The U.S. Gets Deeper Into AIG

And you thought nothing was going down this weekend. Guess again. The government just got a lot deeper into AIG.

From the WSJ:

As part of the plan, the U.S. government is expected to roll back the length and interest rate of its existing loan, buy $40 billion in preferred AIG shares through the U.S. Treasury's Troubled Asset Relief Program, and cancel the bulk of its credit default swap agreements via a massive purchase of their underlying real estate assets. There is also a plan to backstop AIG's securities lending portfolio. In all, the U.S. will end up with total exposure of some $150 billion in investments.

The plan is a tacit admission that as AIG's 79.9% owner, the government now has a vested interest in seeing it thrive, rather than demanding punitive terms for its assistance. Yet the new plan also gives the government an unprecedented, and uncomfortable role as an actor in financial markets. The new government role is sure to draw greater scrutiny from lawmakers as they prepare to revamp the regulatory system for the financial sector.

The Journal goes on to describe the new facility and the additional assistance that will take some of the more troubled assets off of AIG's balance sheet:

Under the plan being finalized on Sunday night, the government would replace its original $85 billion loan with a 2-year duration with a $60 billion loan with a five year duration. Interest on the loan would drop from 8.5% plus three-month Libor interest-rate benchmark to 3% plus Libor.

In addition, the government would tap the $700 billion Troubled Asset Recovery Program to inject $40 billion into AIG in return for preferred shares. Those shares would carry 10% annual interest payments. The government's equity interest in AIG would remain at 79.9% following the changes.

Under the revised deal, AIG would transfer the troubled holdings into two separate entities that would be capitalized by the government.

The first such vehicle would be capitalized with $30 billion from the government and $5 billion from AIG. That money would be used to acquire the underlying securities with a face value of $70 billion that AIG agreed to insure with the credit default swaps. These securities, known as "collateralized debt obligations" are thinly traded investments that include pools of loans. AIG would seek to acquire the securities from their counterparties on the credit default swap contracts for about 50 cents on the dollar.

A second vehicle would be set up to solve the liquidity problems in AIG's securities lending business. The business involves lending out securities to short sellers or others and investing the collateral for gains. The strategy for many has lately backfired as once-reliable credit investments have seized up.

AIG has scrambled to unload illiquid assets in order to give back the collateral it accepted. AIG's exposure to this market forced it to seek a $37.8 billion lending facility from the government to cover its commitments.

Under the new plan, the government would inject about $20 billion into the securities lending vehicle and AIG would put in $1 billion. The vehicle would then buy the illiquid securities the AIG unit holds, known as residential mortgage-backed securities, for about 50 cents on the dollar. AIG would use the proceeds to shut down the $37.8 billion lending facility which is has not yet fully tapped.

So now we get an inkling of where we may be headed. It would probably be naive to assume that this is the last time we see a rework of one of the semi-nationalizized financial institutions. This isn't going to be unique to the U.S. and Lord knows where it ends. Probably with state control of the world's financial system. Will it ever be private again?

Tom Lindmark