Wednesday, September 24, 2008

The Rape of AIG: Open Letter to Mr. Paulson

To Mr. Henry Paulson, Treasurer of the United States,

A few days ago, the nation's largest insurance company, AIG, came to New York Fed and said, "We need help. We are having a liquidity crisis. If we are not given a loan, we are going to default on our collateral calls to Goldman Sachs, Morgan Stanley and other investment banks and declare bankruptcy". The company and the Fed knew that this would be the fatal blow to Wall Street and, in fact, the world financial system. If AIG had chosen to file for Chapter 11 bankruptcy (reorganization not liquidation), their $400B+ in credit default swaps (CDSs), a guarantee of sorts, would have been declared not-secure. The counter-parties to these would then have to mark these instruments down as the guarantee would no longer have firm backing. Three quarters of this CDS portfolio was for "regulatory capital relief" for banks all over the world; half of it from European banks. These banks offloaded much of the risk on their own loans to AIG so they could grow their asset base faster than their capital base while waiting for the new Basel II capital accords which will allow for higher leverage ratios. These banks would instantly be undercapitalized and unable to loan.

But even more pressing would be the crisis that would hit Goldman Sachs. Goldman has survived, unlike Bear Stearns and Lehman Brothers, because they have effectively hedged their exposure to subprime lending by buying this insurance from AIG. Many people, including myself, Ben Bernanke and yourself have claimed that the "fire-sale" prices for mortgage backed securities is not indicative of the true value of these securities. However it is these "fire-sale" prices, combined with mark-to-market accounting that have damaged the balance sheet of companies like AIG and the investment banks. The difference, however, between AIG and Goldman is that Goldman has been able to hedge its exposure. That is, it's mortgage backed securities may have been marked DOWN to unrealistic levels but its CDSs with AIG have been marked UP to unrealistic levels. In other words AIGs pain has been Goldman's gain. If AIG had instead chose the protection of Chapter 11 bankruptcy, then Goldman would be instantly insolvent and the last two of the New York Bulge Bracket firms would have failed.

What did AIG get in return for agreeing to the Fed's offer of a loan and saving Wall Street and the world financial system? It got 80% of its equity stolen and handed to the Fed. AIG did not have a solvency problem. They had a liquidity problem. AIG's breakup or liquidation value has been estimates at $180B after paying off its liabilities. That would have corresponded to roughly $66/share. Maybe we would have only received half of that, $33/share, in a bankruptcy auction and restructuring. Instead our shares trade at $4/share now that the government owns 80% of the company and effectively controls it. Whose interest was it really to enter into this deal?

Lets compare this to the way Goldman Sachs, the company you led as CEO from 1998 to 2006, was treated when they ran into a liquidity crisis earlier in the year. Goldman along with the other investment banks normally raise their funds through commercial paper and relatively short terms bonds. That is because, despite the names, they are not banks. They do not pay FDIC insurance premiums, cannot raise deposits and do not normally have access to the Fed's discount window. They are regulated by the SEC not the Fed, FDIC or OTS that regulate real banks. In fact, they are no more real banks than the subprime mortgage lenders who went bankrupt from a liquidity run earlier in the year. These, you might recall, were thrown to the wolves by the investment banks when the IBs decided that the business model would no longer be profitable. "Well, that's capitalism!", I guess you can say. No one ever promised them a guaranteed line of credit. I guess it was their fault for not securing longer term lines of credit.

So when Goldman Sachs and the other IBs (with 30-40 times leverage) discovered that the commercial paper market was effectively shut off for them, what might one expect to happen to them? Bankruptcy? Perhaps the Fed, to protect the financial system from freezing up would give them a toxic loan, like AIGs, at 11% and take 80% of their equity? Is that what happened? No. Instead the Fed and treasury made unprecedented changes to the entire Federal Reserve System in order to accommodate these companies. They created the Primary Dealer Credit Facility (PDCF) so that the IBs could borrow funds at the discount rate 2.25% (lower than the commercial paper rate they were issuing before) against "good collateral". Eventually the "good" part was removed and any collateral was OK, even common stocks. Then they were given access to the discount window. Then, the Term Auction Facility was created where you just auctioned off money at rates not far above the discount rate to these "banks". because the "banks" said that going to the discount window created a stigma for these "banks".

So instead of punishing these companies for their greed, poor management and investing mistakes, you did everything in your power to bail them out. Despite the fact that they are not real banks you let them borrow directly from the Fed at lower rates than real banks (who pay into the FDIC) can get on their certificate of deposits. When Bear Stearns and Lehman brothers actually became "insolvent" (and who can tell anyway at 40 times leverage), they were allowed to fail but not Goldman and Morgan Stanley. They just had a liquidity crisis. They are solvent and so deserve your protection, right? And AIG? You claimed that because they are just an insurance company, they don't deserve the same protection. After all, they don't pay into the FDIC. They might look like a bank, but they are not really a bank. So you gave them a toxic loan and took 80% of their equity so that they would not declare bankruptcy and destroy the remaining members of the Wall Street money club. You derisively called AIG a "hedge fund on top of an insurance company". Well what is Goldman? It is a giant hedge fund on top of nothing and has four times the leverage of AIG. The difference in treatment between AIG and Goldman is no doubt due to your giant conflict of interest as a Goldman lifer and former CEO and now the secretary of the treasury.

Now you ask for a $700B bailout from the taxpayers so that Goldman can dump mortgage assets worth maybe five times their equity at "hold-to-maturity" (read: wishful thinking) prices. I think the tax payers are going to want a few terms with that. How about 80% equity in Goldman Sachs and Morgan Stanley. They have been already been bailed once by completely restructuring the Federal Reserve System. Then they were bailout out again by convincing AIG to avoid bankruptcy. Now you want another $700B handout? Not without 80% of Goldman. If you don't like those terms, well, that is what bankruptcy protection is for.

David Johnston
An AIG shareholder and a taxpayer