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United States Government Accountability Office:
GAO:
Report to Congressional Requesters:
September 2011:
Financial Crisis:
Review of Federal Reserve System Financial Assistance to American
International Group, Inc.
GAO-11-616:
GAO Highlights:
Highlights of GAO-11-616, a report to congressional requesters.
Why GAO Did This Study:
In September 2008, the Board of Governors of the Federal Reserve
System (Federal Reserve Board) approved emergency lending to American
International Group, Inc. (AIG)—the first in a series of actions that,
together with the Department of the Treasury, authorized $182.3
billion in federal aid to assist the company. Federal Reserve System
officials said that their goal was to avert a disorderly failure of
AIG, which they believed would have posed systemic risk to the
financial system. But these actions were controversial, raising
questions about government intervention in the private marketplace.
This report discusses (1) key decisions to provide aid to AIG; (2)
decisions involving the Maiden Lane III (ML III) special purpose
vehicle (SPV), which was a central part of providing assistance to the
company; (3) the extent to which actions were consistent with relevant
law or policy; and (4) lessons learned from the AIG assistance.
To address these issues, GAO focused on the initial assistance to AIG
and subsequent creation of ML III. GAO examined a large volume of AIG-
related documents, primarily from the Federal Reserve System—the
Federal Reserve Board and the Federal Reserve Bank of New York (FRBNY)—
and conducted a wide range of interviews, including with Federal
Reserve System staff, FRBNY advisors, former and current AIG
executives, AIG business counterparties, credit rating agencies,
potential private financiers, academics, finance experts, state
insurance officials, and Securities and Exchange Commission (SEC)
officials. Although GAO makes no new recommendations in this report,
it reiterates previous recommendations aimed at improving the Federal
Reserve System’s documentation standards and conflict-of-interest
policies.
What GAO Found:
While warning signs of the company’s difficulties had begun to appear
a year before the Federal Reserve System provided assistance, Federal
Reserve System officials said they became acutely aware of AIG’s
deteriorating condition in September 2008. The Federal Reserve System
received information through its financial markets monitoring and
ultimately intervened as the possibility of bankruptcy became
imminent. Efforts by AIG and the Federal Reserve System to secure
private financing failed after the extent of AIG’s liquidity needs
became clearer. Both the Federal Reserve System and AIG considered
bankruptcy issues, although no bankruptcy filing was made. Due to AIG’
s deteriorating condition in September 2008, the Federal Reserve
System said it had little opportunity to consider alternatives before
its initial assistance. As AIG’s troubles persisted, the company and
the Federal Reserve System considered a range of options, including
guarantees, accelerated asset sales, and nationalization. According to
Federal Reserve System officials, AIG’s credit ratings were a critical
consideration in the assistance, as downgrades would have further
strained AIG’s liquidity position.
After the initial federal assistance, ML III became a key part of the
Federal Reserve System’s continuing efforts to stabilize AIG. With ML
III, FRBNY loaned funds to an SPV established to buy collateralized
debt obligations (CDO) from AIG counterparties that had purchased
credit default swaps from AIG to protect the value of those assets. In
exchange, the counterparties agreed to terminate the credit default
swaps, which were a significant source of AIG’s liquidity problems. As
the value of the CDO assets, or the condition of AIG itself, declined,
AIG was required to provide additional collateral to its
counterparties. In designing ML III, FRBNY said that it chose the only
option available given constraints at the time, deciding against plans
that could have reduced the size of its lending or increased the
loan’s security. Although the Federal Reserve Board approved ML III
with an expectation that concessions would be negotiated with AIG’s
counterparties, FRBNY made varying attempts to obtain these discounts.
FRBNY officials said that they had little bargaining power in seeking
concessions and would have faced difficulty in getting all
counterparties to agree to a discount. While FRBNY took actions to
treat the counterparties alike, the perceived value of ML III
participation likely varied by the size of a counterparty’s exposure
to AIG or its method of managing risk.
While the Federal Reserve Board exercised broad emergency lending
authority to assist AIG, it was not required to, nor did it, fully
document its interpretation of its authority or the basis of its
decisions. For federal securities filings AIG was required to make,
FRBNY influenced the company’s filings about federal aid but did not
direct AIG on what information to disclose. In providing aid to AIG,
FRBNY implemented conflict-of-interest procedures, and granted a
number of waivers, many of which were conditioned on the separation of
employees and information. A series of complex relationships grew out
of the government’s intervention, involving FRBNY advisors, AIG
counterparties, and others, which could expose FRBNY to greater risk
that it would not fully identify and appropriately manage conflict
issues and relationships.
As with past crises, AIG assistance offers insights that could help
guide future government action and improve ongoing oversight of
systemically important financial institutions. While the Dodd-Frank
Wall Street Reform and Consumer Protection Act seeks to broadly apply
lessons learned from the crisis in a number of areas, AIG offers other
lessons, including identifying ways to ease time pressure by seeking
private sector solutions sooner or compiling needed information in
advance, analyzing disputes concerning collateral posting as a means
to help identify firms coming under stress, and conducting stress
tests that focus on interconnections among firms to anticipate
financial system impacts.
The Federal Reserve Board generally agreed with GAO’s findings and
provided information on steps taken to address lessons learned that
GAO identified.
View [hyperlink, http://www.gao.gov/products/GAO-11-616] or key
components. For more information, contact Orice Williams Brown at
(202) 512-8678 or williamso@gao.gov. [End of section]
Contents:
Letter:
Background:
The Possibility of AIG's Failure Drove Federal Reserve Aid after
Private Financing Failed:
FRBNY's Maiden Lane III Design Likely Required Greater Borrowing, and
Accounts of Attempts to Gain Concessions From AIG Counterparties are
Inconsistent:
The Federal Reserve's Actions Were Generally Consistent With Existing
Laws and Policies, but They Raised a Number of Questions:
Initial Federal Reserve Lending Terms Were Designed to Be More Onerous
than Private Sector Financing:
The AIG Crisis Offers Lessons That Could Improve Ongoing Regulation
and Responses to Future Crises:
Agency and Third Party Comments and Our Evaluation:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Comments from the Board of Governors of the Federal
Reserve System:
Appendix III: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Participants in First Phase of AIG Private-Financing Attempt,
by Type:
Table 2: Estimates of AIG's First-Phase Liquidity Needs, September
2008:
Table 3: Sources of ML III Value Provided:
Table 4: Division of Earnings Considered for Maiden Lane III, as of
October 26, 2008:
Table 5: Maiden Lane III Counterparty Concession Scenarios:
Table 6: Rates on Selected Federal Reserve AIG-Related Lending:
Table 7: ML III CDO Trustees that Were Also AIG Counterparties:
Table 8: Comparison of the Terms of the Private Lending Plan and
Federal Reserve Revolving Credit Facility:
Figures:
Figure 1: Timeline of Events and Contacts Prior to Initial Federal
Reserve Assistance in September 2008:
Figure 2: Actual and Projected Cumulative Draws on Revolving Credit
Facility, as of October 2, 2008:
Figure 3: Maiden Lane III Structure and Alternatives:
Figure 4: Differences in AIGFP Counterparty Collateralization, as of
October 24, 2008:
Figure 5: Differences in Expected Losses by Counterparty for Extreme
Stress, as of November 5, 2008:
Figure 6: Differences in CDO Credit Ratings by Counterparty, as of
October 29, 2008:
Figure 7: Roles and Relationships among the Federal Reserve, Its
Advisors, and Other Parties:
Abbreviations:
AIG: American International Group, Inc.
AIGFP: AIG Financial Products Corporation:
Bear Stearns: Bear Stearns Companies, Inc.
CDO: collateralized debt obligations:
CDS: credit default swaps:
CTR: confidential treatment request:
CUSIP: Committee on Uniform Securities Identification Procedures:
Federal Reserve Board: Board of Governors of the Federal Reserve
System:
FHLB: Federal Home Loan Banking System:
FRBNY: Federal Reserve Bank of New York:
Lehman: Lehman Brothers Holdings, Inc.
LIBOR: London Interbank Offered Rate:
ML II: Maiden Lane II:
ML III: Maiden Lane III:
NYSID: New York State Insurance Department:
OTS: Office of Thrift Supervision:
RMBS: residential mortgage-backed securities:
SEC: Securities and Exchange Commission:
SIGTARP: Special Inspector General for the Troubled Asset Relief
Program:
TARP: Troubled Asset Relief Program:
Treasury: Department of the Treasury:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
September 30, 2011:
Congressional Requesters:
The financial crisis that reached a peak in 2008 was far-reaching,
threatening the stability of the U.S. banking system as well as the
U.S. and global economies. As the federal government responded to the
crisis, one of its most significant actions was providing
extraordinary assistance to American International Group, Inc. (AIG),
the multinational insurer that was also a significant participant in
the financial derivatives market. AIG was one of the largest
recipients of government aid. The Board of Governors of the Federal
Reserve System,[Footnote 1] through its emergency powers under section
13(3) of the Federal Reserve Act, and the Department of the Treasury
(Treasury), through the Emergency Economic Stabilization Act of 2008,
which authorized the Troubled Asset Relief Program, collaborated to
make available up to $182.3 billion in assistance to AIG.[Footnote 2]
The assistance, which was made available in several stages beginning
in September 2008, addressed large losses that threatened to bankrupt
the company.[Footnote 3] These losses stemmed from two AIG businesses
that involved the lending of securities and the provision of insurance-
like guarantees on the value of bond instruments known as
collateralized debt obligations (CDO). Largely due to the federal
government's assistance, AIG's financial health has improved over time.
The government's unprecedented actions to save AIG from failure were
controversial, raising questions in Congress and among the public
about the federal government's intervention into the private
marketplace. Federal Reserve System officials initially rejected
offering assistance to the company. However, when the financial
markets experienced extreme disruptions during the first 2 weeks of
September 2008, and as AIG faced the prospect of even greater
financial difficulty, the Federal Reserve System decided that
providing assistance could avert a disorderly failure of the company,
which officials believed would pose systemic risk to the financial
system. Nonetheless, questions later arose about, for example, whether
AIG should have instead filed for bankruptcy, whether the government
assumed too much risk in rescuing the company, how the government
arrived at its decisions in providing assistance, and how the
government structured particular features of its assistance to the
company.
Reflecting your interest in the nature and execution of government
assistance to AIG, this report provides a detailed review of
assistance extended by the Federal Reserve System, which was the first
and largest provider of assistance to the company. In particular, this
report examines (1) the sequence of events and key participants as
critical decisions were made to provide the various elements of
federal assistance to AIG; (2) decisions involving the Maiden Lane III
(ML III) vehicle, which was a key part of AIG assistance that followed
the government's initial aid to the company; (3) the extent to which
key actions taken were consistent with relevant law or policy; (4)
criteria that were used to determine the treatment of, or the terms of
key assistance extended to, AIG, its various creditors and
counterparties, and other significant parties; and (5) lessons learned
from the AIG assistance.[Footnote 4]
To address our reporting objectives, we obtained and reviewed a wide
range of AIG-related documents, primarily from the Federal Reserve
System, including records provided by the Federal Reserve System to
Congress. We also reviewed documents from the Securities and Exchange
Commission (SEC). The documents we reviewed included e-mails,
proposals and analyses of options for aid to AIG, research,
memorandums, and other items. We conducted a wide range of interviews,
including with Federal Reserve System staff, advisors to the Federal
Reserve Bank of New York (FRBNY), current and former AIG executives,
advisors to AIG, AIG counterparties, credit rating agencies, potential
private-sector financiers, state insurance regulators, federal banking
regulators, SEC staff, academic and finance experts, and others. We
also reviewed our past work and the work of others who have examined
the government's response to the financial crisis, including the
Congressional Oversight Panel, the Special Inspector General for the
Troubled Asset Relief Program, and the Financial Crisis Inquiry
Commission. As agreed with your staff, our scope is generally limited
to the Federal Reserve System's initial decision to provide assistance
to AIG in September 2008 and the subsequent creation of ML III,
because these two instances of aid involved the largest amount of
funds and were of considerable interest. Our scope and methodology are
detailed in appendix I.
We undertook this performance audit from March 2010 to September 2011
in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.
Background:
AIG is an international insurance organization serving customers in
more than 130 countries. As of June 30, 2011, AIG reported assets of
$616.8 billion and revenues of $34.1 billion for the preceding 6
months. AIG companies serve commercial, institutional, and individual
customers through worldwide property/casualty networks. In addition,
AIG companies provide life insurance and retirement services in the
United States.
Regulation of the Company:
Federal, state, and international authorities regulate AIG and its
subsidiaries. Until March 2010, the Office of Thrift Supervision (OTS)
was the consolidated supervisor of AIG, which was a thrift holding
company by virtue of its ownership of the AIG Federal Savings Bank. As
the consolidated supervisor, OTS was charged with identifying systemic
issues or weaknesses and helping ensure compliance with regulations
that govern permissible activities and transactions.[Footnote 5] The
Federal Reserve System was not a direct supervisor of AIG. Its
involvement with the company was through its responsibilities to
maintain financial system stability and contain systemic risk that may
arise in financial markets.
AIG's domestic life and property/casualty insurance companies are
regulated by the state insurance regulators in the state in which
these companies are domiciled. The primary state insurance regulators
include New York, Pennsylvania, and Texas. These state agencies
regulate the financial solvency and market conduct of these companies,
and they have the authority to approve or disapprove certain
transactions between an insurance company and its parent or its
parent's subsidiaries. These agencies also coordinate the monitoring
of companies' insurance lines among multiple state insurance
regulators. For AIG in particular, these regulators have reviewed
reports on liquidity, investment income, and surrender and renewal
statistics; evaluated potential sales of AIG's domestic insurance
companies; and investigated allegations of pricing disparities.
Finally, AIG's general insurance business and life insurance business
that are conducted in foreign countries are regulated by the
supervisors in those jurisdictions.
AIG's Financial Difficulties:
AIG's financial difficulties stemmed primarily from two sources:
* Securities lending. Until 2008, AIG had maintained a large
securities lending program operated by its insurance subsidiaries. The
securities lending program allowed insurance companies, primarily
AIG's life insurance companies, to lend securities in return for cash
collateral, which was then invested in investments such as residential
mortgage-backed securities (RMBS).
* Credit default swaps. AIG had been active, through its AIG Financial
Products Corporation (AIGFP) unit, in writing insurance-like
protection called credit default swaps (CDS) that guaranteed the value
of CDOs.[Footnote 6]
In September 2008, the Board of Governors of the Federal Reserve
System (Federal Reserve Board), FRBNY, and Treasury determined that
market events could cause AIG to fail.[Footnote 7] According to
officials from these entities, AIG's failure would have posed systemic
risk to financial markets.[Footnote 8] Consequently, the Federal
Reserve System and Treasury took steps to help ensure that AIG
obtained sufficient funds to continue to meet its obligations and
could complete an orderly sale of operating assets and close its
investment positions in its securities lending program and AIGFP.
From July through early September in 2008, AIG faced increasing
liquidity pressure following a downgrade in its credit ratings in May
2008, which was due in part to losses from its RMBS investments. The
company was experiencing declines in the value and market liquidity of
the RMBS assets that served as collateral for its securities lending
operation, as well as declining values of CDOs against which AIGFP had
written CDS protection. These losses in value forced AIG to use an
estimated $9.3 billion of its cash reserves in July and August 2008 to
provide capital to its domestic life insurers following losses in
their RMBS portfolios and to post additional collateral required by
the trading counterparties of AIGFP.
AIG attempted to secure private financing in September 2008 but was
unsuccessful. On September 15, 2008, credit rating agencies downgraded
AIG's debt rating, which resulted in the need for an additional $20
billion to fund its added collateral demands and transaction
termination payments. Following the credit rating downgrade, an
increasing number of counterparties refused to transact with AIG for
fear that it would fail. Also around this time, the insurance
regulators decided they would no longer allow AIG's insurance
subsidiaries to lend funds to the parent company under a credit
facility that AIG maintained, and they demanded that any outstanding
loans be repaid and that the facility be terminated.
In September 2008, another large financial services firm--Lehman
Brothers Holdings, Inc. (Lehman)--was on the brink of bankruptcy. As
events surrounding AIG were developing over the weekend of September
13-14, 2008, Federal Reserve System officials were also addressing
Lehman's problems. On September 15--the day before the Federal Reserve
Board voted to authorize FRBNY to make an emergency loan to AIG--
Lehman filed for bankruptcy.[Footnote 9] Stock prices fell sharply,
with the Dow Jones Industrial Average and the Nasdaq market losing 504
points and 81 points, respectively.[Footnote 10]
Federal Assistance to AIG:
Because of concerns about the effect of an AIG failure, in 2008 and
2009, the Federal Reserve System and Treasury agreed to make $182.3
billion available to assist AIG. First, on September 16, 2008, the
Federal Reserve Board, with the support of Treasury, authorized FRBNY
to lend AIG up to $85 billion through a secured revolving credit
facility that AIG could use as a reserve to meet its obligations.
[Footnote 11] This debt was subsequently restructured in November 2008
and March 2009 to decrease the amount available under the facility,
reduce the interest charged, and extend the maturity date from 2 to 5
years, to September 2013. By January 2011, AIG had fully repaid the
facility and it was closed.
In October 2008, the Federal Reserve Board approved further assistance
to AIG, authorizing FRBNY to borrow securities from certain AIG
domestic insurance subsidiaries. Under the program, FRBNY was
authorized to borrow up to $37.8 billion in investment-grade, fixed-
income securities from AIG in return for cash collateral. These
securities were previously lent by AIG's insurance company
subsidiaries to third parties. This assistance was designed to allow
AIG to replenish liquidity used to settle securities lending
transactions, while providing enhanced credit protection to FRBNY in
the form of a security interest in the securities. This program was
authorized for up to nearly 2 years but was terminated in December
2008.
