So What's the Deal with the Fed?

Most news sites, taking their cue from the Fed NY Press Release, are reporting that AIG will be receiving a loan of $85 billion which will be paid back in two years with an interest rate of LIBOR + 850 basis points.

The loan will be collateralized by AIG's assets including its subsidiaries.

In return, the Fed will receive an equity interest of 79.9% of AIG immediately. It will have the right to suspend dividend payments to common and preferred shareholders. It will replace top management.

AND it owns and will maintain ownership of 79.9% of the company AFTER being paid back in full at a 10+% rate of interest over two years.

What, no penalty clause for prepayment?

Seriously, doesn't something seem a little wrong in that description? Who negotiated for the Fed? Tony Soprano?

Is it a purchase or a collateralized loan? The way people are describing it is a purchase for 79.9% of the company, and AIG repays the full purchase price to the Fed in two years for with 10+% annual interest, AND the Fed keeps the ownership.

We suspect the press release was written hurriedly and the newswires and bloggers are running with it without questioning what it really means, and details will be forthcoming.

We admit we do not understand the deal as it is being explained. It does not make sense. We suspect that the ownership is really warrants with either a strike price or exercisable upon some prearranged condition of non-payment.

The change in management can be a negotiated item in the note, and does not require actual majority share ownership control.

Its not a trivial question because it speaks to existing shareholder dilution and the stock price. We are sure Hank Greenberg knows the answer, but we can't seem to find his phone number.

But like everyone else we are tired and in news overload, so let's call it a night and let the market decide what's what.

Fed to Make an $85 Billion Bridge Loan to AIG

AIG will receive its bridge loan, will have a limited time in which to sell assets to pay it back, the top management is replaced. Fed Considering Loan Package for AIG

We still don't quite understand the Fed's 79.9% stake in AIG. If AIG pays back the loan, with interest, does the Fed (Treasury?) still own 79.9% of the company? Is this a purchase or does that stake represent a kind of warrant should the terms of the loan not be met? Is this a purchase with an 'option to return' like a repo, or is the stake a form of collateral?

The obvious question is the amount of dilution to the shareholders. The details will like be released and clarified over time.

This may be a solution to the AIG crisis, but with regard to the US credit crisis it is more likely the end of the beginning.

For release at 9:00 p.m. EDT

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

Here is the relevant section of the Federal Reserve Act referenced in the press release.

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions.

And the most important question of all: Is the NY Fed really going to replace AIG in the Dow Jones Industrial Average tomorrow?

Are they going to have options?

AP
Stocks stabilize, but critical insurer teeters
September 16, 8:56 pm ET
By Ellen Simon

NEW YORK (AP) -- The Federal Reserve resisted a cut in interest rates Tuesday and then forged a plan to take over American International Group Inc. and rescue the insurance giant from the brink of bankruptcy with an extraordinary $85 billion loan.

The moves, along with a slight rebound on Wall Street, offered some respite after the chaos that shook the financial system Monday when investment house Lehman Brothers declared bankruptcy and the Dow Jones industrials suffered its biggest point drop since the 2001 terrorist attacks.

Investors worried that a failure by AIG, the world's largest insurer, would set off even more financial turmoil.

AIG is little known off Wall Street but does business with almost every financial institution in the world. It insures $88 billion worth of assets and plays an outsized role insuring mortgages and corporate loans, but even more threatening was its integral role in the murky world of hedge funds and credit derivatives.

People with knowledge of the situation, who asked not to be identified because of the sensitive nature of the negotiations, said bankers and federal officials had decided a government bailout of AIG was the best solution to save it from collapse. An announcement of the takeover was expected late Tuesday.

The plan called for the government to seize up to 80 percent of the company and remove its management, similar to the way it took control of mortgage giants Fannie Mae and Freddie Mac.
All three major credit rating agencies had cut AIG's ratings at least two notches late Monday night, and while the new ratings were still considered investment grade, they added pressure on AIG as it sought tens of billions of dollars to strengthen its balance sheet.

New York Gov. David Paterson said Monday he would support allowing AIG to use $20 billion of assets held by its subsidiaries to pay for its business -- essentially giving it a bridge loan from itself.

A collapse of AIG would force Wall Street to untangle the complex credit derivatives markets and send the market scrambling to figure out who owes what to whom -- or even who owns what.

"Regulators knew that if Lehman went down, the world wouldn't end," money manager Michael Lewitt wrote in an op-ed column Tuesday in The New York Times. "But Wall Street isn't remotely prepared for the inestimable damage the financial system would suffer if AIG collapsed."

The Fed stepped in hours after it decided, in its first unanimous vote this year, to keep the closely watched federal funds rate unchanged at 2 percent. At the same time, however, the Fed noted that strains on the market have "increased significantly" and said it was ready to act if needed.

