Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [91]
In September 2008, AIG’s problems grew worse. One of the reasons AIG may have initially resisted showing losses on its credit derivatives positions is that price declines triggered a need for more cash to meet collateral calls from AIG’s trading counterparties. Warren was right. Credit derivatives are weapons of mass liquidity destruction. By the end of July 31, 2008, the company that refuted my August 2007 assertion that it had risk from credit derivatives, had already put up $16.5 billion in collateral. To paraphrase Warren, AIG sucked its thumb in 2007. AIG was in the midst strategic review and had set its deadline at September 25, 2008.16 The Fed took over AIG on September 15.
Moody’s rated AIG Aa2 at the beginning of May 2008, and downgraded it to Aa3, the lowest double-A rating, on May 22, 2008. In early September 2008, AIG’s rating neared single-A territory. AIG had lived in denial for more than a year. It had failed to sell assets to raise the cash it needed to face additional margin calls (triggered by the downgrade) of $14.5 billion. AIG has valuable assets, but the assets are illiquid and AIG was short of cash. On September 15, 2008, AIG was downgraded to single-A. AIG asked the Fed for a loan. When the Fed resisted, it sought a $75 billion loan from Goldman Sachs and JPMorgan Chase.17 No dice.
Goldman Sachs said its exposure to AIG is not material.18 Of course, it wouldn’t be if Goldman’s trades have collateral triggers (or if it bought credit default swap protection on AIG). A better question is, what is the combined trading, insurance and reinsurance exposure of Bazooka Hank’s old firm if AIG did not have to pony up so much of its cash and if Goldman had no default protection on AIG? Is it material? JPMorgan is one of the largest credit derivatives traders in the world, and with its acquisition of Bear Stearns, it was probably the largest. AIG sold credit default protection on $441 billion of assets to a number of European and U.S. counterparties. If AIG could not make good on its promises, it would affect the entire financial community.19 The technical term for this is systemic risk. In this case it is the result of global financial institutions doing foolish things at the same time.
The Fed changed its mind and decided to give AIG the loan after all. Although the Fed never regulated AIG, it agreed to provide AIG with a $85 billion credit line for two years (similar to a credit card with an $85 billion limit - wouldn’t you just love one of those?) in exchange for interest payments and stock warrants (the right to buy, under certain conditions, up to 79.9 percent of AIG). The Fed will end up controlling a private insurer with the help of U.S. taxpayer dollars.20 What gave the Fed the right to do that? It invoked an obscure rule under section 13(3) of the Federal Reserve Act with the full support of Bazooka Hank’s Treasury Department, just as it did when it helped JPMorgan Chase purchase Bear Stearns.21 The new Wall Street speak for institutions like AIG that have illiquidity problems requiring intervention is that the “situation is fluid.” It remains to be seen how successful the Fed will be in stabilizing and making a profit (or loss) from AIG.
Bill Gross’s Pimco Total Return Fund had sold $760 million of default guarantees (as credit default swaps) on AIG, and it would have cost him if AIG went under.22 Mr. Gross might have thought he had a good idea of how the Fed would behave. Pimco had hired Alan Greenspan as a consultant.23 I was not surprised when Bill Gross said the Fed intervention was a “necessary step.”24
AIG seemed