In late 2008, AIG's mounting debt--the result of borrowing from the
Revolving Credit Facility--led to concerns that the company's credit
ratings would be lowered, which would have caused its condition to
deteriorate further. In response, the Federal Reserve Board and
Treasury in November 2008 announced the restructuring of AIG's debt.
Under the restructured terms, Treasury purchased $40 billion in shares
of AIG preferred stock (Series D), and the cash from the sale was used
to pay down a portion of AIG's outstanding balance from the Revolving
Credit Facility. The limit on the facility also was reduced to $60
billion, and other changes were made to the terms of the facility.
This restructuring was critical to helping AIG maintain its credit
ratings.
To provide further relief, FRBNY also announced in November 2008 the
creation of two new facilities to address some of AIG's more pressing
liquidity issues. AIG's securities lending program continued to be one
of the greatest ongoing demands on its working capital, and FRBNY
announced plans to create an RMBS facility--Maiden Lane II (ML II) --
to purchase RMBS assets from AIG's U.S. securities lending portfolio.
The Federal Reserve Board authorized FRBNY to lend up to $22.5 billion
to ML II; AIG also acquired a subordinated $1 billion interest in the
facility, which would absorb the first $1 billion of any losses. In
December 2008, FRBNY extended a $19.5 billion loan to ML II to fund
its portion of the purchase price of the securities. The facility
purchased $39.3 billion face value of the RMBS directly from AIG
subsidiaries (domestic life insurance companies). As part of the ML II
transaction, the $37.8 billion Securities Borrowing Facility
established in October before was repaid and terminated. As of August
17, 2011, ML II owed $7.3 billion in principal and interest to FRBNY.
[Footnote 12]
In addition, FRBNY announced plans to create a second facility--ML
III--to purchase multisector CDOs on which AIGFP had written CDS
contracts.[Footnote 13] This facility was aimed at facilitating the
restructuring of AIG by addressing one of the greatest threats to
AIG's liquidity position. In connection with the purchase of the CDOs,
AIG's CDS counterparties agreed to terminate the CDS contracts,
thereby eliminating the need for AIG to post additional collateral as
the value of the CDOs fell.[Footnote 14] The Federal Reserve Board
authorized FRBNY to lend up to $30 billion to ML III. In November and
December 2008, FRBNY extended a $24.3 billion loan to ML III. AIG also
paid $5 billion for an equity interest in ML III, which would absorb
the first $5 billion of any losses. As of August 17, 2011, ML III owed
$11.2 billion in principal and interest to FRBNY.
When the two AIG Maiden Lane facilities were created, FRBNY officials
said that the FRBNY loans to ML II and ML III were both expected to be
repaid with the proceeds from the interest and principal payments, or
liquidation, of the assets in the facilities. The repayment is to
occur through cash flows from the underlying securities as they are
paid off. Accordingly, FRBNY did not set a date for selling the
assets; rather, it has indicated that it is prepared to hold the
assets to maturity if necessary. In March 2011, FRBNY announced it
declined an AIG offer to purchase all ML II assets, and said that
instead, it would sell the assets in segments over an unspecified
period, as market conditions warrant, through a competitive sales
process.
In March 2009, the Federal Reserve Board and Treasury announced plans
to further restructure AIG's assistance. Among other items, debt owed
by AIG on the Revolving Credit Facility would be reduced by up to
about $26 billion in exchange for FRBNY's receipt of preferred equity
interests in two special purpose vehicles (SPV) created to hold the
outstanding common stock of two AIG life insurance company
subsidiaries--American Life Insurance Company (ALICO) and AIA Group
Limited (AIA).[Footnote 15]
Also in March 2009, the Federal Reserve Board and Treasury announced
plans to assist AIG in the form of lending related to the company's
domestic life insurance operations. FRBNY was authorized to extend
credit totaling up to approximately $8.5 billion to SPVs to be
established by certain AIG domestic life insurance subsidiaries. As
announced, the SPVs were to repay the loans from the net cash flows
they were to receive from designated blocks of existing life insurance
policies held by the insurance companies. The proceeds of the FRBNY
loans were to pay down an equivalent amount of outstanding debt under
the Revolving Credit Facility. However, in February 2010, AIG
announced that it was no longer pursuing this life insurance
securitization transaction with FRBNY.
Treasury also has provided assistance to AIG. As noted, in November
2008, Treasury's Office of Financial Stability announced plans under
the Troubled Asset Relief Program (TARP) to purchase $40 billion in
AIG preferred shares. AIG entered into an agreement with Treasury
whereby Treasury agreed to purchase $40 billion of fixed-rate
cumulative preferred stock of AIG (Series D) and received a warrant to
purchase approximately 2 percent of the shares of AIG's common stock.
[Footnote 16] The proceeds of this sale were used to pay down AIG's
outstanding balance on the Revolving Credit Facility.
In April 2009, AIG and Treasury entered into an agreement in which
Treasury agreed to exchange its $40 billion of Series D cumulative
preferred stock for $41.6 billion of Series E fixed-rate noncumulative
preferred stock, allowing for a reduction in leverage and dividend
requirements. The $1.6 billion difference between the initial
aggregate liquidation preference of the Series E stock and the Series
D stock represents a compounding of accumulated but unpaid dividends
owed by AIG to Treasury on the Series D stock. Because the Series E
preferred stock more closely resembles common stock, principally
because its dividends were noncumulative, rating agencies viewed the
stock more positively when rating AIG's financial condition.
Also in April 2009, Treasury made available a $29.835 billion equity
capital facility to AIG whereby AIG issued to Treasury 300,000 shares
of fixed-rate noncumulative perpetual preferred stock (Series F) and a
warrant to purchase up to 3,000 shares of AIG common stock. The
facility was intended to strengthen AIG's capital levels and improve
its leverage.
On January 14, 2011, with the closing of a recapitalization plan for
AIG, the company repaid $47 billion to FRBNY, including the
outstanding balance on the original $85 billion Revolving Credit
Facility. With that, AIG no longer had any outstanding obligations to
FRBNY.[Footnote 17]
AIG's Federal Securities Filings:
As a publicly traded company, AIG makes regular filings with SEC. In
December 2008, AIG filed two Form 8-K statements related to ML III.
These filings included ML III contract information and did not
initially include a supporting record known as "Schedule A"--a listing
of CDOs sold to ML III, including names of the counterparties,
valuations, collateral posted, and other information.[Footnote 18]
Questions arose about FRBNY's role in AIG's filings and the degree to
which the Reserve Bank may have influenced the company's filing
decisions, as well as whether the company's filings satisfactorily
disclosed the nature of payments to the counterparties.
AIG's Crisis Came Amid Overall Market Turmoil:
AIG's financial difficulties came as financial markets were
experiencing turmoil. A sharp decline in the U.S. housing market that
began in 2006 precipitated a decline in the price of mortgage-related
assets--particularly mortgage assets based on subprime loans--in 2007.
Some institutions found themselves so exposed that they were
threatened with failure, and some failed because they were unable to
raise capital or obtain liquidity as the value of their portfolios
declined. Other institutions, ranging from government-sponsored
enterprises such as Fannie Mae and Freddie Mac to large securities
firms, were left holding "toxic" mortgages or mortgage-related assets
that became increasingly difficult to value, were illiquid, and
potentially had little worth. Moreover, investors not only stopped
buying private-label securities backed by mortgages but also became
reluctant to buy securities backed by other types of assets. Because
of uncertainty about the liquidity and solvency of financial entities,
the prices banks charged each other for funds rose dramatically, and
interbank lending conditions deteriorated sharply. The resulting
liquidity and credit crunch made the financing on which businesses and
individuals depend increasingly difficult to obtain. By late summer
2008, the effects of the financial crisis ranged from the continued
failure of financial institutions to increased losses of individual
savings and corporate investments to further tightening of credit that
would exacerbate an emerging global economic slowdown.
The Possibility of AIG's Failure Drove Federal Reserve Aid after
Private Financing Failed:
A year before the first federal assistance to AIG, warning signs of
the company's financial difficulties began to appear. Over the
following months, the Federal Reserve System received information
about AIG's deteriorating condition from a variety of sources and
contacts, and it stepped in to provide emergency assistance as
possible bankruptcy became imminent in mid-September 2008. Attempts to
secure private financing, which would have precluded or limited the
need for government intervention, failed as the extent of AIG's
liquidity needs became clearer. Both the Federal Reserve System and
AIG considered bankruptcy issues, with AIG deciding independently to
accept federal assistance in lieu of bankruptcy. Because of urgency in
financial markets by the time the Federal Reserve System intervened,
officials said there was little opportunity to consider alternatives
before extending the initial assistance in the form of the Revolving
Credit Facility. When AIG's financial troubles persisted after the
Revolving Credit Facility was established, the company and the Federal
Reserve System considered a range of options for further assistance.
Throughout the course of AIG assistance, the company's credit ratings
were a critical consideration, according to Federal Reserve System
officials, as downgrades would have triggered large new liquidity
demands on the company and could have jeopardized government
repayment. As a result, Federal Reserve System assistance reflected
rating agency concerns, although both FRBNY and the rating agencies
told us the rating agencies did not participate in the decision-making
process.
The Federal Reserve Monitored AIG's Deteriorating Condition in 2008
and Took Action as Possible Bankruptcy Was Imminent:
The difficulties that culminated in AIG's crisis in September 2008
began to draw financial regulators' attention in 2007, when issues
arose relating to the company's securities lending program and the CDS
business of its AIGFP subsidiary (see figure 1). In December 2006,
AIG's lead state insurance regulator for the company's domestic life
insurers ("lead life insurance regulator") began a routine examination
of AIG in coordination with several other state regulators.[Footnote
19] During the examination, the state regulators identified issues
related to the company's securities lending program. Prior to mid-
2007, state regulators had not identified losses in the securities
lending program, and the lead life insurance regulator had reviewed
the program without major concerns. As the examination continued into
the fall of 2007, the program began to show losses resulting from
declines in the value of its RMBS portfolio. The lead life insurance
regulator told us the program had become riskier as a result of how
AIG had invested cash collateral it received from its lending
counterparties--in RMBS rather than in safer investments. The RMBS
investments were declining in value and had become less liquid, AIG
told us.[Footnote 20]
Figure 1: Timeline of Events and Contacts Prior to Initial Federal
Reserve Assistance in September 2008:
[Refer to PDF for image: timeline]
2006:
December 8: AIG’s lead state life insurance regulator begins routine
examination of AIG.
2007:
October 5: AIG’s lead state life insurance regulator meets with AIG
management to discuss growing losses in AIG’s securities lending
business found during examination. No information shared with Federal
Reserve System or AIG’s then-consolidated supervisor, Office of Thrift
Supervision (OTS).
October 25: Federal Reserve Bank of New York (FRBNY) staffer sends
market update to FRBNY President and other FRBNY officials, citing
decline in AIG stock price on rumors of multi-billion dollar write-
down stemming from subprime mortgage-related assets.
November 5: FRBNY official receives market update citing potential $4
billion AIG write-down on subprime mortgage-related assets.
November 7: At OTS meeting on AIG, company’s lead state life insurance
regulator notifies OTS of losses in company’s securities lending
business.
2008:
January 2: FRBNY President receives report of private research firm
with analysis and estimates of AIG losses in residential mortgage-
backed securities, collateralized debt obligations (CDO), and credit
default swaps (CDS).
February 11: FRBNY memo on AIG’s condition notes large CDS/CDO losses;
memo was distributed to FRBNY officials. AIG reports in Securities and
Exchange Commission filing that company auditor found material
weakness in internal control of financial reporting and oversight
relating to valuation of AIG Financial Products CDS portfolio.
May 12: S&P and Fitch Ratings downgrade AIG.
May 21: FRBNY staffer advises FRBNY President that AIG’s market
perception is declining, as measured by AIG CDS pricing.
May 23: Moody’s Investors Service downgrades AIG.
May 29: FRBNY staffer reports to FRBNY President and others that
purpose of recent AIG capital-raising was to address CDS liquidity
demands; says meeting will be attempted with FRBNY, Board of Governors
of the Federal Reserve System (Federal Reserve Board), and OTS to
further understand liquidity impact of AIG’s CDS portfolio.
July 8: AIG Chief Executive Officer (CEO) and FRBNY President meet;
some discussion of AIG, but not capital or liquidity needs, or overall
health of company portfolio.
July 29: AIG CEO, FRBNY President meet again; AIG CEO asks if
government assistance would be available in a crisis; they also
discuss possible AIG access to Federal Reserve System discount window.
August 11: In “long sought” session, FRBNY staff meet with OTS’s AIG
staff to open dialogue about AIG and discuss issues facing company.
August 14: FRBNY memo discusses deteriorating conditions, saying it
appears AIG needs to move aggressively.
August 18: Goldman Sachs report published, warning against buying AIG
stock and citing potential credit rating downgrades and need to raise
capital.
August 19: FRBNY begins studying stability and systemic importance of
a number of large financial institutions, including AIG.
August 22: AIG CEO attempts to contact FRBNY President.
September 2: FRBNY memo states that AIG’s liquidity position is
precarious and that borrowing through Primary Dealer Credit Facility
could allow company to unwind its positions in orderly manner while
satisfying immediate liquidity demands.
September 6: FRBNY President asks FRBNY staff to research AIG’s
liquidity and capital situation and to establish contacts with company
executives and OTS.
September 9: AIG CEO meets with FRBNY President to inquire about
discount window access by means of becoming primary dealer. FRBNY
President says he will get back to him, but no follow-up, according to
AIG CEO.
September 12: AIG CEO talks with FRBNY President, saying that AIG
faces serious situation and efforts to find private financing are
underway, but no solution possible without the Federal Reserve
System.FRBNY officials meet with AIG to discuss liquidity needs; AIG
presents application to become primary dealer, to gain access to
Federal Reserve System lending.
September 13: Weekend meetings begin at AIG in attempt to identify
private financing. Federal Reserve System officials analyze AIG
situation, including evaluating company forecast of its liquidity
needs.
September 14: AIG CEO calls Federal Reserve Board Vice Chair to renew
request for loan, warning of looming downgrade and accelerating
demands for collateral, and saying $50 billion needed.
Source: GAO.
[End of figure]
Regulators recognized that left unaddressed, AIG's practices in the
securities lending program, including the losses they observed, could
create liquidity risks for AIG. In particular, these declines could
lead AIG's securities lending counterparties to terminate their
borrowing agreements, thereby requiring AIG to return the cash
collateral the counterparties had posted, which AIG had invested in
the RMBS. According to the lead life insurance regulator, about 20
percent of the funds AIG had collected as collateral remained in cash,
indicating a potentially large liquidity shortfall if the
counterparties terminated their transactions. The lead life insurance
regulator also noted that AIG was disclosing relatively little
information in its regulatory filings about the program and its
losses, which were off-balance sheet transactions.[Footnote 21]
Another state insurance regulator told us that as part of its review,
it noted that AIG life insurance companies engaging in securities
lending were not correctly providing information in annual statements
or taking an appropriate charge against capital for the securities
lending activities. This regulator said it began discussions with the
company about securities lending in 2006. AIG told us it was unaware
of the regulator's concerns.
The lead life insurance regulator met with AIG management in October
and November 2007 and presented the securities lending issues it had
noted at a "supervisory college" meeting held by AIG's then-
consolidated regulator, OTS.[Footnote 22] The lead life insurance
regulator told us it did not share with all participants that it had
identified off-balance-sheet losses but that it privately advised OTS
that it saw unrealized losses building in AIG's securities lending
portfolio, with the total reaching an estimated $1 billion by November
2007. It also told us this was the first time OTS learned about issues
in the company's securities lending program.[Footnote 23]
At the time, OTS had concerns about a different matter at AIG.
According to OTS, in late 2007, it began to have concerns about
AIGFP's practices for valuing the CDOs on which the company wrote CDS
protection, in particular whether the company's valuations
corresponded to market values. Part of the concern was that AIGFP's
CDS counterparties were seeking collateral from the company based on
their own valuations. Thus, in general, there were difficulties in
assessing the value of the CDOs behind the company's CDS contracts.
[Footnote 24] According to AIG's lead life insurance regulator, OTS
did not communicate its concerns about AIGFP to state insurance
regulators at the supervisory college meeting in November 2007.
[Footnote 25] As a result, the lead life insurance regulator told us
it did not understand the extent of potential risks AIGFP posed to the
AIG parent company that in turn could have created risks for the
regulated insurance subsidiaries.[Footnote 26]
AIG executives and advisors told us that the company made thorough
disclosures about securities lending program issues, including losses
and the manner in which collateral was being invested, by the third
quarter of 2007.[Footnote 27] They said that state regulators did not
identify issues of which the company was not aware and disclosing
publicly.
With Losses Growing, Regulators Step Up Oversight:
AIG notified regulators in early 2008 that the securities lending
program had experienced significant losses as of December 2007, at
which time the lead life insurance regulator told us it began efforts
to coordinate regular communication among the states.[Footnote 28]
Results of the examination of the securities lending program provided
greater disclosure of information to regulators, such as credit
ratings of underlying securities in the pool of securities in which
AIG had invested its counterparties' collateral. By February 2008,
regular meetings were being held among AIG and state insurance
regulators.
As the monitoring continued into 2008, state insurance regulators held
a number of in-person and phone meetings with AIG executives, as the
company took steps to increase its liquidity and improve cash-flow
management within the securities lending program.[Footnote 29] The
lead life insurance regulator told us that prior to the stepped-up
monitoring, the company's limited disclosure about the program did not
allow the regulators to understand the extent of the problem. Overall,
the lead life insurance regulator said, the consensus among the state
regulators was that securities lending issues, while of concern, did
not present imminent danger as long as AIG's counterparties did not
terminate their lending transactions.[Footnote 30] Meanwhile, AIG
management had already taken steps to bolster liquidity and cash flow
management--beginning in August 2007, AIG told us--and the regulators
hoped the company would recover investment losses as market conditions
improved. Moreover, the lead life insurance regulator had a guarantee
from the AIG parent company to cover up to $5 billion in losses
stemming from the program. The lead life insurance regulator said this
provided some comfort as a backstop, but it was not certain that the
company had the money to fulfill that agreement.