Stocks slumped immediately after the Fed announcement. The Dow initially dropped about 100 points but rallied to finish the day up 141, and back over 11,000.

As AIG teetered, central bankers around the globe scrambled to revive credit markets. The Fed injected $70 billion into the American financial system. The European Central Bank pumped one-day financing of nearly $100 billion into the 15-nation zone. The Bank of Japan added $24 billion, and England's central bank almost $36 billion.

Cash left world markets Monday like an outgoing tide. The interest rate banks charge each other for overnight loans soared as high as 6 percent -- far above the Fed's target rate of 2 percent and a sign banks didn't trust each other enough to make even 12-hour loans...

New York Times
Fed Readies A.I.G. Loan of $85 Billion for an 80% Stake
By MICHAEL J. de la MERCED and ERIC DASH
Published: September 16, 2008

In an extraordinary turn, the Federal Reserve was close to a deal Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people briefed on the negotiations.

All of A.I.G.’s assets would be pledged to secure the loan, these people said, and in return, the Fed would receive warrants that would give it an ownership stake. Stock of existing shareholders would be diluted, but not wiped out.

If the Fed takes a controlling stake, it is likely that it would want to replace A.I.G.’s board as well as its chief executive and chairman, Robert B. Willumstad.

The Fed’s action came after Treasury Secretary Henry M. Paulson and Ben S. Bernanke, president of the Federal Reserve, went to Capitol Hill on Tuesday night to meet with House and Senate leaders. Mr. Paulson called the Senate majority leader, Harry Reid, Democrat of Nevada, about 5 p.m. and asked for a meeting in the Senate leader’s office, which began about 6:30 p.m.

The Federal Reserve and Goldman Sachs and JPMorgan Chase had been trying to arrange a $75 billion loan for A.I.G. to stave off the financial crisis caused by complex debt securities and credit default swaps. The Federal Reserve stepped in after it became clear Tuesday afternoon that the banking consortium would not be able to complete the deal.

Without the help, A.I.G. was expected to be forced to file for bankruptcy protection.

The need for the loans became necessary after the major credit ratings agencies downgraded A.I.G. late Monday, a move that likely to have forced the company to turn over billions of dollars in collateral to its derivatives trading partners worsening its financial health.

Until this week, it would have been unthinkable for the Federal Reserve to bail out an insurance company, and A.I.G.’s request for help from the Fed of just a few days ago was rebuffed.

But with the prospect of a giant bankruptcy looming — one with unpredictable consequences for the world financial system — the Fed abandoned precedent and agreed to let the money flow.

AIG Said to Accept Federal Takeover, Replace Managers
By Hugh Son

Sept. 16 (Bloomberg) -- American International Group Inc., the biggest U.S. insurer by assets, has accepted a deal to turn over control in exchange for an $85 billion loan from the Federal Reserve, a person familiar with the situation said.

AIG will replace management as part of the deal, said the person, who declined to be named because no public announcement has been made. AIG spokesman Peter Tulupman had no immediate comment.

The agreement would keep New York-based AIG in business, averting a collapse that could have threatened more financial companies and caused $180 billion in losses, according to RBC Capital Markets. AIG needed the loan to stave off a collapse after its credit ratings were cut and shares plunged 79 percent since Sept. 11.

The federal lifeline will allow AIG to sell assets in an orderly fashion, the person said. Proceeds from the divestments may be used to help pay back the two-year loan, the person said.

``The alternatives are much worse,'' said U.S. Senator Charles Schumer, Democrat of New York, in a statement after lawmakers met with U.S. regulators.

Money Market Fund "Breaks the Buck" on Lehman Losses

Money Market Fund Says Customers Could Lose Money
By DIANA B. HENRIQUES
September 16, 2008

In a new sign of market turbulence, managers of a multibillion-dollar money market fund said on Tuesday that customers might lose money in the fund, a type of investment that has long been considered as safe and risk-free as a bank savings account.

The announcement was made by the Primary Fund, which had almost $65 billion in assets at the end of May. It is part of the Reserve Fund, a group whose founder helped invent the money market fund more than 30 years ago. .

The fund said that because the value of some investments had fallen, customers now have only 97 cents for each dollar they had invested.

This is only the second time in history that a money market fund has “broken the buck” — that is, reported a share’s value below a dollar.

This year alone, big banks and fund management companies have pledged more than $10 billion to rescue affiliated money funds that were caught holding mortgage market securities that were deteriorating rapidly in value. As a result, consumers have felt confident in the safety of money funds, and have been moving assets into such funds as markets have grown more turbulent.

The Investment Company Institute, the mutual fund industry’s trade group, issued a statement Tuesday assuring investors that “the fundamental structure of money-market funds remains sound.” It noted, too, that in the only previous case of a fund breaking the buck, investors nevertheless were paid 96 cents on the dollar.

