. In the meantime, its creditors will be made whole. Equity holders may properly bear some of the cost as the government has veto power over dividends. At the end of the 24 month period...hopefully...the company, in whatever form it takes, can resume something approaching normalcy. Assuming, of course, that it has any reputation left. Perhaps sometime during or after that 24 months a suitable buyer can be found. These are questions that no one can answer now.
Make no mistake, this is not something that the Fed should enter into lightly, and I am quite confident that they took this step only when it became apparent that it was the last option. But this might have been one of those turning points where a decisive action had to be made. Anyone who has not read chapter 7 of Friedman and Schwartz needs to do so right now. Every time I tell a macroeconomics class about the mistakes the Fed made in the Great Depression, I end by talking about the many things we have learned since then about how not to let it happen again. Few people know those lessons better than Mr. Bernanke. Dithering in the face of these problems only makes them worse. Better to have swift decisive action and move toward a resolution.
To those who say that this fails to properly punish those who took excessive risk, I agree in part but can only say that protecting the innocent (or perhaps less guilty) is more important right now than punishing the truly guilty. To those who would say that this is an affront to the free market system, I would simply say that without confidence in market institutions the system doesn't work. The system's ability to restore that confidence has been compromised by the foolish actions of many people. Some will get their comeuppance. Some will not. It's not a perfect world. We'll try to reform the system so as to do better next time. Right now let's focus on doing it better than last time.
There will be more grim news, perhaps for another year or more. And there is definitely some possibility of a systemic financial collapse (see Professor Roubini's excellent discussion of the downside risks). But unlike observers that believe this only marks the end of the beginning, I believe there is a chance that these events mark the beginning of the end of the crisis.
As I said yesterday, I think the end game has begun. Clearly the push to mark down the values of these assets is in full swing. The AIG deal could be a catalyst for an orderly sale of these assets, a rebalancing of portfolios, and a fair market valuation of assets on the books of other firms. In the process, we might find other AIGs, but more than likely any of the truly enormous problems will be discovered first, and that process may not take too long. Several months, perhaps--but not several years. Indeed, we are fortunate that these problems are being discovered and dealt with rather than festering for a decade or more.
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