Our review indicated that neither OTS nor state insurance regulators
communicated with the Federal Reserve System about AIG's problems
before the summer of 2008. FRBNY officials told us they monitored
financial institutions not regulated by the Federal Reserve System,
including AIG, based on publicly available information, as part of
monitoring overall financial market stability. In particular, FRBNY e-
mails from late 2007 and January 2008 indicated that staff were
monitoring AIG's exposure and potential losses related to the subprime
mortgage market. For instance, market updates were circulated to FRBNY
officials in October and November 2007 highlighting multibillion
dollar write-downs in AIG's subprime mortgage portfolio. Additionally,
in January 2008, an FRBNY staffer sent a market report of a private
research firm to the then-FRBNY President that included analyses and
estimates of AIG's losses for its RMBS, CDO, and CDS activities. In
February 2008, FRBNY staff wrote a memorandum on AIGFP's CDS
portfolio, which FRBNY officials said was prepared as part of FRBNY's
regular monitoring of market events. The report, circulated to some
FRBNY staff, noted unrealized losses related to the CDS portfolio and
AIG's exposure to the subprime mortgage market. During the spring and
summer of 2008, internal FRBNY e-mails show that FRBNY officials
circulated information on a range of AIG issues, including reports
about the company's earnings losses, widening CDS spreads, potential
credit rating downgrades, and worsening liquidity and capital
positions.[Footnote 31] FRBNY officials told us that the level of
monitoring and internal reporting conducted for AIG was consistent
with that of other institutions not regulated directly by the Federal
Reserve System.
Under financial pressure, AIG raised $20 billion in new capital in May
2008 and also considered additional private financing options. AIG
raised the capital through three sources: common stock, hybrid
securities, and debt financing. The purpose, according to
communication between FRBNY staff and the then-FRBNY President, was to
address liquidity demands stemming from AIGFP's requirements to post
cash collateral to its CDS counterparties.[Footnote 32] In addition,
FRBNY intended to have discussions with OTS to further understand the
liquidity impact of AIGFP's CDS portfolio. This meeting occurred 3
months later in August 2008. Also during the summer of 2008, AIG
considered joining the Federal Home Loan Bank System (FHLB) via the
company's insurance subsidiaries. Such membership could have allowed
AIG's insurance operations to pledge some of their qualified assets
against an extension of credit.[Footnote 33] AIG executives told us
the company discarded the idea after learning that funds its
subsidiaries might have received would not have been accessible to the
parent company.
AIG and FRBNY Shared Concerns about a Liquidity Crisis at the Company:
By July 2008, AIG's then-chief executive officer had concerns that the
company's securities lending program could generate a liquidity
crisis, according to interviews we conducted. He shared these concerns
with AIG's Board of Directors, telling them the only source from which
the company could secure enough liquidity if such a crisis occurred
was the government. He thought it was unlikely the company could
approach the capital markets again after raising $20 billion only 2
months before. On July 29, the chief executive officer approached the
then-FRBNY President seeking government assistance. During the
meeting, the chief executive officer said he explained AIG's liquidity
situation and requested access to the Federal Reserve System discount
window.[Footnote 34] According to the chief executive officer, the
President did not think Federal Reserve System officials could or
would do that because if the discount window was made available to
AIG, it would likely precipitate the liquidity crisis the company
wanted to avoid. The chief executive officer noted that the Federal
Reserve System had allowed other nondepository institutions to borrow
from the discount window after the failure of Bear Stearns Companies,
Inc. (Bear Stearns), but said the argument failed to alter the FRBNY
President's position.
In the weeks following this meeting, FRBNY officials and staff
continued to gather information on AIG's condition and liquidity
issues and to circulate publicly available information. For instance,
an e-mail sent in the first week of August 2008 to FRBNY officials
highlighted the concerns of one rating agency about AIG's
deteriorating liquidity situation due to strains from its securities
lending program and CDS portfolio. The message concluded that AIG
needed to raise a large amount of additional capital. On August 11,
2008, FRBNY officials held their first meeting with OTS staff
regarding AIG. According to a subsequent FRBNY e-mail, the meeting was
an introductory discussion about AIG's situation and other issues that
could affect companies like AIG, such as problems facing monoline
insurance companies.[Footnote 35] Topics discussed relating to AIG
included the company's raising of capital in May 2008, its liquidity
and capital positions, liquidity management, rating agency concerns,
and problems associated with AIGFP and the securities lending program.
In addition, a report on August 14 from an FRBNY staff member who
attended the meeting warned staff about AIG's increasing capital and
liquidity pressures, asset and liability mismatches, and the potential
for credit rating downgrades, saying AIG needed to take action on
these issues.[Footnote 36] FRBNY officials told us that previously,
OTS staff had not communicated information about AIG that FRBNY staff
would have flagged as issues to raise with FRBNY management.
While FRBNY continued monitoring AIG's situation into September 2008,
FRBNY staff also raised concerns internally about the company's
ability to manage its liquidity problems. On August 18, 2008, FRBNY
staff circulated a new research report on AIG by a large investment
bank, which highlighted concern that AIG management may be unable to
accurately assess its exposures or losses given the complexity of the
company's businesses. In its own memorandum on September 2, FRBNY
noted that AIG's liquidity position was precarious and that the
company's asset and liability management was inadequate given its
substantial liquidity needs. Further, a memorandum circulated among
FRBNY officials on September 14, which discussed possible lending to
AIG, stated that one rating agency's rationale for potentially
downgrading the company stemmed from concerns about AIG's risk
management, not its capital situation. A private research report, also
circulated that day, further detailed the view of the rating agency
that even if AIG were to raise capital, it might not offset risk
management concerns. FRBNY officials told us AIG had fragmented and
decentralized liquidity management before the government intervention.
Liquidity management became the responsibility of the AIG holding
company in early 2008. As one official stated, AIG understood
corporate-level liquidity needs but not the needs of subsidiaries,
including AIGFP.
Leading up to the weekend of September 13-14, 2008, AIG made renewed
attempts to obtain discount window access while also initiating
efforts to identify a private-sector solution. On September 9, AIG's
then-chief executive officer met again with the then-FRBNY President
in another attempt to obtain relief, this time by means of becoming a
primary dealer.[Footnote 37] According to the AIG chief executive, the
President said he had not considered this option and would need to
respond later. The chief executive told us that he did not receive a
response and that he made another effort to contact the FRBNY
President on September 11 but was unsuccessful. Meanwhile, AIG also
made an inquiry about federal aid to Federal Reserve Board staff,
according to a former member of the Federal Reserve Board. According
to the former FRBNY President, at the time, a variety of firms,
including AIG, were inquiring about discount window access, and he did
not recall in his meetings with the AIG chief executive that the AIG
chief executive conveyed any evidence or concern about an acute,
impending liquidity crisis at the company.
On Friday, September 12, 2008, AIG began assembling private equity
investors, strategic buyers, and sovereign wealth funds to discuss
funding and investment options. Also, AIG's then-chief executive
officer said he spoke with the then-FRBNY President again about the
company's liquidity problems, saying that although the company was
pursuing private financing, any solution would require assistance from
the Federal Reserve System. Federal Reserve System officials and AIG
executives held a meeting, during which the company provided details
about its liquidity problems and actions it was considering to address
them. According to the FRBNY President, September 12 was the first
time the Federal Reserve System received nonpublic information
regarding AIG, which indicated AIG was facing "potentially fatal"
liquidity problems.[Footnote 38]
One option discussed at that meeting was whether AIG could borrow from
the discount window through its thrift subsidiary. FRBNY officials
told us, however, that the thrift only had $2 billion in total assets
and only millions of dollars in assets that could be used to
collateralize a loan, which would have been small relative to AIG's
overall liquidity needs. According to an FRBNY summary of the meeting,
AIG mentioned its plan to become a primary dealer over a 6-to 12-month
period, but FRBNY officials determined this was not viable because its
liquidity needs were immediate. On the morning of September 13,
according to an internal communication, AIG executives asked Federal
Reserve System officials about how to obtain an emergency loan under
the authority provided in section 13(3) of the Federal Reserve Act.
Officials responded that the company should not to be optimistic about
such assistance.
Over the September 13-14, 2008, weekend, FRBNY officials conducted
various analyses related to AIG, including an evaluation of the
company's systemic importance, before the Federal Reserve Board
ultimately decided to authorize government assistance on September 16.
[Footnote 39] We found at least one instance of quantitative analysis
of the systemic risk AIG posed to the financial system. In this
analysis, historical equity returns of AIG were assessed, with a
conclusion that the company was not systemically important. However,
FRBNY officials told us that this analysis was conducted prior to the
September 15 bankruptcy of Lehman and did not take into account market
conditions that followed that event. Beyond this example, officials
could not say whether any other quantitative analyses were conducted
regarding systemic risk posed by AIG. Internal correspondence and
documents indicate that officials' assessment of AIG's systemic risk
relied primarily on qualitative factors. For instance, documents show
that officials assessed the potential impact on subsidiaries of the
AIG parent company filing for bankruptcy, the potential response of
state insurance regulators in that situation, and differences between
a failure of AIG and Lehman.
Officials told us the Lehman bankruptcy was a key factor in how they
assessed the systemic risk of an AIG failure, given what they believed
would be the strain AIG's bankruptcy would place on financial markets.
Officials told us that had the Federal Reserve System prevented
failure of Lehman Brothers, they would have reassessed the potential
systemic impact of an AIG bankruptcy. A former senior AIG executive
expressed a similar idea to us, saying that had AIG's crisis occurred
before that of Lehman Brothers, the Federal Reserve System would have
not provided any assistance to AIG, which would have led to its
failure. On September 16, a day after Lehman filed for bankruptcy, an
FRBNY official sent a memorandum to the then-FRBNY President and other
officials assessing the expected systemic impacts of an AIG failure,
including an analysis of the qualitative factors previously discussed.
Officials decided that a disorderly failure of AIG posed systemic risk
to the financial system, and on that basis, the Federal Reserve Board
approved the $85 billion Revolving Credit Facility.[Footnote 40] They
said the only other viable outcome besides the assistance package
would have been bankruptcy.
Although the Federal Reserve System had various contacts and
communications about AIG's difficulties in the months preceding aid to
the company, officials appear to have not acted sooner for various
reasons. FRBNY's then-President has said that because the Federal
Reserve System was not AIG's regulator, it could not have known the
full depth of the company's problems prior to AIG's September 12
warning. In addition, FRBNY officials told us that from March to
September 2008, following the collapse of Bear Stearns, they were
intensively involved in monitoring the remaining four large investment
banks (Merrill Lynch, Lehman, Goldman Sachs, and Morgan Stanley) not
then supervised by the Federal Reserve System. They said the concern
was the possibility of another collapse like that of Bear Stearns, and
this unusual effort consumed a significant amount of management
attention.
As AIG's Needs Became Clearer, Private Financing Failed, Prompting the
Federal Reserve to Become More Involved:
Following AIG's unsuccessful requests for discount window access, the
company and the Federal Reserve System pursued what became a two-phase
private-financing effort in advance of the ultimate government
intervention.[Footnote 41] In the week beginning September 15, 2008,
AIG faced pressing liquidity needs, and expected to receive rating
agency downgrades. The company anticipated this would result in $13
billion to $18 billion in new liquidity demands, primarily stemming
from collateral postings on AIGFP CDS contracts. The ability to raise
private financing was a key issue for AIG because private funding
could have reduced or eliminated the company's need for government
assistance.[Footnote 42] Further, as discussed later, the inability to
obtain private financing was a condition for Federal Reserve System
emergency lending. For the first phase of attempts to secure private
financing, which AIG led, the company had developed a three-part plan
that envisioned raising equity capital, making an asset swap among its
insurance subsidiaries, and selling businesses. In the second phase of
attempts to secure private financing, which began on September 15,
2008, FRBNY assembled a team of bankers from two large financial
institutions to pursue a syndicated bank loan.[Footnote 43]
AIG Attempted to Obtain Private Financing Several Ways:
For the first phase, AIG assembled private equity investors, strategic
buyers, and sovereign wealth funds over the weekend of September 13-
14. These parties considered scenarios ranging from equity investments
in AIG life insurance subsidiaries to purchases of AIG assets. In all,
we identified at least 14 entities as participating in the first phase
(see table 1). This effort identified at least $30 billion in
potential financing--well short of estimated needs that ran as high as
$124 billion.
Table 1: Participants in First Phase of AIG Private-Financing Attempt,
by Type:
Type of participant: Private equity firms;
Number: 4.
Type of participant: Strategic buyers;
Number: 4.
Type of participant: Investment banks[A];
Number: 3.
Type of participant: Sovereign wealth funds;
Number: 2.
Type of participant: Advisor[B];
Number: 1.
Type of participant: Total;
Number: 14.
Source: GAO interviews with private-sector participants.
Note: A private equity firm typically raises capital from investors
and borrows from banks to invest in companies for majority or complete
control and seeks to improve operations so that the investment can be
sold at a gain. A strategic buyer typically invests in a company to
complement or expand existing businesses.
[A] One of these investment banks also acted as an advisor to AIG.
[B] The advisor's investment arm considered making an investment.
[End of table]
Throughout the September 13-14, 2008, weekend, private equity firms
and strategic buyers weighed investments in AIG's life insurance
subsidiaries, although they had concerns about the parent company's
solvency and liquidity needs. On September 12, AIG asked an investment
bank advisor to assist in contacting potential investors and to
provide financial information to these entities to assist in their
assessments of whether and under what terms they could invest in
AIG.[Footnote 44] Also on September 12, AIG engaged two investment
banks and an advisor to research and identify options to raise $20
billion in private financing. According to the advisor, it was not
certain at the time whether AIG was facing a problem of insolvency or
liquidity.[Footnote 45]
According to participants with whom we spoke, the process at AIG over
the weekend consisted of a series of formal and informal meetings,
during which they discussed potential investments and received
briefings from AIG about its financial condition and estimates of its
liquidity shortfall. Participants in the process told us there was
uncertainty whether any private investment could satisfy AIG's
liquidity needs and what those specific needs were. One private equity
firm told us that AIG did not provide an agenda for the weekend, and
although it said the process became more organized on September 14,
the firm did not receive data it ordinarily obtains when considering
an investment. According to another private equity firm, AIG did not
provide clear direction amid what the private equity firm described as
a chaotic environment. This private equity firm added that some
bankers expressed frustration that the process could have been less
hurried had AIG started it earlier.
As noted, one element of AIG's three-part plan during the first phase
contemplated raising equity capital from commercial sources. We
identified two proposals the company received. First, on September 14,
a private equity firm, a sovereign wealth fund, and an insurance
company together made a $30 billion proposal to AIG. The offer
included a private equity investment totaling $10 billion in exchange
for a 52 percent stake in two life insurance subsidiaries. In
addition, according to our review, the potential investors included
four other elements in their plan.
1. The proposal would have created $20 billion in liquidity from an
exchange of assets between AIG's property/casualty and life insurance
subsidiaries. This swap required approval of the New York State
Insurance Department (NYSID).
2. The proposal relied on the Federal Reserve System granting AIG
access to its discount window for a $20 billion line of credit, to be
secured by bonds from the asset swap.
3. The proposal required that rating agencies commit to maintaining
the company's credit rating at AA-.
4. The proposal required replacement of AIG senior management,
including the chief executive officer.
A former senior AIG executive said AIG's Board of Directors rejected
the proposal because it was an inadequate bid with insufficient
private equity contribution and many conditions.
Another private equity firm told us that it also made an offer to AIG,
proposing to buy an AIG insurance subsidiary at a discounted price of
$20 billion.[Footnote 46] Like other firms participating in the first
phase, the private equity firm determined that investing in one of
AIG's life insurance subsidiaries, rather than the parent company,
posed less financial risk. AIG rejected the proposal, according to the
private equity firm.[Footnote 47] Our review showed that other private
equity firms present over the weekend considered investing in AIG, but
no formal proposals resulted. For instance, one private equity firm
contemplated a $10 billion investment in AIG life insurance
subsidiaries in exchange for a 30 percent ownership interest,
contingent upon additional financing from commercial banks or the
Federal Reserve System. Another private equity firm said it considered
an investment in AIG but was unable to make an offer given time
pressure and its available investment capacity.
The second part of AIG's three-part plan during the first phase was an
asset swap. In addition to being incorporated into one of the plans
discussed earlier, the asset swap was also a standalone option. The
company contemplated an exchange of assets between AIG property/
casualty and life insurance subsidiaries to make available $20 billion
in securities to pledge for cash, but this plan was contingent upon
approval from NYSID. AIG executives told us they first contacted the
then-Superintendent of NYSID late on September 12, 2008, in an effort
to assess whether such a swap was feasible. According to our review,
NYSID assisted AIG in developing the idea, although it never reached
final approval. A condition for approval was that the swap would be
part of a comprehensive solution that would include raising equity
capital and selling assets--conditions that ultimately were not met.
Additionally, state insurance regulators wanted to ensure that the
property/casualty companies that would be involved in the plan would
still have sufficient capital to protect policyholders after the asset
swap occurred. According to a former senior AIG executive, the asset
swap would have generated $20 billion in securities for AIG to use as
security for borrowing, yielding the company $16 billion to $18
billion in cash proceeds. Toward that end, the company explored
repurchase agreements, secured by assets from the swap, with two
investment banks.[Footnote 48] One of the investment banks committed
to $10 billion in such repurchase financing, and it noted that another
investment bank was contemplating an additional $10 billion in
repurchase financing. This second investment bank told us, however,
that it considered providing the full $20 billion in repurchase
financing to the company. According to executives of the bank, the
deal never materialized because certain assets they thought AIG would
post as collateral for the financing were unavailable.