But the Reserve Fund’s announcement may shake investors’ confidence. Moreover, institutional markets that are already under severe stress could be further shaken if this giant fund, and others like it, are forced to sell some less-liquid holdings to meet redemption demands from nervous customers in coming weeks.

The Primary Fund allowed its share price to fall below a dollar “after reviewing the unprecedented market events of the past several days and their impact” on the fund, the company said in a statement.

Specifically, the fund’s management, which boasted as recently as July about its cautious approach to the current crisis, determined that its stake in debt securities issued by Lehman Brothers Holdings, with a face value of $785 million, was essentially worthless, given the investment bank’s filing for bankruptcy protection. As a result, the fund said, its per-share value fell to 97 cents a share.

The fund’s financial records also show that more than half of its portfolio on May 31 consisted of asset-backed commercial paper and notes from a host of issuers besides Lehman, few of them names likely to be familiar to the financial markets.

If these arcane investments had to be sold or cashed out quickly to meet redemptions, it is unclear what prices they would fetch or whether the issuers would be able to return the fund’s money promptly, said Keith Long, of Otter Creek Management, a hedge fund based in Palm Beach, Fla.

The Primary Fund reported that, until further notice, it would delay paying redemptions to customers for up to seven days, as permitted under mutual fund law. That delay will not apply to debit-card transactions, automated clearinghouse transactions or checks written against the assets of the Primary Fund, provided that the transactions do not exceed $10,000 from single or affiliated investors.

The fund is part of the complex run by Bruce R. Bent, who invented the money market fund concept with Henry B. R. Brown in 1970.

Since their inception, money market funds increasingly have been seen by individual investors as a safe harbor in turbulent times. According to industry statistics, the assets of money funds have grown sharply since the credit crisis began to intensify last summer.

But, as prospectuses and regulators make clear, money funds are not legally required to keep their share prices at or above a dollar, or to redeem investors’ shares immediately. Like all regulated mutual funds, their share prices are determined solely by dividing total portfolio assets by the number of shares outstanding, and they have seven days to meet redemption demands.

Those facts would probably surprise most money fund investors, who have come to think of money funds as being “just like cash, just like a checking account,” a fund industry lawyer, Jay Baris, said.

Whenever money funds have run into trouble, they were propped up by parent banks and investment managers that provided the necessary cash. The single exception was in 1994, when one small regional money fund reported a share price below a dollar, according to the Investment Company Institute.

The continuation of this informal bail-out policy “is much-discussed in the fund industry, because funds are so much bigger today,” said Barry P. Barbash, a fund industry lawyer with Wilkie Farr & Gallagher and a former senior mutual fund regulator at the Securities and Exchange Commission.

In the past, regulators tended to focus on banning money funds from buying inappropriate investments in the first place, he said. “But now,” he added, “we’re talking about instruments that were completely appropriate for a money fund when they were purchased. That’s what makes this so much harder.”

Not only are funds bigger, markets are more turbulent. A host of mutual funds have found their portfolios battered by investments in commercial and investments banks that were long considered close to bedrock on Wall Street. Money funds, too, suddenly found that some of their blue chips were tarnishing.

But with individual mutual fund investors showing little sign of panic, most funds have simply ridden out the current turbulence.

However, several industry analysts said on Tuesday that the Reserve Fund’s action came after its Primary Fund had been hit by heavy redemption demands that intensified the impact of the Lehman losses.

“We’re really in uncharted territory here,” said Peter Crane, the president of Crane Data, a fund industry newsletter.

Conservatorship Is an Option Being Considered for AIG

Reuters
Futures fall on report conservatorship eyed for AIG
Tuesday September 16, 5:06 pm ET

NEW YORK (Reuters) - U.S. stock index futures fell after the market closed on Tuesday on a Bloomberg report that the United States was considering conservatorship as an option for troubled insurer American International Group.
The report, citing two people briefed on the talks, caused a 48 percent drop in AIG shares after the bell...

Treasury Said to Be Considering AIG Conservatorship
By Craig Torres and Elizabeth Hester

Sept. 16 (Bloomberg) -- The U.S. Treasury is considering taking over American International Group Inc. under a conservatorship as one option to address the insurer's crisis, according to two people briefed on the discussions.

Executives from AIG, bankers and Treasury and Federal Reserve officials are meeting today on the company's situation at the New York Fed. A number of options are under being discussed to fill a shortfall of $75 billion to $100 billion in funding one of the people said. The talks are continuing, he said.

Goldman Sachs Group Inc. and JPMorgan Chase & Co., which have been leading efforts to find a private-sector solution, informed the Fed that such an effort would be difficult, the person said. Under another option, the Fed would extend a loan to New York-based AIG, according to a person informed of the matter.

Treasury Secretary Henry Paulson earlier this month seized Fannie Mae and Freddie Mac and put them into conservatorships, where officials will oversee the firms and aim to protect their assets...