Monday, November 10, 2008

AIG CDS Solution: Financing Entity #2

What is commonly referred to as AIG bailout #2 has been ripped by bloggers.  One of the more articulate rants by Yves Smith at naked capitalism, is titled AIG, the Looting Continues.

The crux of this rather long post is that the "...treasury is going to buy crap assets at amazing (high) prices..."
A price of 50 cents on the dollar for CDOs across all tranches, particularly when the objective is to buy the dreckiest dreck (the ones where AIG's losses on its CDS guarantees would be greatest) is simply breathtaking. It's a wet dream for anyone who owns them.

Remember, this would be the price across ALL tranches. Recall that in Merrill's not-all-that-long-ago sale of its super-senior CDOs (the very best tranches) it got a nominal price of 22 cents on the dollar, but that did not accurately represent the economics of the transaction. The hedge fund Lone Star paid only 25% of that amount (or 5.5 cents) in cash, the rest was contingent on performance. So Merrill might have sold the CDOs for as little as 5.5%.
However passionate the argument, the facts simply don't support this criticism.  The problem is that AIG wrote credit default swaps to insure them at par.  They also plan on buying them at par, putting them into a SIV and commuting the credit default swaps.  

Here is what the press release says about this "vehicle."
Reduction of Exposure to Multi-Sector Credit Default Swaps: AIG and FRBNY will create a second financing entity that will purchase up to approximately $70 billion of Multi-Sector CDO exposure on which AIG has written CDS contracts. Approximately 95% of the write-downs AIG Financial Products has taken to date in its CDS portfolio were related to Multi-Sector CDOs.

In connection with this transaction, CDS contracts on purchased Multi-Sector CDOs will be terminated. AIG will provide up to $5 billion in subordinated funding and FRBNY will provide up to $30 billion in senior funding to the financing entity. As a result of this transaction, AIG’s remaining exposure to losses on the Multi-Sector CDOs underlying the terminated CDS’s will be limited to declines in market valueprior to closing and its up to $5 billion funding to the financing entity. As with the securities lending program, FRBNY and AIG will share in any recoveries in the market prices of assets.
They also have a little graphic on the slides they used at their earnings announcement.  Unfortunately I can't seem to upload pictures, so just go to page 5.

Basically they have a notional value of $70.  They are insured for $70.  AIG will buy them for $70, then put the collateral of $35 billion in the SIV, throw in another $5 billion, and borrow up to $30 billion from the FRBNY.  

The interesting thing will be those situations where the purchaser of the CDS doesn't own the underlying CDO.  They will either have to find them in the market, buy them and book the profit.  Or work out a value with AIG.

Then the CDS's will be in a SIV.  They will then sit until they amortize (not much chance of a sale)  and the Fed gets their cash back first, having $40 billion subordination.  As I recall, that was the original idea of the bailout -- buying bad assets and getting them out of the system.

The owners of the CDO's will no longer have any counter party risk.  They also will no longer have to pay premiums to AIG.  AIG won't be getting collateral calls.  The actual cash losses on these CDO's has been minimal to date.  There will no longer be any argument regarding what they are worth, since they will just amortize.

Like it or not, I don't see how this can be construed as looting.  But whatever, the idea that the price that the holders of the CDS's get isn't much of an issue.  That was settled by contract when the CDS was written (no doubt for a hundred basis points or some pathetically small premium).     

I read the conference call transcript.  Although they talked a lot about how this would be done, they never came out and said they would have to buy them at par.  I suspect the reason is that every deal is unique and they will try to drive the best bargain possible.  Particularly when the CDS holder doesn't own the underlying.

Anyway, it was clear that they would have AIG directly settle/commute with the CDS holder at "market value" and then the new SIV would buy the CDS at "market value".  Not saying that the two "market values" would be identical.  

The one thing that was clear is that the SIV will just buy assets (multi sector CDO's).  They won't assume the liability for the CDS's.  AIG already has written down the CDS's by $30 billion of the $72 billion.  

Anyone that really wants to know what these things are can look at AIG's financial supplement.  The CDO's in question still have about 20% subordination.  They consist of 137 "transactions" which I assume means CDS contracts.  The transactions would have to be on specific tranches of CDO's if they are quoting subordination percentages.

They also are publishing the results of their "roll rate model" for estimating ultimate credit losses and say that it is $12 billion compared to the "accounting" estimate based on CDO market prices.    

1 comment:

ps said...

Just read your blog after posting some questions re your post at naked capitalism. I appreciate your explanations, they have been very helpful. I will be following your blog and hope you continue to post your comments on this mess.