For the third part of its plan, AIG or its advisor contacted strategic
buyers in an effort to generate cash from asset sales. On September
12, AIG offered to sell its property/casualty business for $25 billion
to another insurance company. However, according to the potential
buyer, the deal proved to be too expensive given time pressure. In
another potential deal with the same company, AIG revived previous
discussions regarding a guarantee of $5.5 billion of guaranteed
investment contracts that AIGFP had written.[Footnote 49] The
guarantee would have allowed AIG to avoid posting $5.5 billion in
collateral in the event of a credit rating downgrade in exchange for a
one-time fee. The fee contemplated was in the form of a transfer of
life settlement polices from AIG to the insurance company. According
to an executive of the insurance company, negotiations surrounding the
fee continued until September 15, but the parties could not reach an
agreement.
An FRBNY e-mail also showed internal discussions about two other asset
sales to other insurance companies--potential purchase of AIG's
Variable Annuity Life Insurance Company for $8 billion and potential
purchase of another AIG subsidiary for $5 billion. In addition to
these possible sales, an AIG advisor told us about a potential $20
billion deal with a sovereign wealth fund that was considering asset
purchases. According to the advisor, the fund's primary interest was
in purchasing tangible assets, such as real estate.
By late in the day on September 14, the first phase of efforts to
identify private financing had failed, for reasons including financing
terms, time constraints, and uncertain AIG liquidity needs, according
to those involved. Two private equity firms indicated that a private
solution was not possible without assistance from the Federal Reserve
System to assure AIG's solvency. Similarly, according to a former
senior AIG executive, potential investors wanted assurances of
solvency before making any investments, and the Federal Reserve System
was the only entity in a position at the time to provide such
assurances. AIG executives with whom we spoke acknowledged that any
investments in the parent company would have been risky. In addition,
two would-be investors also told us that a weekend was too little time
to construct a deal that would usually take at least 4 weeks. As these
participants and AIG executives noted, there was not enough time or
money to assist the company. Moreover, participants said the company
lacked an understanding of its own liquidity needs, and there was
insufficient data to support would-be investors' decision making. As
table 2 shows, AIG's liquidity needs grew as analysis of the company's
financial situation progressed over the weekend.
Table 2: Estimates of AIG's First-Phase Liquidity Needs, September
2008:
Date: September 11-12;
Estimate (dollars in billions): $20-40.
Date: September 13;
Estimate (dollars in billions): $30-40.
Date: September 14;
Estimate (dollars in billions): $35-124[A].
Source: GAO analysis based on review of Federal Reserve System and
public records and interviews with participants.
[A] According to FRBNY records, $124 billion represented the worst-
case scenario if all securities lending, repurchase funding, and
maturing guaranteed investment contracts became due the week of
September 15-19, 2008.
[End of table]
The Federal Reserve System Initially Limited Its Involvement to
Monitoring Developments at AIG:
Over the weekend of September 13-14, 2008, as AIG attempted to secure
private financing, the Federal Reserve System avoided actions that
could have signaled to companies or other regulators that it would
assist AIG. Officials received AIG requests for Federal Reserve System
assistance on at least five occasions during approximately the week
leading up to September 14. As noted, one of these instances occurred
during a meeting between Federal Reserve System officials and AIG
executives on the morning of September 13. A Federal Reserve System
internal communication documenting the meeting shows that during a
discussion about emergency lending under section 13(3) of the Federal
Reserve Act, officials indicated to AIG that an emergency loan would
send negative signals to the market. Officials told us that during the
meeting, they discouraged AIG from relying on a section 13(3) loan.
Meanwhile, an e-mail from an FRBNY official communicated to staff that
they should avoid conveying to firms or other regulators that the
Federal Reserve System was taking responsibility for AIG.
Although Federal Reserve System officials were downplaying assistance
to AIG, records we reviewed show they began considering the merits of
lending to AIG as early as September 2 and continuing through the
September 13-14 weekend. One communication we reviewed noted that
allowing AIG to borrow through the Federal Reserve System's Primary
Dealer Credit Facility could support an orderly unwinding of the
company's positions but questioned whether such assistance was
necessary for AIG's survival.[Footnote 50] In addition, e-mails on
September 13 show officials considering the operational aspects of
lending to AIG through the Primary Dealer Credit Facility, including
an evaluation of the collateral available for AIG to post against a
loan. Reflecting other concerns, a September 14 communication
discussed the merits and drawbacks of lending to AIG. The merits
included the possibility that Federal Reserve System lending could
prevent an AIG bankruptcy and the potential impacts on global markets
that could follow. The drawbacks included that such a loan could
diminish AIG's incentives to pursue private financing to solve its
problems. Similarly, some staff preliminarily discussed reasons why
the Federal Reserve System should not lend to AIG. These staff were
concerned that although there could be short-term benefits, such as
helping to stabilize the financial system, the potential moral hazard
costs would be too great, according to information we
reviewed.[Footnote 51] Federal Reserve Board officials told us that,
given insufficient information and the speed at which events unfolded,
no written staff recommendation on whether to lend to AIG was ever
finalized or circulated to the Federal Reserve Board.
While Federal Reserve System officials considered implications of
lending to AIG, they also analyzed the company's financial condition,
including its liquidity position and risk exposures. FRBNY officials
told us that staff were instructed to "understand" the nature and size
of AIG's exposures. According to internal correspondence, officials
established a team to develop a risk profile of the AIG parent company
and its subsidiaries and to gather information, such as financial
data. They also worked on a series of memorandums over the weekend
highlighting issues at AIG. Much of the analysis focused on the
exposures of AIGFP. In addition, records from the weekend show that
officials evaluated AIG's asset-backed securities and CDS portfolio,
the company's systemic importance, and bankruptcy-related issues.
According to FRBNY officials, a team from FRBNY's Bank Supervision
Group looked at public information to assess AIG's condition and, in
particular, whether the company's insurance subsidiaries were a source
of financial strength for the company. Officials also met with AIG
executives to discuss the company's liquidity risks. The company
provided information detailing the financial institutions with the
largest exposures to the company, including credit, funding,
derivatives and CDS exposures.
The Federal Reserve System also monitored AIG's discussions with
potential investors and NYSID on September 13-14. As noted, Federal
Reserve System officials met with AIG executives on September 13.
According to minutes from the meeting, although the company needed
financing immediately, asset sales could require 6-12 months to
complete. For that reason, as noted in the summary of the meeting, AIG
expressed interest in Federal Reserve System lending facilities to
support its liquidity needs as it sold assets.
Federal Reserve System records also indicate uncertainty among
officials about whether a private-sector solution would be forthcoming
over the weekend. For example, on the morning of September 13, Federal
Reserve Board and FRBNY officials discussed telling AIG that it could
not rely on the Federal Reserve System for financing, so that the
company would focus on its own actions to solve its problems. On the
night of September 14, a Federal Reserve Board official described two
private equity plans under consideration, both of which were
conditioned on Federal Reserve System assistance. After AIG had
rejected one plan, a question was raised on what would prompt AIG to
consider restructuring or a strategic partnership. Further, an e-mail
from September 14 shows the view of one official that AIG was
unwilling to sell assets it thought would offer profit-making
potential in the future, while at the same time attempting to use the
situation to its advantage to convince the Federal Reserve System to
offer discount window access. According to the official who wrote the
e-mail, AIG was avoiding difficult but viable options to secure
private financing.
As part of its weekend monitoring of private-sector efforts, officials
also had discussions with NYSID and AIG about the status of plans
being considered. In addition, one FRBNY official told us of a meeting
with a private equity firm over the weekend in order to assess whether
its plans to finance AIG were genuine. Overall, FRBNY officials told
us that they acted as observers to the events unfolding at AIG over
September 13-14 and did not participate in any negotiations on private
financing. Rather, they told us their primary focus was addressing the
Lehman crisis occurring that same weekend. Officials had meetings
throughout the weekend with senior executives of various financial
institutions about the Lehman situation. During these meetings, the
issue of AIG arose. FRBNY officials told us they received assurances
from chief executive officers of three financial institutions present
that they were working on AIG's problems and would address the
company's liquidity needs. Although the Federal Reserve System's own
monitoring of the situation that weekend showed AIG was unable to
arrange private financing, an FRBNY official told us there was no
information calling into question the financial institutions'
assurances that they would handle the AIG situation. Rather, the
Lehman bankruptcy on September 15 and its effect on financial markets
eventually called the assurances into question, the official told us.
A related issue arose regarding assurances and AIG's regulators. FRBNY
officials said in Congressional testimony that state insurance
regulators and OTS had assured them over the September 13-14 weekend
that a private-sector solution was available for AIG, and that
officials had no basis to question those assurances.[Footnote 52]
State insurance regulators, however, told us no such assurances were
given. According to Federal Reserve System officials, they did not
consult OTS about AIG's condition, given the time pressure of events.
Further, records we examined indicate that AIG and Federal Reserve
System officials themselves communicated the difficulties the company
encountered in attempting to obtain private financing over the weekend.
Private-Financing Efforts Shifted to a Syndicated Loan:
Following the failure of the AIG-led weekend efforts, FRBNY began what
became the second phase of the private-financing effort on Monday,
September 15, 2008. This attempt moved away from equity investments or
asset sales and instead focused on syndicating a loan. FRBNY records
we reviewed show that some officials continued to believe on September
15 that AIG had options to solve its problems on its own. Nonetheless,
FRBNY called together a number of parties and urged them to come up
with a private loan solution. According to our review, participants in
the meeting included AIG, Treasury, three investment banks, an AIG
advisor, an FRBNY advisor, and NYSID. The then-FRBNY President
initiated this effort late in the morning of September 15 and
requested that the two investment banks identify a commercial bank
loan solution for AIG. According to investment banks we interviewed,
the FRBNY President did not specify any deadlines or provide special
instructions to the financial institutions but asserted that
government assistance was not an option.
One of the investment banks told us that participants focused on four
areas during the second phase--assessing liquidity needs, valuing
assets, creating loan terms, and identifying potential lenders.
Participants contemplated a $75 billion syndicated loan, consisting of
$5 billion contributions from 15 financial institutions. According to
FRBNY, the banks envisioned that AIG would need 6 months to sell
assets and repay the loan. While the banks worked to create a loan
package, FRBNY focused on assessing the exposures to AIG of regulated
financial entities, nonbank institutions, and others. Late on
September 15, according to our review, the participants reported to
the then-FRBNY President about difficulties in securing a loan, to
which the President responded with a request that they continue--but
this time, also considering a potential government role. According to
a former Treasury official, the then-FRBNY President said the Federal
Reserve System would provide $40 billion in financing for AIG, but the
participants would have to find the remainder. This was the first
instance we identified in which officials indicated externally that
they would consider government assistance. According to an investment
bank, the participants then continued discussions. Nonetheless, the
loan effort failed. By the night of September 15, officials concluded
private firms could not find the resources to solve the problem, the
former FRBNY President told us. The next day, the then-FRBNY President
ended the second phase of attempts to find private financing for AIG.
The former President told us he could not recall the first mention of
government intervention, but that he believed the possibility of
government assistance was discussed with the Federal Reserve Board and
Treasury on the night of September 15.
Participants and FRBNY officials provided varying explanations for why
the second phase failed. According to one of the investment banks,
AIG's liquidity needs at the time exceeded the value of any security
to back a loan. Therefore, the participants on September 15 did not
attempt to line up syndication partners. In addition, one senior AIG
executive expressed the view that the Federal Reserve System waited
too long to understand and act on the company's problems. FRBNY
officials, however, cited a desire by the banks to protect their
finances amid general market turmoil that was exacerbated by the
Lehman bankruptcy. They added that private-sector collateral concerns
notwithstanding, the collateral AIG used to back the $85 billion
Revolving Credit Facility fully secured the Federal Reserve System to
its satisfaction, a condition of section 13(3) emergency lending. On
the morning of September 16, 2008, the then-Secretary of the Treasury,
the Chairman of the Federal Reserve Board, and the then-FRBNY
President held a conference call regarding AIG. According to an FRBNY
official on the call, the three agreed that the Federal Reserve Board
should approve lending to the company. The former FRBNY President told
us nothing more could have been done to secure private financing, as
the extent and severity of AIG's liquidity needs, coupled with
mounting panic in financial markets that was accelerated by the
failure of Lehman, meant private firms had no capacity to satisfy
AIG's needs. Later that day, after the two failed efforts at private
financing, the Federal Reserve Board authorized FRBNY to enter into
the Revolving Credit Facility with AIG to avoid what officials judged
to be unacceptable systemic consequences if AIG filed for bankruptcy.
The Federal Reserve Offered AIG Help in Avoiding Bankruptcy, and AIG
Made the Final Decision to Accept Government Assistance:
By September 12, 2008, as AIG headed into the weekend meetings aimed
at identifying private financing, the company had also begun
considering bankruptcy issues, as it faced possible failure during the
week of September 15. According to a former senior AIG executive,
around September 12, the company engaged legal counsel to begin
preparations for a possible bankruptcy. As noted, AIG also gave a
presentation to FRBNY officials on September 12, which included
information about possible impacts of bankruptcy. After AIG's
presentation, FRBNY officials began their own assessment of the
prospect and possible effects of AIG's failure, focusing on the
systemic consequences of bankruptcy and how the legal process of
filing might unfold. On September 14, FRBNY held a discussion about
AIG with risk managers of an investment bank as well as the Office of
the Comptroller of the Currency. According to a meeting record, AIG
would have been forced to file for bankruptcy on September 15, absent
private financing to meet its liquidity demands.
Officials' concern about the systemic effect of an AIG bankruptcy
included whether such a filing would have prompted state insurance
commissioners to seize AIG insurance subsidiaries. According to FRBNY
officials, regulatory seizures of AIG's insurance subsidiaries
following a bankruptcy filing would have complicated any efforts to
rescue the company because AIG's businesses were interconnected in
areas such as operations and funding. Therefore, according to the
officials, discrete seizures by individual state insurance regulators
would have made bankruptcy unworkable. In addition, foreign
authorities were becoming concerned, and bankruptcy could have
resulted in insurance regulators worldwide seizing hundreds of AIG
entities. According to the officials, they looked at the experience of
previous insurance company failures, but none were comparable to AIG's
situation.
According to our review, both AIG executives and a number of
government officials expressed concerns about possible seizures of AIG
assets shortly before the Federal Reserve Board authorized the
Revolving Credit Facility. For example, at an AIG Board meeting on
September 16, an AIG executive stated that NYSID would seize the
company's New York insurance units if AIG went into bankruptcy. A
former senior AIG executive told us that on September 16, at least
three state insurance regulators said they would seize AIG insurance
subsidiaries in their states if the parent company filed for
bankruptcy. In a number of records we examined, government officials
also stressed the likelihood that insurance subsidiaries would be
seized, particularly those experiencing financial difficulties.
[Footnote 53]
State insurance regulators were less certain of the likelihood of
seizure, according to our review. A former state insurance official
told us that he cautioned FRBNY officials that seizures were highly
likely. AIG's lead life insurance regulator told us it considered the
possibility of intervention, but added that states generally have an
incentive not to place insurance companies into receivership, as that
has negative connotations that could diminish companies' value.
Several state insurance officials overseeing AIG's property/casualty
and life insurance businesses told us that bankruptcy of the AIG
parent company would not have required them to act as long as the
insurance subsidiaries were solvent, and they did not foresee
insolvency. Two state insurance regulators also told us they did not
communicate to the Federal Reserve System or AIG that they would
intervene in the company's subsidiaries. State insurance officials
said that in the past, their approach has been to monitor the
situation when a parent company filed for bankruptcy--for example,
Conseco, Inc.--because statutory provisions protected insurance
company assets.[Footnote 54]
In offering to assist AIG, the Federal Reserve Board sought
specifically to give the company the means to avoid a bankruptcy
filing because of concerns about systemic risk, officials told us. Our
review showed that beyond offering a way to avoid such a filing, the
Federal Reserve Board had no direct role in the AIG board's
consideration of bankruptcy on September 16. On that day, an AIG board
meeting had already been scheduled at 5 p.m. to discuss the
possibility of bankruptcy, according to a former senior AIG executive.
After the Federal Reserve Board offer earlier in the day, the meeting
became a discussion about government assistance versus filing for
bankruptcy, the former executive said, which was described as the only
available alternative. According to information we reviewed, the AIG
board's view was that the terms of the government's offer were
unacceptable, given a high interest rate and the large stake in the
company--79.9 percent--the government would take at the expense of
current shareholders. AIG executives telephoned FRBNY officials during
the AIG board meeting in an effort to negotiate terms of the Revolving
Credit Facility, but the FRBNY officials said the terms were
nonnegotiable and that the company had no obligation to accept the
offer.[Footnote 55]
During the AIG board meeting, AIG's advisors also discussed
implications of a potential bankruptcy filing. This discussion
included the value of potential future asset sales and the value of
the company's subsidiaries generally, as well as legal advice on what
the company's fiduciary duties were in any such event. As part of its
bankruptcy issues consideration, AIG's board also contemplated debtor-
in-possession financing from an investment bank.[Footnote 56] But AIG
told us its financial adviser believed such financing would have been
difficult in light of then-current market conditions, and a former
senior AIG executive told us AIG would have required debtor-in-
possession funding of unprecedented size at a time when markets were
volatile.
The AIG board decided that government assistance was the best option
because that would best protect AIG's value, according to records we
reviewed. Additionally, a former senior AIG executive told us that AIG
accepted the Federal Reserve System's offer of assistance because of
uncertainty about how bankruptcy proceedings would unfold. Ultimately,
10 of the 11 directors voted to accept the federal loan offer.
