Treasury and Fed help AIG lay-off CDO risk

AIG was shored up by a restructuring plan hammered out by the US Treasury and Federal Reserve Bank of New York today, which involved the creation of an off-balance-sheet vehicle to neutralise some of the insurer’s hefty collateralised debt obligation (CDO) exposures.

Through its subsidiary, AIG Financial Products, AIG is saddled with the increasingly expensive credit risk of souring subprime-related CDOs. Despite an infusion of $85 billion for 79.9% of the company by the New York Fed in September, as well as an additional liquidity line extended in October, the company on November 11 reported a $24.5 billion net loss for the third quarter.

Under the restructuring plan, AIG and the New York Fed will sponsor two new financial entities – one to deal with the risks of AIG’s shaky CDO of asset-backed securities (ABSs) book and another to close-out AIG’s loss-making securities lending business.

The biggest of the vehicles will be collateralised by up to $30 billion from the New York Fed and a $5 billion subordinated loan from AIG. It will then purchase up to around $70 billion of multi-sector CDOs of ABSs on which the firm has written credit default swaps (CDSs), terminating the protection sold on them in the process.

According to AIG, multi-sector CDOs of ABSs have accounted for 95% of the writedowns suffered by the firm on its CDS portfolio. Although AIG will take the first $5 billion of any losses on the acquired assets, its exposure will be limited to this amount once the transaction is executed. Meanwhile, both AIG and the Fed will share in any potential upside from the deal.

AIG and the Fed are also contributing $1 billion and $22.5 billion, respectively, to another entity that will purchase assets relating to the insurer’s securities lending business. It will buy up bad residential mortgage-backed securities purchased by the securities lending business, limiting AIG’s exposure to them at $1 billion. Similar to the first vehicle, it allows both AIG and the New York Fed to share in any profits that result from the purchases.

The second vehicle also removes the need for the securities lending facility established by AIG and the New York Fed on October 8, which allowed the firm to deposit investment-grade fixed-income securities in return for a maximum of $37.8 billion of additional cash collateral. This facility had $19.9 billion outstanding on November 5, according to the insurer.

The restructuring plan sees the Treasury injecting new capital into the insurer, purchasing warrants on 2% of AIG’s common stock and investing $40 billion in perpetual preferred stock under the Troubled Asset Relief Programme (Tarp). The new capital will be used to pay down $25 billion of the $85 billion New York Fed credit facility originally extended on September 16.

A number of other terms are being adjusted on the deal, including the reduction of the punitive 8.5% interest rate, which will now come down to 3%. The duration of the loan will also increase from two years to five.

AIG chief executive Edward Liddy praised the various measures, saying they would establish a “durable capital structure” for the beleaguered insurer. The US Treasury noted admission to the Tarp meant the company would now have to “comply with the most stringent limitations on executive compensation for its top five senior executives”, as well as limits on golden parachutes and a freeze in the bonus pool for its top 70 executives.

See also: CFO replaced in compensation probe at AIG
Fed to lend additional $37.8 billion to AIG
US government takes control of AIG
AIG secures $20 billion bridge loan, but still downgraded
AIG replaces CEO after subprime losses mount