AIG executives and advisors stressed to us that the only matter
presented for consideration that day was whether to accept the Federal
Reserve System's loan offer. As part of that, however, directors
considered issues and implications that might arise from a bankruptcy
filing, they said. The executives said that at that point, the company
was not prepared to file for bankruptcy if it did not accept the loan,
and no bankruptcy petition had been prepared for filing or directed to
be prepared.
AIG executives told us that after accepting the Federal Reserve System
loan, they did not consider bankruptcy issues again but rather focused
on devising solutions to the company's problems. FRBNY officials told
us that as a practical matter, AIG's acceptance of the Revolving
Credit Facility had effectively precluded bankruptcy as an option, at
least in the short term, because it would have immediately put the
funds that FRBNY had loaned to AIG at risk. Nevertheless, FRBNY
continued to examine bankruptcy as an alternative to additional
government assistance over the next several months following the
establishment of the Revolving Credit Facility, according to records
we examined. For instance, in briefing slides circulated to FRBNY
officials on October 7, one FRBNY staff member argued that bankruptcy
was the least-cost resolution for AIG, even though the company
continued to pose systemic risk. Also, Federal Reserve Board staff
began gathering data on the systemic implications of an AIG bankruptcy
and devising a contingency plan to protect the banking system.
A bankruptcy advisor to FRBNY told us that officials continued to
discuss bankruptcy in lieu of federal assistance throughout the fourth
quarter of 2008 and into early 2009. Internal FRBNY briefing slides
from February 2009 show consideration of the consequences and costs of
bankruptcy versus further government assistance, including
restructuring of the government's TARP investment in AIG and
additional capital commitments for AIG's subsidiaries. The assessment
concluded that bankruptcy costs would reflect loss of the government's
TARP investment in preferred stock, plus any additional losses from
unpaid portions of the Revolving Credit Facility.[Footnote 57] It
further noted that AIG would be more likely to repay the government if
it received more assistance than if it filed for bankruptcy. Moreover,
due to AIG's interconnections with other financial institutions,
bankruptcy had other potential costs to the government, such as the
possibility that other institutions with exposure to AIG would need
subsequent government support. There could also be a run on the life
insurance industry, the assessment noted. The Federal Reserve Board
also weighed effects of bankruptcy when considering additional
government assistance, according to minutes of a Federal Reserve Board
meeting on February 19, 2009. The minutes show that given the
potential costs of bankruptcy to AIG's insured parties, the governors
generally agreed that stabilizing AIG with more government aid was the
only option at that point, notwithstanding concerns over potentially
increased taxpayer exposure.
In addition to these concerns, FRBNY, its bankruptcy advisor, and
state insurance regulators also cited other factors that complicated
the viability of bankruptcy for either the AIG parent company or its
subsidiaries. First, according to the advisor, AIG's Delaware-based
federal savings bank, as well as the company's foreign and domestic
insurance subsidiaries, could not file for bankruptcy protection
because they were not eligible to be Chapter 11 debtors. State
insurance regulators told us that if AIG failed, then the parent
company, its AIGFP unit, and other entities would have filed for
bankruptcy, but that state insurance laws prevented the parent company
from accessing insurance subsidiary assets to satisfy claims of any
entities other than policyholders.[Footnote 58] FRBNY's advisor told
us that the legal limitations on any partial bankruptcy were as
important to assessing whether to provide assistance to AIG as the
issues concerning the company's close connections with other entities.
Second, AIG's parent company had guaranteed many liabilities of its
subsidiaries. For example, AIGFP relied on the strength of the parent
company's finances and credit ratings. As a result, according to
FRBNY's bankruptcy advisor, a bankruptcy of either the parent or AIGFP
would have constituted a default under AIGFP's CDS contracts,
potentially leading to termination of the contracts and additional
demands for liquidity. As noted in a document circulated among FRBNY
officials on October 7, 2008, a default on AIGFP's CDS contracts could
have involved a large number of the company's counterparties.
Moreover, according to an advisor, the CDS contracts were defined as
agreements that would have been exempt from automatic stay under the
U.S. bankruptcy code.[Footnote 59] As a result, AIGFP's CDS
counterparties could have terminated their contracts notwithstanding
an AIG bankruptcy filing, obligating AIG to pay the counterparties
early termination amounts on those transactions.[Footnote 60] FRBNY's
bankruptcy advisor told us that neither AIGFP nor the parent company,
as guarantor of AIGFP's obligations, would have had the funds to pay
the cost of early terminations of all such positions in AIGFP's
derivatives portfolio, including CDS and other types of derivatives.
As discussed earlier, FRBNY briefing slides indicated that AIG's
bankruptcy at the time would have resulted in $18-24 billion in
funding needs. Also, because some of the company's CDS counterparties
were European banks, the potential economic loss from a default could
have affected the global banking system.
Another concern underlying officials' bankruptcy considerations was
whether refusing to provide additional support for AIG beyond the
original aid would have hurt the government's reputation or market
confidence, according to records we reviewed. For instance, one
memorandum notes that allowing AIG to fail after providing the
Revolving Credit Facility would have caused loss of market confidence
in government support, which could have had systemic consequences.
FRBNY officials told us that a similar concern existed about
preserving confidence in policymakers and that withdrawing from the
Federal Reserve System's strategy only weeks after the Revolving
Credit Facility was extended would have been extraordinary.
There were similar confidence issues with respect to AIG that
contributed to decisions on assistance. An FRBNY advisor told us there
were questions of whether AIG could survive a bankruptcy proceeding
because the company had built its business model on long-term customer
confidence. For example, the advisor noted that during the fall of
2008, customers were saying they would not renew their coverage
without a solution in place to address AIG's problems. Another advisor
opined that if AIG filed for bankruptcy, officials could have avoided
moral hazard and criticism over use of additional public funds.
However, bankruptcy also could have led to further market
deterioration at a time when there was already uncertainty about
Lehman and other financial issues, the advisor said.
FRBNY officials told us they continued to consider contingency plans
for AIG, including the desirability of bankruptcy, until around August
2009, by which time new board members and a new chief executive had
been named. According to officials, the contingency planning reflected
overall concerns about financial market stability that persisted
beyond the September 2008 weekend of the Lehman bankruptcy and AIG
crisis. For example, officials told us that between September 16,
2008, and January 2009, insurance companies other than AIG lost
approximately $1 trillion in market value, and many of them were on
the verge of bankruptcy. By the end of 2009, however, the company's
situation had improved to a point that bankruptcy ceased to be a focus
in consideration of options, according to the officials.
Given the Crisis, There Was Little Time to Consider Alternatives for
Initial Aid, but AIG and the Federal Reserve Considered a Range of
Options for Later Assistance:
FRBNY officials told us that overwhelming pressure to act quickly at
the time the Revolving Credit Facility was established prevented them
from thoroughly considering other options. They said this pressure was
the result of three factors:
* They did not understand the size and nature of AIG's liquidity needs
until AIG's presentation on September 12, 2008.
* AIG, as noted, faced a potential credit rating downgrade on
September 15 or 16 that would have generated large demands for cash.
* The company was unable to roll over commercial paper at maturity, so
large cash commitments would have been due on September 17.[Footnote
61]
Officials told us that given these constraints, there was no time to
engage advisors and fully explore options. Still, records we examined
show that some alternatives were considered. An FRBNY staff memorandum
from September 13, 2008, cited two alternatives to the Revolving
Credit Facility. One was to lend to AIG through an intermediary to
which a Reserve Bank had the authority to lend, such as a commercial
bank or primary dealer. Officials told us the problem with this idea
was uncertainty whether an intermediary would execute any plan and
under what terms. The other idea was to provide financing to AIG from
Treasury or NYSID. Officials told us, however, that at that time,
Treasury had no authority to offer assistance and NYSID did not have
the necessary funds.
There was also discussion before the Revolving Credit Facility of
potential financing through the FHLB system. FRBNY e-mails on
September 15, 2008, show consideration of whether AIG could secure
FHLB financing through its insurance subsidiaries, which as noted
earlier, AIG itself had contemplated over the summer of 2008. The e-
mails note that AIG's federal savings bank was a member of the FHLB of
Pittsburgh and indicate that the FHLB of Dallas was willing to lend to
AIG against high-quality collateral.[Footnote 62] Nevertheless, FRBNY
officials said the time constraints prevented meaningful exploration
of solutions other than to either let AIG fail or to provide the
emergency loan.
In the week following establishment of the Revolving Credit Facility,
officials began their own assessment of AIG's condition before
considering options for additional assistance. Previously they had
relied on information from AIG and those involved in private financing
efforts. Records we reviewed show that on September 17, 2008, the day
after AIG accepted the Revolving Credit Facility, FRBNY had a team at
AIG to monitor collateral valuation practices, risk management, and
exposures of various subsidiaries. According to FRBNY officials, there
were two main objectives during that first week: (1) to forecast AIG's
liquidity situation to better understand the company's needs moving
forward and (2) to verify that the Revolving Credit Facility was
secured and that AIG's draws against it did not exceed the value of
posted collateral. FRBNY officials said that they wanted to develop
their own views on these matters and engaged three advisors for
assistance during that week.
Following initial assessments, FRBNY and its advisors shifted
attention to considering additional options for AIG. According to
FRBNY officials, they already had begun to think about other ways to
provide aid they believed AIG would need while still in the process of
drafting documents for the Revolving Credit Facility. For that reason,
officials said, they drafted a credit agreement for the facility that
would allow them to make changes in government support for AIG without
the company's consent.[Footnote 63] FRBNY officials said their general
approach in considering options was to have AIG bear a cost for any
benefit received, so that the company had a strong economic incentive
to repay assistance. According to these officials, FRBNY had no
interest in providing funds beyond the initial Revolving Credit
Facility unless the clear purpose was to stabilize the company.
[Footnote 64] Also, the officials said they did not want aid to create
negative incentives in the company that could create reliance on
government protection, and they were mindful of rating agencies'
concerns. Further, avoiding arrangements that created a continuing
relationship with AIG was important.
An FRBNY advisor told us that this approach also included trying to
contain the problems at AIGFP. FRBNY officials told us that in
general, the process for developing options, given the objectives
cited previously, was to brainstorm ideas while taking note of
applicable constraints or barriers. In the end, the available options
narrowed to essentially the plans that were implemented.
As a Number of Options were Considered, Planning Relied on AIG Asset
Sales:
FRBNY officials said that in developing options, one element remained
constant--the expectation that AIG's source of repayment for its
emergency lending would be through liquidation or sale of whole
subsidiaries, rather than through company earnings. Officials did not
consider company earnings alone to be sufficient in light of AIG's
needs to reduce its size and stabilize itself through
recapitalization. Further, the officials told us that while the
private-sector lending plan of September 15, 2008, contemplated
liquidating the company in 6 months, they were doubtful that could be
achieved.[Footnote 65] According to these officials, liquidation over
a short period would have led to additional credit rating downgrades,
furthering concerns about AIG's rating-sensitive business model.
[Footnote 66]
After the initial provision of aid, AIG's liquidity problems remained
and the original terms of the Revolving Credit Facility contributed to
higher debt costs. Officials were concerned the company's credit
ratings would be lowered, which would have caused its condition to
deteriorate further. There were also continuing concerns about AIG's
solvency. As discussed in October 2008, market doubts about solvency
stemmed from concerns about liquidity, the company's exposure to RMBS
and asset-backed securities (via its CDS transactions), and the impact
of AIG's difficulties on the business prospects of its insurance
subsidiaries. FRBNY officials noted that in addition to its own
particular problems, AIG also was facing the same difficulties as
other financial institutions at the time, such as the loss of access
to the commercial paper market.
In the weeks following the announcement of the Revolving Credit
Facility, AIG's actual and projected draws on the facility grew
steadily (see figure 2). AIG used almost half the facility by
September 25 and was projected to begin approaching the $85 billion
limit by early October. Ultimately, AIG's actual use of the facility
peaked at $72.3 billion on October 22, 2008.
Figure 2: Actual and Projected Cumulative Draws on Revolving Credit
Facility, as of October 2, 2008:
[Refer to PDF for image: vertical bar graph]
Month/day: 9/23;
Actual draws: $42 billion.
Month/day: 9/24;
Actual draws: $44.5 billion.
Month/day: 9/25;
Actual draws: $47.5 billion.
Month/day: 9/26;
Actual draws: $49 billion.
Month/day: 9/29;
Actual draws: $55 billion.
Month/day: 9/30;
Actual draws: $61 billion.
Month/day: 10/1;
Actual draws: $61 billion.
Month/day: 10/2;
Actual draws: $62.5 billion.
Month/day: 10/3;
Projected draws: $63 billion.
Month/day: 10/6;
Projected draws: $70.5 billion.
Month/day: 10/7;
Projected draws: $74.5 billion.
Month/day: 10/8;
Projected draws: $75.5 billion.
Month/day: 10/9;
Projected draws: $78.5 billion.
Month/day: 10/10;
Projected draws: $78.5 billion.
Source: FRBNY.
[End of figure]
In response to AIG's continuing difficulties, FRBNY officials told us
that they considered a range of options leading up to the November
2008 restructuring of government assistance.[Footnote 67] However, our
review identified that the first possibility for modifying assistance
to AIG came from the private-sector. We found that on September 17,
2008, a consultant contacted the Chairman of the Federal Reserve Board
and the then-FRBNY President to raise an idea, suggested by a client,
to form an investor group that was willing to purchase about $40
billion of the $85 billion Revolving Credit Facility. The client said
such a purchase would be advantageous to the Federal Reserve System
because it would provide a positive signal to financial markets and
could transfer some of the risk of the loan to the private parties,
whose involvement would also demonstrate that the Revolving Credit
Facility had commercial appeal. Federal Reserve Board officials told
us that this idea, which came only days after the failure to obtain
private financing for AIG, did not develop further. Earlier, as AIG's
board contemplated government assistance on September 16, the former
FRBNY President told the company he was willing to consider an offer
for private parties to take over the credit facility. The President
characterized the idea as a preliminary offer and told us he
understood one feature was to make the investors' $40 billion
investment senior to the government's interest. That would have
significantly increased the risk of the FRBNY loan, making the Reserve
Bank more vulnerable to a loss, the former President said. He said
allowing FRBNY's interest to become subordinate to that of private
investors would not have been in the best interest of taxpayers.
During October 2008, the Federal Reserve System considered options
that included what became ML II and ML III, as well as an accelerated
asset sales process and government purchases of AIG's life insurance
subsidiaries. As discussed earlier, officials expected that AIG would
have to divest assets to generate cash to repay the government's loan.
Toward that end, the Federal Reserve Board asked staff to encourage
AIG to sell assets with greater urgency, according to information we
reviewed from October 2008. In addition, as FRBNY briefing slides from
October 2, 2008, show, officials contemplated other options, including
financial guarantees on the obligations of AIGFP and its CDS
portfolio, increasing the $85 billion available under the Revolving
Credit Facility, and becoming the counterparty to the company's
securities lending portfolio (the latter of which was acted upon, with
the Securities Borrowing Facility). FRBNY officials also considered a
proposal to directly support AIG's insurance subsidiaries, to preserve
their value, according to the October 2 slides. The presentation notes
that these potential support actions would include "keepwell"
agreements and excess-of-loss reinsurance agreements, which would
ultimately terminate upon sale of the subsidiary.[Footnote 68] It
further noted that this approach would have allowed officials to
address credit rating concerns by severing the link between the
ratings of AIG's parent and its subsidiaries.
Some Potential Options Were Not Possible:
When considering options for AIG, FRBNY officials said they also took
into account legal barriers, which eliminated some of the alternatives
contemplated, such as guarantees, keepwell agreements, and ring-
fencing of AIG's subsidiaries.[Footnote 69] Under section 13(3) of the
Federal Reserve Act, a Reserve Bank's authority did not extend beyond
making loans authorized by the Federal Reserve Board that were secured
to the Reserve Bank's satisfaction. Moreover, officials told us they
had no authority to issue a guarantee. In mid-October, Federal Reserve
Board and FRBNY staff discussed options, such as a guarantee or
keepwell agreement, with Federal Reserve Board staff being opposed to
these options. The staffs also discussed the possibility of Treasury
providing such arrangements and whether these options were important
in case of a credit rating downgrade. The issues were whether the
government could protect the value of the AIG insurance subsidiaries
that collateralized the FRBNY credit facility and prevent the abrupt
seizure of those companies by state insurance regulators. As for ring-
fencing, officials told us it was not viable due to time constraints
and the lack of a legal structure to facilitate it. An FRBNY advisor
told us that Treasury may have been able to provide a guarantee to AIG
but that the amount of any guarantee would have been subject to
limitations. The advisor added that the guarantee also raised moral
hazard issues.
As Federal Reserve System officials continued to consider the best
approach for AIG, other relief became available. In late October 2008,
some AIG affiliates began to access the Federal Reserve System's newly
created Commercial Paper Funding Facility. The Emergency Economic
Stabilization Act of 2008, enacted the same month, gave Treasury the
authority to make equity investments, which it used to make its $40
billion investment in AIG in November 2008. Meanwhile, according to
records and interviews with FRBNY officials, AIG proposed plans--
including the provision of additional government funds to purchase
CDOs that were the subject of the company's CDS contracts and a
repurchase facility with the government--in which AIG would purchase
assets in a transaction similar to what ML III did. The officials told
us that while they aimed to stem AIG's liquidity drains, they also
wanted to limit erosion of the company's capital, and a repurchase
facility would have jeopardized that objective. In addition, the
repurchase facility would have placed FRBNY in a continuing
relationship with AIG, which FRBNY officials told us was generally an
unwanted outcome for any option. Ultimately, the assistance provided
to AIG in the 2 months following the Revolving Credit Facility
included the Securities Borrowing Facility, ML II and ML III,
restructuring of the Revolving Credit Facility's terms, the Commercial
Paper Funding Facility, and assistance from Treasury under TARP.
[Footnote 70]
Before the March 2009 restructuring of government assistance, FRBNY
and its advisors continued to consider more possibilities for
assisting AIG, in particular, for helping it sell assets. According to
one advisor, AIG faced a number of challenges in the months leading up
to this second restructuring of government assistance. For example,
AIG was expecting a loss for the fourth quarter of 2008 of $40
billion, which was $15 billion more than its loss in the previous
quarter. (The actual loss AIG reported was $61.7 billion, which was
reported at the time as being the largest quarterly loss in U.S.
corporate history.) In addition, AIG's asset-sale plan was under
pressure from low bids, delays, and limited interest from buyers who
lacked financing in a fragile credit market. As a result of these and
other issues, FRBNY officials expected AIG to receive a credit rating
downgrade. In response, both the company and FRBNY considered a number
of new options. According to company records, AIG considered a package
of options that included asset and funding guarantees, a debt exchange
to reduce the Revolving Credit Facility, and recapture of fees the
company paid on the Revolving Credit Facility worth $1.7 billion plus
interest. Ideas of FRBNY or its advisors included additional TARP
investments by Treasury, $5 billion in guaranteed financing for AIG's
International Lease Finance Corporation, and nationalization of the
company. The latter, as noted in the records of an advisor, included
provisions for winding down AIGFP, converting Treasury's preferred
stock investment under TARP into common stock, and providing
government guarantees of all AIG obligations.[Footnote 71]
FRBNY and its advisors continued to develop options after the
restructuring on March 29, 2009, but that was the last time the
Federal Reserve Board formally authorized assistance for AIG, as the
company's prospects began to stabilize.[Footnote 72] According to
records we reviewed, these options included creation of a derivatives
products company with a government backstop to engage in transactions
with AIGFP's derivative counterparties and separating AIGFP from the
AIG parent company to mitigate risks the subsidiary posed.
According to FRBNY officials, their general attitude toward AIG and
consideration of options in the months following the Revolving Credit
Facility was to listen and observe, trying to see how the firm was
attempting to solve its problems. This approach sometimes meant they
did not share information or plans with AIG--for example, when they
were considering details for ML III or expected contingencies if the
government decided not to provide additional support for the company.
AIG executives described their relationship with FRBNY as
collaborative and said that FRBNY officials did not deter the company
from proposing solutions. They also noted there was frequent contact
between the company and FRBNY.
Overall, FRBNY officials told us that they led the development of
options, while relying on three advisors for expertise in designing
structures and analyzing scenarios. FRBNY engaged advisors primarily
for evaluation of technical details, as staff did not have the
expertise to conduct the depth of analysis and modeling required, for
example, in creating ML II and ML III. FRBNY officials also told us
they gave guidance to AIG while focusing on options that would
stabilize the company and provide repayment of the government
assistance--although those goals were not always aligned. In mid-
October 2008, for instance, AIG approached officials about the
company's idea for the repurchase facility noted earlier. FRBNY
officials said they told the company not to pursue that course but to
continue attempts to negotiate terminations with its CDS
counterparties.[Footnote 73] Officials said that they were in a good
position to assess ideas AIG proposed because they had begun work
related to ML II and ML III in the weeks after the establishment of
the Revolving Credit Facility.
Credit Ratings Were a Key Consideration in AIG Assistance:
Although the performance of credit rating agencies during the
financial crisis has drawn criticism, Federal Reserve System officials
said AIG's credit ratings were central to decisions about assistance
because rating downgrades could have triggered billions of dollars in
additional liquidity demands for the company.[Footnote 74] Downgrades
could also have jeopardized AIG's asset sales plan and repayment of
government aid, if a downgrade led to events that significantly
reduced the value of AIG assets. As a result, FRBNY joined with AIG to
address rating agency concerns throughout the course of government
assistance to the company.
Beginning in late 2007, AIG's exposure to the subprime mortgage market
and its deteriorating derivatives portfolio raised concerns among
rating agencies, rating agency executives told us. In February 2008,
AIG announced a material weakness in the valuation of its CDS
portfolio, leading Moody's Investors Service to lower its ratings
outlook for AIG senior debt from stable to negative.[Footnote 75] In
the same month, other rating agencies also placed AIG on negative
outlook, suggesting the possibility of a future downgrade. As 2008
progressed, AIG executives met with rating agencies to discuss the
company's situation. Following reviews of AIG's deteriorating
condition and the announcement of losses for the first quarter of
2008, Moody's Investors Service, Standard & Poor's, Fitch Ratings, and
A.M. Best Company all downgraded AIG's ratings in May 2008.
Over the summer of 2008, AIG communicated with rating agencies about
its development of a strategic plan to address its problems. The
company expected to announce the plan at the end of September, a
former AIG executive told us. On August 6, AIG announced a second
quarter loss of $5.36 billion. Rating agencies initially said they
would hold off action until the company's chief executive officer
presented the new strategic plan, the former executive told us. By
late August, however, rating agencies had indicated to AIG that they
would review the company and probably downgrade its rating, the
executive said. This development, the senior executive added, was
ultimately responsible for the company's liquidity crisis in September
2008.
In the weeks leading up to AIG's crisis weekend of September 13-14,
rating agencies cited concerns about mounting problems in AIG's CDS
portfolio and indicated they would lower AIG's credit ratings unless
the company took actions to prevent the move. Other rating agency
concerns included AIG's declining stock price, its liquidity position
in general, and its risk management practices above and beyond capital
needs. One rating agency said that during the second week of
September, concerns about AIG's financial condition increased greatly
over a short period of time.
Immediately after the Federal Reserve Board authorized the Revolving
Credit Facility, the potential for downgrades following the
announcement of an expected quarterly loss effectively established a
deadline for the Federal Reserve System as it worked to restructure
its assistance to the company. FRBNY officials told us they timed
restructuring plans to coincide with AIG's release of its third
quarter results on November 10, 2008, because they expected that an
announcement of a quarterly loss would result in a downgrade without a
strategy to further stabilize the company.[Footnote 76] By early
October, Federal Reserve Board staff identified forestalling a ratings
downgrade as the priority because a downgrade would hurt AIG
subsidiaries' business, among other problems. Although the Federal
Reserve System's Securities Borrowing Facility implemented earlier had
helped to prevent downgrades, rating agencies wanted to see additional
measures taken. FRBNY also considered asking rating agencies to take a
"ratings holiday," whereby the rating agencies would agree not to
downgrade AIG.
Information we reviewed further indicates that leading up to the
announcement of restructuring of government assistance in November
2008, FRBNY and Federal Reserve Board officials were concerned about
ratings and whether options they were considering would prevent a
downgrade. October 26 briefing slides from an FRBNY advisor detailed
various rating agency concerns, including ongoing liquidity and
capital problems at AIGFP, the parent company's debt levels following
the Revolving Credit Facility, and risks associated with executing
AIG's asset sales plan. When the Federal Reserve Board considered
authorization of the restructuring package, a key factor was rating
agency concerns.
Ratings implications continued to factor into officials' decisions
leading up to the second restructuring of government assistance in
March 2009 but with a greater focus on AIG's asset sale plans and the
performance of its insurance subsidiaries. According to an FRBNY
advisor, potential losses, combined with AIG's deteriorating business
performance, difficulties selling assets, and a volatile market
environment, meant that a ratings downgrade was likely unless the
government took additional steps to assist the company. FRBNY
officials told us a main rating agency concern was whether AIG could
successfully execute its restructuring plan over the multiyear period
envisioned.
Both rating agency executives and FRBNY officials told us they had no
contact with one another concerning AIG before September 16.[Footnote
77] After the establishment of the Revolving Credit Facility, FRBNY
officials began to develop a strategy for communicating with the
rating agencies to address their concerns. They told us that they
implemented this approach after the rating agencies contacted them in
the week following September 16, 2008, seeking to understand what the
government had planned. FRBNY officials also said there was a rating
agency concern that the FRBNY loan was senior to AIG's existing debt.
As a result, according to the officials, it became clear early that
the rating agencies would play a key role, because further downgrades
would have a serious impact on AIG and cause further harm to financial
markets. In response to rating agency issues, officials said they
provided information about the Revolving Credit Facility in the 2
weeks following authorization of the lending, but not about AIG or
potential future government plans. FRBNY engaged three advisors to
develop its strategy for rating agency communications. As part of the
effort, FRBNY officials began participating in discussions between AIG
and the rating agencies about the implications of government
assistance on AIG's ratings.
FRBNY officials told us they generally met with AIG and rating
agencies together, but that officials had some independent discussions
with the rating agencies, along with a Treasury official, to confirm
details of federal plans to assist the company. These separate
sessions were not, however, related to what AIG itself was doing or
intended to do, the officials said. In general, interacting with
rating agencies in this way was new for FRBNY officials, who told us
they were concerned that talking to the rating agencies without AIG
present could influence the ratings without allowing AIG to have any
input. They also noted that the proper relationship was between the
rating agencies and the company, as FRBNY was not managing AIG.
FRBNY officials said that they viewed the rating agencies as a
limiting factor in considering options but not necessarily a driving
force, as restructuring efforts focused on stabilizing AIG and not
necessarily on preventing a downgrade. AIG's business partners,
brokers, and bank distribution channels had concerns about the
company's ratings, because a specified credit rating can be required
to transact business, the officials said. But FRBNY's policy objective
was to prevent a disorderly failure of AIG, and FRBNY officials said
they did not believe that would have been possible if AIG was
downgraded to the levels rating agencies were considering. The rating
agencies, FRBNY officials said, were an indicator of how the market
would view AIG upon implementation of various solutions. They added
that the rating agencies wanted to hear solutions and that the
government was flexible and committed to helping AIG but did not wish
to participate in decision making.
Several rating agencies told us they did not see their role in
discussions with AIG executives and FRBNY officials as becoming
involved in decision making or management of AIG. Instead, meetings
with AIG were standard in nature, whereby the agencies would gather
information, react to plans, or share perspectives on potential
ratings implications of contemplated actions.[Footnote 78]
Representatives from one rating agency described, for example,
meetings at which AIG presented its plans and the agency commented
about the potential implications on ratings in general without
mentioning a specific rating that would result. Similarly, another
agency told us that it would ask questions about options AIG presented
but did not offer input or recommendations regarding individual plans.
The agency added that legal barriers prevented it from suggesting how
to structure transactions so that a company could improve its rating.
FRBNY officials concurred with the rating agencies' description of
their role. They said the agencies did not indicate what they
considered acceptable or provide detailed feedback on government
plans. To the contrary, FRBNY officials told us that they would have
liked for the rating agencies to provide instructions on minimum
actions needed to maintain AIG's ratings. But the agencies frequently
pointed out that they did not want to be in the position of
effectively running the company by passing judgment on various plans.
FRBNY officials said that they generally understood the rating
agencies' concerns, but did not make specific changes to the
restructured Revolving Credit Facility, ML II, or ML III based on
rating agency feedback.
FRBNY's Maiden Lane III Design Likely Required Greater Borrowing, and
Accounts of Attempts to Gain Concessions From AIG Counterparties are
Inconsistent:
After the first extension of federal assistance to AIG--the Revolving
Credit Facility--ML III was a key part of the Federal Reserve System's
continuing efforts to stabilize the company. We found that in
designing ML III, FRBNY decided against plans that could have reduced
the size of its lending or increased the loan's security, as it opted
against seeking financial contributions from AIG's financial
counterparties. We also found that the Federal Reserve Board approved
ML III with an expectation that concessions would be negotiated with
the counterparties, but that FRBNY made varying attempts to obtain
these discounts, which could have been another way to provide greater
loan security or to lower the size of the government's lending
commitment. FRBNY officials told us, however, that the design they
pursued was the only option available given constraints at the time,
and that insistence on discounts in the face of counterparty
opposition would have put their stabilization efforts at serious risk.
In creating ML III, FRBNY sought to treat the counterparties alike,
with each of them receiving full value on their CDO holdings. However,
because the circumstances of individual counterparties' involvement
with AIGFP varied, the counterparties' perception of the value of ML
III participation likely varied as well.
Need to Resolve Liquidity Issues Quickly Drove the Federal Reserve's
Decision Making on Maiden Lane III:
The financial pressures on AIGFP arose primarily from collateral calls
on approximately 140 CDS contracts on 112 mortgage-related,
multisector CDOs with $71.5 billion in notional, or face, value for
about 20 financial institution counterparties.[Footnote 79] To address
AIGFP's difficulties, FRBNY had three broad approaches it could take,
according to the then-FRBNY President: (1) let AIG default on the CDS
contracts that were causing its liquidity problems; (2) continue to
lend to AIG, so it could meet its obligations under those CDS
contracts; or (3) restructure the CDS contracts to stop the financial
pressure. FRBNY chose the third approach, and officials said that in
the subsequent design of a specific structure for ML III, time
pressure was a key factor.
Collateral figured prominently in ML III assistance. Shortly prior to
ML III's creation in November 2008, AIGFP had posted approximately
$30.3 billion in collateral to its counterparties. AIG faced the
prospect of being required to post still more collateral if there were
further declines in the market value of the CDOs being covered, which
could have created significant additional liquidity demands for the
company.
In addressing AIGFP's liquidity risk from additional collateral calls,
FRBNY contracted with financial advisors in September and October
2008.[Footnote 80] These advisors, among other things, developed
alternatives, forecasted scenarios of macroeconomic stress to be used
in decision making, calculated the value of CDOs that would be
included in ML III, and helped develop messages to describe ML III to
AIG's rating agencies. According to FRBNY and its advisors, the
process of considering options was collaborative, with FRBNY providing
guiding principles and direction and the advisors developing detailed
designs.
FRBNY's goal was to have a structure in place before AIG's quarterly
earnings announcement on November 10, 2008, when AIG was expected to
report a large loss that likely would have resulted in a credit rating
agency downgrade, which in turn, would have caused additional CDS
collateral calls for AIGFP.[Footnote 81] FRBNY and its advisors
considered three alternatives designed to halt AIGFP's liquidity
drain, each of which contemplated differing funding contributions and
payments to AIGFP's CDS counterparties. As illustrated in figure 3,
the alternatives were:
* the as-adopted ML III structure, in which FRBNY loaned and AIG
contributed funds to the ML III vehicle;
* a "three-tiered" structure, in which AIG and FRBNY, plus AIGFP's
counterparties, would have contributed funds to the structure; and:
* a "novation" structure, in which AIGFP's CDS contracts would have
been transferred to a new vehicle funded by FRBNY, AIG, and collateral
previously posted to AIGFP's counterparties.
Figure 3: Maiden Lane III Structure and Alternatives:
[Refer to PDF for image: illustration]
As adopted:
Federal Reserve:
1) $24.3 billion loan to Maiden Lane III.
AIG:
2) $5 billion equity contribution to Maiden Lane III.
Maiden Lane III:
3) Purchases CDOs at “fair market value” from AIG counterparties.
AIG counterparties:
4) CDOs transfer (minus AIG’s CDS protection) to Maiden Lane III.
AIG:
5) Counterparties retain collateral previously posted by AIG when CDO
values fell.
Note: Maiden Lane III also transferred $2.5 billion to AIG to reflect
what Federal Reserve officials described as excess collateral the
company had posted to counterparties.
First alternative: the three-tiered option:
Federal Reserve:
1) loan to Maiden Lane III.
AIG:
2) equity contribution to Maiden Lane III.
Maiden Lane III:
3) Purchases CDOs from AIG counterparties.
AIG counterparties:
4) CDOs transfer (minus AIG’s CDS protection) to Maiden Lane III.
5) Loans (to help fund Maiden Lane III).
AIG:
5) Counterparties retain collateral previously posted by AIG when CDO
values fell.
Second alternative: the “novation” option:
Federal Reserve:
1) guarantee to Maiden Lane III.
AIG:
2) equity contribution to Maiden Lane III.
3) AIG’s Financial Products unit “novates,” or assigns, its CDS
contracts protecting AIG’s counterparties to Maiden Lane III, with the
consent of the counterparties.
Maiden Lane III:
4) Regular CDS contract payments from AIG counterparties
(counterparties retain CDOs and do not sell them).
5) CDS contract payouts to AIG counterparties (only if credit event
occurs on CDOs protected by CDS).
6) Previously posted AIG collateral from AIG counterparties (given up
to help fund Maiden Lane III).
Source: GAO.
[End of figure]
The as-adopted structure. Under the as-adopted ML III structure, AIG's
counterparties received essentially par value--that is, the notional,
or face, value--for their CDOs (or close to par value after certain
expenses).[Footnote 82] They did so through a combination of receiving
payments from ML III plus retaining collateral AIG had posted to them
under the company's CDS contracts. In return, the counterparties
agreed to cancel their CDS contracts with AIG. The as-adopted ML III
structure was financed with a $24.3 billion FRBNY loan in the form of
a senior note and a $5 billion AIG equity contribution, resulting in
an 83/17 percent split in total funding, respectively.[Footnote 83] ML
III used these funds to purchase the CDOs from AIG counterparties at
what were determined to be then-fair market values. The AIG equity
contribution was designated to absorb the first principal losses the
ML III portfolio might incur.
The three-tiered structure. Under the three-tiered alternative, the
counterparties choosing to participate would have received less than
par value for their CDOs. This would have been through a combination
of retaining collateral AIG had posted and receiving payment from ML
III for the sale of their CDOs, but also making funding contributions
to ML III. In return, as in the as-adopted structure, the
counterparties would have canceled their CDS contracts with AIG and
transferred the CDOs to the structure. The three-tiered structure
would have been financed with an FRBNY loan in the form of a senior
note and an AIG equity contribution, as in the as-adopted structure,
plus loans from AIGFP counterparties in the form of "mezzanine" notes.
[Footnote 84] As under the as-adopted structure, the AIG equity
contribution would have absorbed the first principal losses. In
contrast to the chosen model, however, the counterparties' mezzanine
contribution would have covered losses exceeding the AIG equity
amount. Thus, under the three-tiered option, FRBNY's loan would have
been more secure because it would have had both the AIG and the
mezzanine contributions to absorb principal losses. The mezzanine
contribution could have reduced the size of FRBNY's loan to ML III.
However, the potential size of FRBNY's loan under this plan was not
known, FRBNY officials told us. It would have depended on the size of
the mezzanine contribution and hence the counterparties' willingness
to participate, they said.
The novation structure. Under this structure, the counterparties
choosing to participate would have kept their CDOs, rather than
selling them to the ML III vehicle. The CDS protection on the CDOs
would have remained, except that losses protected by the CDS contracts
would be paid by the ML III vehicle and not AIG. Counterparties would
have consented to AIGFP novating, or transferring, their CDS contracts
to the vehicle. In return, the counterparties would have received par
payment from ML III only if a CDO credit event occurred, such as
bankruptcy or failure to pay. The counterparties would also have
continued to pay CDS premiums, but to the vehicle rather than to
AIGFP, which had initially sold them the protection.[Footnote 85] The
novation structure would have been financed with an FRBNY guarantee;
the collateral AIG had previously posted to the counterparties, which
the counterparties would have remitted to the vehicle; and an AIG
equity contribution. Overall, novation would have meant that the
counterparties would not have initially received par value in return
for canceling their CDS contracts. Instead, the CDS coverage would
have continued. Even assuming that legal issues, discussed in the
following section, could have been resolved, FRBNY would have needed
to fully fund the vehicle, essentially lending an amount equal to the
difference between par value and collateral already posted by AIG to
the counterparties, FRBNY officials told us.[Footnote 86]
FRBNY's Evaluation of the ML III Alternatives:
FRBNY and its advisors identified a number of merits and drawbacks for
each of the three ML III options. The as-adopted ML III structure had
lower execution risk than the other structures, FRBNY officials told
us, meaning there was lower risk that the vehicle would ultimately not
be implemented after the parties agreed to terms. It was also the
simplest structure. However, it could have required a greater FRBNY
financial commitment, and after the AIG equity contribution, there
were no other funds contributed to offset potential losses.[Footnote
87]
The three-tiered structure, with its counterparty contributions, could
have required a smaller FRBNY loan and provided FRBNY greater
protection because the counterparty funding would have absorbed any
principal losses that exceeded AIG's equity contribution. This added
protection would have been a major benefit in providing more security
for the FRBNY loan, according to FRBNY officials, because at the time,
financial markets were in turmoil and it was difficult to know when
declines would end. However, according to FRBNY, the three-tiered
structure would have required complex, lengthy negotiations with the
counterparties, including pricing of individual securities in the
portfolio. An FRBNY advisor told us those negotiations could have
taken a year or longer. The structure also would have required
discussion on how potential losses would be shared among the
counterparties. Under this option, credit rating agencies might also
have had to rate notes issued by ML III to the counterparties, which
would have required time. Further, the structure would have created
ongoing relationships between counterparties and FRBNY, which an
advisor said created the potential for conflicts due to the Federal
Reserve System's supervisory relationships. In particular, FRBNY
officials told us, the key feature of the three-tiered structure was
that it would have forced the counterparties into a new position:
being required to absorb losses on their own assets and perhaps those
of other counterparties participating in the vehicle. It would have
been a significant undertaking--lengthy negotiations with no assurance
of success--to persuade the counterparties to take that risk, the
officials said, although they did not have any such discussions with
counterparties before rejecting this option. However, they told us
that they were aware of difficulties in AIG's efforts to negotiate
with its counterparties during this time, and that these negotiations
factored into their expectations about the three-tiered option.
The novation option could also have reduced the amount of ML III
payments made to the counterparties. However, according to FRBNY, the
chief factor against novation was that officials did not think they
had the legal authority to execute this kind of structure because it
likely would not have met the Federal Reserve System's requirement to
lend against value.[Footnote 88] In addition, according to FRBNY and
an advisor, any novation structure would have been complex; would have
required counterparty consent, including agreement to give up the
collateral if the structure was to be fully funded; could have caused
concern among credit rating agencies; and would have required giving
up the opportunity for potential future gains in CDO value because the
vehicle would not have owned the CDO assets. An advisor also cited
concern that a novation structure would drain liquidity from the
financial system during a time of market weakness because the
counterparties would give up collateral AIG had already provided to
them to the new vehicle, where it would no longer be available to the
counterparties for their own uses. In all, there would have been
considerable execution risk while under great time pressure, FRBNY
officials said.
FRBNY and its advisors assessed the three structures against their
goals of both meeting policy objectives and stabilizing AIG. Policy
objectives included lending against assets of value; ensuring that
FRBNY funding would be repaid, even in a stressed economic
environment; speed of execution; and avoiding long-term relationships
with counterparties. AIG stabilization objectives included eliminating
AIGFP's liquidity drain stemming from CDS collateral calls while
limiting the burden on the company through the contribution AIG would
make to ML III. Other stabilization objectives were avoiding
accounting rules that would have required AIG to consolidate any ML
III structure onto its own books and also enabling AIG to share in
potential gains once the federal lending and the company's equity
position were repaid.[Footnote 89]
FRBNY officials told us they ultimately chose the as-adopted ML III
structure because it was the only one that worked, given the
constraints at the time. According to FRBNY, time to execute was the
most important objective, and compared to the other alternatives, the
as-adopted ML III structure was simpler, could be executed more
quickly, and had lower execution risk.
As noted, the value the counterparties received under the as-adopted
ML III structure came from two sources--retaining the collateral AIGFP
had already posted to them, plus payments from ML III to purchase
their CDOs. By the time of ML III in November 2008, much of the
collateral the counterparties had received from AIG had been funded
with proceeds from FRBNY's Revolving Credit Facility. Accounting for
use of these loan proceeds, of the $62.1 billion in value the
counterparties received through the process of establishing the ML III
vehicle, about 76 percent came from FRBNY, as shown in table 3.
Table 3: Sources of ML III Value Provided:
Value Received by Counterparties:
Collateral posted by AIGFP:
Funded by AIG: $14.8 billion.
Funded by FRBNY Revolving Credit Facility: $20.2 billion.
ML III payments to purchase CDOs:
Funded by FRBNY loan proceeds: $27.1billion.
Total value received by counterparties: $62.1 billion.
Total funded by FRBNY: $47.3 billion.
Percentage funded by FRBNY: Approximately 76%.
Source: GAO analysis of Federal Reserve System information.
Note: According to FRBNY, figures are indicative, but not precise.
[End of table]
ML III's Design Focused on Three Major Features:
FRBNY officials designed the as-adopted ML III with a focus on three
main features: (1) the debt and equity structure of the vehicle, (2)
the different interest rates to be used to calculate payments to FRBNY
and AIG on their respective contributions, and (3) a division of
future earnings between FRBNY and AIG.
The first key design feature involved establishing the debt and equity
structure of the total funding provided to ML III so that the FRBNY
loan would be repaid even under conditions of extreme economic stress
and so that AIG's equity contribution would be sufficient to protect
the FRBNY loan. The Federal Reserve Board authorized FRBNY to extend a
loan of up to $30 billion to ML III, secured with the CDOs that ML III
would be purchasing. The actual amount of the loan was $24.3 billion,
which, coupled with a $5 billion AIG equity contribution, provided
total funding of $29.3 billion to ML III. The allocation between the
FRBNY loan and the AIG equity contribution was a balance between
providing safety for the loan and knowledge that FRBNY's previously
approved Revolving Credit Facility would fund the AIG contribution,
FRBNY officials said. As part of its consideration, FRBNY took into
account potentially extreme ML III portfolio losses. During this
process, FRBNY directed an advisor to examine a larger AIG
contribution than initially proposed, in the interest of providing
stronger protection for its loan, and that examination produced the $5
billion figure eventually selected.
In November 2008, using three economic stress scenarios, an FRBNY
advisor estimated that CDO losses on a portfolio close to what became
the ML III portfolio could be 32 percent, 46 percent, and 54 percent
of notional, or face, value under a base case; a stress case; and an
extreme stress case, respectively.[Footnote 90] In particular, based
on expected losses during extreme stress, our analysis of FRBNY
advisor information showed the ML III portfolio was expected to lose
57 percent of its notional value of $62.1 billion, leaving a value of
about $27 billion. That amount, however, was still expected to be $2.7
billion greater than FRBNY's $24.3 billion loan. Thus, the stress
tests indicated that the CDO collateral held by ML III would be
sufficient to protect the FRBNY loan under the extreme stress scenario
indicated.
Likewise, AIG's equity contribution of $5 billion to ML III was
designed to protect FRBNY's loan during extreme economic stress. As
noted, the equity position absorbs first principal losses in the ML
III portfolio. Under the extreme stress case, ML III's CDO recovery
value would be $2.6 billion less than ML III's total funding,
according to our analysis. That is, after the projected loss of 57
percent, as noted previously, the assets would have a value of $26.7
billion.[Footnote 91] That would be less than the $29.3 billion in ML
III funding provided by the combination of FRBNY's $24.3 billion loan
and AIG's $5 billion in equity financing. However, if such a $2.6
billion shortfall occurred, the loss would be applied first against
AIG's $5 billion equity investment. Thus, the structure would allow
AIG's equity position to provide protection for FRBNY's loan.
Although AIG made an equity contribution to ML III, the company funded
its investment using proceeds from the Revolving Credit Facility.
FRBNY officials said they knew that AIG would need to borrow to fund
its contribution, but they preferred that the company borrow from the
Revolving Credit Facility as they did not want AIG to take on
expensive debt to make its contribution. Nevertheless, this situation
presented FRBNY with a trade-off when determining the size of AIG's
contribution to ML III. On one hand, a higher contribution would have
provided more protection to FRBNY. On the other, a higher contribution
would have required AIG to borrow more under the Revolving Credit
Facility, and officials wanted to minimize use of that facility. FRBNY
officials also said they did not want the size of AIG's contribution
to undermine the company if the contribution was entirely lost in a
worst-case scenario. Our review showed that FRBNY also considered
other methods for AIG to fund its contribution, such as a quarterly
payments plan or financing the AIG equity contribution with a secured
loan from ML III.
The second key ML III design feature was the interest rate used to
calculate payment on FRBNY's loan and AIG's equity contribution. The
Federal Reserve Board approved an interest rate on FRBNY's loan of 1-
month London Interbank Offered Rate (LIBOR) plus 100 basis points,
with the rate paid on AIG's equity position set at 1-month LIBOR plus
300 basis points.[Footnote 92] Proceeds from the ML III CDO portfolio
were to be applied first to FRBNY's senior note until the loan was
paid in full and then to AIG's equity until it was also repaid in
full. According to internal correspondence, FRBNY chose LIBOR as the
base rate because LIBOR was also the base rate for a number of the
assets in the ML III portfolio. As for the add-ons to the base rate,
an FRBNY advisor judged the 100 and 300 basis point spreads to be
normal market terms a year prior to the financial crisis. In addition,
FRBNY officials told us that they wanted to leave open the option of
selling the FRBNY loan in the future and thus wanted to include
features that might be appealing to a potential future investor. The
spread might be attractive to an investor as a form of profit-sharing.
The final design feature addressed allocation of residual cash flow--
that is, any income received by ML III from CDOs in its portfolio
after repayment of the FRBNY loan and the AIG equity contribution. The
as-adopted structure split residual cash flows between FRBNY and AIG
on a 67 percent and 33 percent (67/33) basis, respectively. As of
November 5, 2008, just before ML III was announced, residual cash
flows to FRBNY and AIG were estimated to total $31.8 billion and $15.7
billion, respectively, under the base economic scenario. The division
of residual cash flows was determined based on the proportion of
funding contributed to ML III and what FRBNY officials deemed would be
a fair return for its loan and AIG's equity position. Table 4 shows
the divisions of residual cash flows that FRBNY and its advisors
considered based on variations in the size of AIG's equity
contribution, as of October 26, 2008.
Table 4: Division of Earnings Considered for Maiden Lane III, as of
October 26, 2008:
Size of AIG equity contribution: $5 billion (adopted);
Funding split, FRBNY loan/AIG equity: 85%/15%;
Division of residual cash flow, FRBNY vs. AIG: 67%/33%.
Size of AIG equity contribution: $3 billion;
Funding split, FRBNY loan/AIG equity: 91%/9%;
Division of residual cash flow, FRBNY vs. AIG: 83%/17%.
Size of AIG equity contribution: $1 billion;
Funding split, FRBNY loan/AIG equity: 97%/3%;
Division of residual cash flow, FRBNY vs. AIG: 95%/5%.
Source: GAO analysis of FRBNY records.
[End of table]
Under these alternatives, as AIG's equity position increased, its
residual cash flow allocation also increased, but at a
disproportionately higher rate. Conversely, as FRBNY's contribution
decreased because AIG would be contributing more, FRBNY's share of
residual cash flow decreased at a higher rate.
Another factor that influenced the choice of the residual split was
the issue of consolidation of ML III onto AIG's books. FRBNY requested
that one of its advisors determine how much ML III could increase
AIG's allocation of residual cash flows before consolidation became an
issue. FRBNY officials said they determined that FRBNY would need to
take at least a 55 percent share of the residual cash flows to avoid
AIG having to consolidate. That, however, would have provided a 45
percent share for AIG, which in turn would have produced an
extraordinarily high rate of return on the company's $5 billion
contribution, FRBNY officials told us. As a result, FRBNY chose the
67/33 division, which also had the advantage of being a more
conservative position for the FRBNY loan.
Rating agency concerns also played a role in the allocation of the
residual cash flows, according to FRBNY officials. The agencies told
FRBNY that in assessing AIG for rating purposes, they would have
concerns if there was no benefit for the company via the residual cash
flow, because that could leave the company in a weaker position. FRBNY
officials told us they viewed the rating agencies' position as a
constraint to be considered in their design, along with such factors
as tax considerations and market perceptions. As a result, FRBNY
included a residual share for AIG, although officials said that was
not necessarily for the sake of the rating agencies alone. According
to advisor estimates as of November 5, 2008, FRBNY could have expected
to receive an additional $15.7 billion in residual cash flows had it
decided not to provide AIG with a share.
In general, according to FRBNY officials, they were not looking to
earn large returns from the residual earnings. Instead, they said
their primary interest was ensuring FRBNY would be repaid even in a
highly stressed environment, while also seeking to stabilize AIG. The
primary driver of repayment was the size of the AIG first-loss
contribution. FRBNY wanted a bigger first-loss piece, to protect its
loan, and in return, was willing to provide AIG with a bigger share of
the residual earnings. Although the 67/33 split favored FRBNY, its
focus was not on the residual earnings per se, officials told us.
As part of the ML III process, ML III and AIGFP also executed another
agreement, known as the Shortfall Agreement, under which ML III
transferred about $2.5 billion to AIGFP. This amount was based on what
FRBNY officials described as excess collateral that AIGFP had posted
to the counterparties, based on fair market values determined for the
CDOs in question. As described later, a portion of the Shortfall
Agreement became an issue with AIG securities filings and disclosure
of information about AIG counterparties participating in ML III.
While the Federal Reserve Expected Concessions Would Be Negotiated,
Accounts of FRBNY's Attempts to Obtain Them Are Inconsistent:
The Federal Reserve Board authorized ML III with an expectation that
concessions, or discounts, would be obtained on the par value of AIGFP
counterparties' CDOs. Our review found that FRBNY made varying
attempts to obtain concessions and halted efforts before some of the
counterparties responded to the Bank's request for the discounts. The
counterparties opposed concessions, we found, and FRBNY officials told
us that insistence on discounts in the face of that opposition would
have put their stabilization efforts at serious risk.
The business rationale for seeking concessions from AIG's CDS
counterparties was similar to the logic for the option--not adopted--
of having counterparties contribute to the three-tiered ML III
structure--namely, to provide an additional layer of loss protection
for FRBNY's ML III loan. Some Federal Reserve Board governors also
raised concerns that the counterparties receiving par value on CDOs
could appear too generous, noting that the counterparties would
receive accounting benefits from the transaction and no longer be
exposed to AIG credit risk. Concessions would be a way for the Federal
Reserve System to recover some of the benefits the counterparties had
obtained through its intervention in AIG.
According to FRBNY officials, discounts were justified because the
counterparties would benefit from participation in ML III, while at
the same time, such concessions would better protect FRBNY's risk in
lending to the vehicle. Under ML III, the theory of concessions was
that counterparties would be relieved of a risk early, and be provided
additional funding they would not otherwise get. Because the
counterparties themselves were facing a risky partner in AIG, they
should have been willing to accept concessions, officials told us. In
particular, according to FRBNY and an advisor, ML III could have
benefited AIG CDS counterparties in several ways:
* Liquidity benefits. The counterparties would receive ML III cash
payments immediately for purchase of their CDOs.
* Financial statement benefits. Sale of CDOs would allow release of
any valuation reserves previously booked in connection with the CDS
transactions, which reflected potential exposure to AIG. Upon
cancellation of AIG's CDS contracts, the counterparties would no
longer need to hold reserves against these exposures, and the reserves
could be released into earnings.
* Capital benefits. The counterparties would receive a capital
benefit, by reducing risk-weighted assets on their balance sheets.
* Risk of future declines in value. By participating in ML III,
counterparties would avoid the risk of exposure to AIG on potential
future declines in the value of CDOs protected by the company's CDS
contracts.
In addition, we identified other potential benefits of counterparty
participation in ML III. According to our review, before the
government's intervention, AIG and some of its CDS counterparties
collectively had billions of dollars of collateral in dispute under
the CDS contracts. Sale of the CDOs and termination of the CDS
contracts would eliminate those disputes and their cost. Also, some
counterparties had obtained hedge protection on their CDS contracts
with AIG. Likewise, termination of the contracts would eliminate the
costs of that protection.[Footnote 93]
Prior to discussions with counterparties on concessions, FRBNY asked
an advisor to estimate potential concession amounts. The advisor
developed three scenarios, with total concessions ranging from $1.1
billion to $6.4 billion, representing 1.6 percent to 9.6 percent of
CDO notional value. Individual counterparty discounts ranged from $0
to $2.1 billion (see table 5). The advisor also prepared an analysis
of factors seen as affecting individual counterparties' willingness to
accept discounts. For instance, the analysis identified one
counterparty as resistant to deep concessions because a significant
portion of its portfolio was high quality with little expectation of
losses.
Table 5: Maiden Lane III Counterparty Concession Scenarios:
Concession option: 1;
Total concessions: $1.1 billion;
Range of individual concessions: $2 million to $322 million;
Method: Discount of 50 basis points annually on notional value of CDOs
until projected credit event under extreme economic stress scenario,
up to maximum of 300 basis points. Weighted average concession for all
the counterparties would have been 1.6 percent.
Concession option: 2;
Total concessions: $1.3 billion;
Range of individual concessions: $2 million to $328 million;
Method: Discount of 2 percent on CDO notional value.
Concession option: 3;
Total concessions: $6.4 billion;
Range of individual concessions: $0 to $2.1 billion;
Method: Discount calculated as 50 percent of collateral received up to
close of ML III transaction. Total discounts would have been 9.6
percent on entire CDO portfolio.
Source: GAO analysis of FRBNY records.
Note: Figures reflect slightly different CDO portfolio than what ML
III ultimately acquired.
[End of table]
At the time the Federal Reserve Board authorized ML III, the
understanding was that concessions would be negotiated with the
counterparties. We found differing accounts of the request for, and
consideration of, counterparty concessions. FRBNY officials told us
that they made a broader outreach effort to the counterparties, while
counterparties described a more limited effort.
FRBNY officials told us that in seeking concessions, they contacted 8
of the 16 counterparties, representing the greatest exposure for AIG,
in discussions on November 5 and 6, 2008.[Footnote 94] According to
FRBNY officials, their initial calls were typically made to the chief
executive officers or other senior management of the counterparty
institutions. In the initial calls, FRBNY officials explained the ML
III structure generally, and the institutions identified the
appropriate internal contacts for detailed discussions. FRBNY
officials said that they conveyed a sense of urgency about working out
pricing details and concessions.
FRBNY officials said that counterparties' initial reactions to these
requests were negative, and that FRBNY officials asked the
counterparties to reconsider. After the initial contacts, some
counterparties called FRBNY to obtain more information on the
transaction, but these conversations did not include concessions,
according to the officials. FRBNY gave the counterparties until the
close of business Friday, November 7, to make an offer. Only one of
the eight counterparties indicated a willingness to consider
concessions and provided a concession offer, FRBNY officials told us.
This willingness was conditioned on all other counterparties agreeing
to the same concession, the counterparty told us.
Counterparties we spoke with provided a different account of FRBNY's
effort to obtain concessions. As a starting position, they generally
said they opposed a request for concessions because their CDS
contracts gave them the right to be paid out in full if CDOs
defaulted. As a result, they said they had no business case to accept
less than par. Counterparties also cited responsibilities to
shareholders, saying that accepting a discount from par would run
counter to these duties. According to our interviews with 14 of the 16
counterparties, FRBNY appears to have started the process of seeking
discounts with attempts of varying degrees of assertiveness to obtain
concessions from five counterparties.[Footnote 95]
In particular, according to our interviews, FRBNY requested a discount
from two counterparties, which said they needed to consult internally
before replying. These two counterparties said that FRBNY implied they
might not receive financial crisis assistance or discount window
access in the future if they did not agree to a discount.[Footnote 96]
FRBNY officials disputed these accounts. However, FRBNY made contact
soon afterward seeking to execute an ML III agreement without a
discount, and FRBNY officials did not provide any explanation for
their change in position, according to the counterparties we
interviewed. Our interviews also indicated that FRBNY requested "best
offer" of a discount from two other counterparties, and briefly
referenced seeking a discount from another counterparty, before
similarly withdrawing its request with little or no explanation,
according to our interviews. Before that, one of the counterparties
asked to make an offer told us it was still considering a range of
possible discounts. The other said that it told FRBNY it would accept
a 2 percent concession, but at that point, FRBNY officials told the
counterparty they had decided against concessions, and that they would
provide par value instead. The remaining counterparties we contacted
indicated that FRBNY did not seek concessions from them. According to
FRBNY officials, however, the same message had been delivered to each
counterparty contacted. Similarly, the former FRBNY President said in
congressional testimony that a majority of all 16 counterparties had
rejected concessions.
Following discussions with counterparties, the then-FRBNY President
and Federal Reserve Board Vice Chairman, upon staff recommendation,
decided to move ahead with ML III without concessions. In making the
recommendation on the evening of Friday, November 7, 2008, FRBNY
officials described the challenges to obtaining concessions and their
concerns about continued negotiations. FRBNY officials told us that
taking additional time to press further for discounts could risk not
reaching agreement on the ML III transaction by the target date of
November 10, 2008. The cost of not being able to announce the
transaction as planned, coupled with a resultant credit rating
downgrade, would have been greater than the amount of any concessions
achievable in the best case, they said. Although FRBNY did not
continue to pursue concessions, officials told us that ML III was
nevertheless designed to allow repayment of the FRBNY loan under
extreme economic stress without them. Therefore, FRBNY officials told
us they were comfortable moving ahead without concessions. The former
FRBNY President said that officials could not risk lengthy
negotiations in the face of a severe economic crisis, AIG's rapidly
deteriorating position, and the prospect of a credit rating downgrade.
Counterparties approached for a concession told us that once FRBNY
dropped the request for a discount, they agreed to par value, and the
transactions moved forward as final details were resolved. Federal
Reserve Board officials told us that although the expectation was that
concessions would be obtained, securing such discounts was not a
requirement at the time ML III was authorized.
According to FRBNY officials and records we reviewed, there were a
number of reasons FRBNY decided not to pursue concessions:
* Participation in ML III was voluntary, and coercing concessions was
inappropriate, given the Federal Reserve System's role as regulatory
supervisor over a number of the counterparties.
* There was no coherent methodology to objectively evaluate
appropriate discounts from par.[Footnote 97]
* Getting all counterparties to agree to an identical concession would
have been a difficult and time-consuming process. Consistency was
important, both to maximize participation and to make clear that FRBNY
was treating the counterparties equally. Lengthy negotiations would
have been a challenge for executing ML III over 4 days by the November
10 target.
* FRBNY had little or no bargaining power given the circumstances. The
attempts at concessions took place less than 2 months after the
Federal Reserve System had rescued AIG, and the counterparties
expected that the government would not be willing to put the credit it
had extended to the company in jeopardy.
FRBNY officials said in congressional testimony that the probability
of the counterparties agreeing to concessions was modest. Even if they
had agreed, FRBNY did not expect them to offer anything more than a
small discount from par.[Footnote 98] FRBNY officials told us that
setting aside any attempts to coerce concessions, the economic basis
for concessions was relatively modest because AIG had been providing
the counterparties with collateral. Thus, any exposure of the
counterparties upon an AIG default would have been low compared to the
notional size of the CDS transactions.
Because some of the counterparties were French institutions, French
law also entered into concession considerations. FRBNY officials told
us that FRBNY had contacted French regulators for assistance, but that
the French regulators opposed concessions. Also at issue was whether
French law permitted discounts. FRBNY officials said that the French
regulator was forceful in saying concessions were not possible under
French law, and the former FRBNY President has testified that the
French regulator unequivocally told FRBNY officials that under French
law, absent an AIG bankruptcy, the French institutions were prohibited
from voluntarily agreeing to accept less than par value. FRBNY told us
that they did not conduct any legal analysis. Nevertheless, whatever
an analysis might have determined, if the French regulator was not
willing to support its institutions accepting concessions, then
concessions would not be possible, FRBNY officials told us. Given the
desire for consistent treatment of the counterparties, the French
opposition effectively prevented concessions, the officials said.
However, in congressional testimony, the then-FRBNY President said
legal issues faced by the French institutions were not the deciding
factor.[Footnote 99]
A French banking official offered a different view to us. The official
declined to discuss conversations with Federal Reserve System
officials, citing French secrecy law. In general, though, the official
provided a more nuanced explanation of French law's treatment of any
concessions than that cited by the former FRBNY President. According
to the French banking official, there could be legal liability if an
institution accepted a discount, with liability depending on
individual facts and circumstances and a key consideration being
whether any discount involved all creditors.[Footnote 100] In
addition, one French institution told us its research indicated French
law would not have been a factor in concessions.
While FRBNY Sought to Treat Counterparties Alike, the Perceived Value
of Maiden Lane III Participation Likely Varied Among Counterparties:
In establishing ML III, FRBNY sought to broadly include the AIGFP
counterparty CDOs from the portfolio that was creating liquidity risk
for AIG, because the more that were included, the greater the
liquidity relief for the company. For various reasons, however, not
all such CDOs were acquired for inclusion in ML III. In acquiring CDOs
for ML III, FRBNY focused on the counterparties receiving the same
total value as a way to ensure equal treatment, without which
officials said ML III would not have been successful. Specifically, ML
III paid counterparties an amount determined to be the fair market
value of their CDOs, while the counterparties also retained collateral
AIG had posted with them under terms of the CDS contracts being
terminated. The sum of these two amounts was roughly equal to par
value of the CDOs. Although FRBNY applied this equal treatment
approach consistently, the perceived value of benefits derived from ML
III participation likely varied because the circumstances of
individual counterparties varied. FRBNY officials agreed there were
differences among counterparty positions, but they said the most
important consideration was the overall value provided and that taking
account of individual circumstances would have been unfeasible and too
time-consuming given the time pressure of addressing the financial
crisis.
FRBNY Sought to Include a Broad Range of CDOs in Maiden Lane III:
To select the CDOs to be purchased for inclusion in ML III, FRBNY
reviewed a list of CDOs protected by AIGFP CDS contracts. FRBNY's
focus was multisector CDOs because these securities were subject to
collateral calls and were one of the main sources of AIG's liquidity
pressure. FRBNY officials told us their strategy was for ML III to
acquire a large volume of CDOs from AIGFP's largest counterparties so
as to attract other counterparties to participate. In addition, the
concern was that without the largest counterparties' participation, ML
III would not have been successful. FRBNY officials said, however,
that no formal analysis was conducted to determine a specific CDO
acquisition target amount that would produce ML III success.
Ultimately, about 83 percent by notional value, or $62.1 billion of
about $74.5 billion in CDOs, were sold to ML III, according to
information from an FRBNY advisor.[Footnote 101]
CDOs that ML III did not purchase were excluded due to decisions by
both FRBNY and counterparties. FRBNY did not include "synthetic" CDOs
due to questions of practicality and legal authority.[Footnote 102] It
excluded synthetics because they might not have met the Federal
Reserve System's requirement to lend against assets of value, given
that they were not backed by actual assets. According to an FRBNY
advisor, excluded synthetics totaled about $9.7 billion in notional
value.[Footnote 103]
AIG counterparties decided to exclude certain CDO assets for financial
and operational reasons. They elected to exclude euro-denominated
trades with a total notional value of $1.9 billion after the trades
were converted to dollars. For example, one counterparty told us that
it elected not to participate with some of its holdings because
movement in foreign exchange rates would have caused a loss, based on
FRBNY's structuring of the transaction.[Footnote 104] Additionally,
another counterparty told us that $500 million in assets were not
included because the counterparty did not have the underlying bonds
and could not get them back for delivery to ML III.
FRBNY Aimed for Counterparties to Receive Par Value on CDOs:
To obtain the agreement of AIG counterparties to participate in ML
III, FRBNY sought to treat the counterparties consistently by
providing each, through the ML III structure, with essentially par
value on their CDO holdings, FRBNY officials told us. This value--for
selling their CDOs and terminating their AIG CDS contracts--was based
on the sum of two parts: (1) fair market value of the CDOs as
determined shortly before ML III acquired them and (2) collateral that
AIG had posted with the counterparties, which the counterparties
retained. Under this structure, ML III itself did not pay par value
for the CDOs it acquired. Rather, it paid fair market value, which at
the time was below the initial, or notional, values of the CDOs. FRBNY
officials told us that providing the counterparties with essentially
par value based on these two components was important to achieving the
objective of broad counterparty participation. They said that if
counterparties had thought they were getting different arrangements,
they would not have elected to participate in ML III, and FRBNY would
not have achieved its goal of liquidity relief for AIG.
The decision to provide the counterparties with essentially par value
for selling their CDOs and terminating their CDS protection on them,
rather than providing a lower level of compensation, was based on
making them whole under terms of their CDS contracts, FRBNY officials
told us. Because AIG had guaranteed the notional, or par, value in
those CDS contracts, FRBNY officials said it was appropriate to
provide essentially par value to the counterparties, which reflected
the market value of the covered CDOs plus the value of AIG's CDS
protection on those securities.[Footnote 105] FRBNY officials
explained that underlying their approach was the assumption that AIG
would have been able to make good on its CDS obligations.
For the counterparties, the risk of AIG failing to fulfill its CDS
obligations had two elements: First, that AIG could not pay out on the
contracts if CDOs protected by the company were unable to repay all
principal and interest due at maturity, and second, that AIG could
fail to make required collateral postings as required under the CDS
contracts. According to FRBNY officials, of the two, failing to post
collateral was the more important risk because under the CDS
contracts, AIG would not have been required to make payouts following
default on any principal balances until the maturity of the CDOs,
which could be years into the future. On the other hand, a failure by
AIG to post collateral when required would have represented a more
immediate dishonoring of its CDS contracts.
FRBNY officials told us that the assumption underlying their approach
for providing par value--that AIG would make good on its CDS
obligations--was appropriate because there was no realistic concern
among the counterparties that AIG, with its recent government support,
would fail to honor its CDS obligations. However, some counterparties
we spoke with said that when ML III was created, they did have
concerns that AIG would not be able to fulfill its CDS guarantees. For
example, one counterparty told us that it believed there was still a
risk of losses based on an AIG default because posting of collateral
mitigated risk but did not eliminate it. Another counterparty said
that providing par value was attractive because it provided an exit to
a position it viewed as risky.
In addition to concerns that counterparties had about AIG's ability to
honor its CDS contracts, market indicators at the time showed newly
elevated concern about AIG's health. This can be seen in the cost of
obtaining CDS protection on AIG itself. On November 7, 2008, the last
business day before the announcement of ML III and other assistance on
November 10, 2008, premiums on CDS protection on AIG were near the
level reached on September 16, 2008, when the company was on the verge
of failure. Reflecting market perceptions of AIG's financial health,
the premium costs on November 7 were about 43 times higher than the
cost at the start of the year.[Footnote 106]
Counterparties Might Have Valued Benefits Differently:
Although FRBNY used the same approach in acquiring CDOs from all the
counterparties, the counterparties' perception of the value of ML III
participation likely varied, according to FRBNY officials and analysis
that we conducted. FRBNY officials said that counterparties'
circumstances differed based on factors such as size of exposure to
AIG, methods of managing risk, and views on the likelihood of
continued government support for AIG. As a result, counterparties
would have perceived different benefits and value from participating
in ML III, FRBNY officials said. The ML III combination of the market
value of the purchased CDOs and collateral retained had different
value to different counterparties, which might have created different
desires to participate, they said.
In addition, there are other ways that counterparties might have been
differently situated before agreeing to participate in ML III. In
particular, we examined (1) the degree to which the counterparties had
collected collateral under their CDS contracts following declines in
the value of their CDO holdings and (2) the counterparties' credit
exposure to AIG based on the quality of the CDO securities they held.
Differences in collateral collected under CDS contracts. FRBNY
officials told us that the measure of a counterparty's exposure to AIG
was the amount of decline in CDO value that had not been offset by
AIG's posting of collateral under its CDS contracts. For example, if
two counterparties each had $1 billion in CDOs and each group of CDOs
had lost $400 million in value, each counterparty would expect AIG to
post collateral to offset the loss in value. But if one counterparty
had collected the entire $400 million while the other had collected
only $200 million, the first counterparty would have fully
collateralized its exposure, while the second counterparty would have
had uncollateralized exposure to AIG.
We found that prior to ML III, the counterparties had widely varying
uncollateralized exposure to AIG. Figure 4 shows each counterparty's
uncollateralized exposure to AIG as of October 24, 2008, shortly
before ML III was announced. For each counterparty, it shows the
percentage of the loss in CDO value that had been covered by
collateral collected from AIG.[Footnote 107] Collateral posted
included payments that AIG had made to its counterparties using
proceeds from the Revolving Credit Facility provided by FRBNY in
September 2008.
Figure 4: Differences in AIGFP Counterparty Collateralization, as of
October 24, 2008:
[Refer to PDF for image: illustrated table]
Value of CDO holdings from largest to smallest:
AIG counterparty: 1;
Collateral posted as a percentage of CDO loss in value: 99.9%.
AIG counterparty: 2;
Collateral posted as a percentage of CDO loss in value: 97.9%.
AIG counterparty: 3;
Collateral posted as a percentage of CDO loss in value: 77.5%.
AIG counterparty: 4;
Collateral posted as a percentage of CDO loss in value: 92.2%.
AIG counterparty: 5;
Collateral posted as a percentage of CDO loss in value: 94.8%.
AIG counterparty: 6;
Collateral posted as a percentage of CDO loss in value: 73.7%.
AIG counterparty: 7;
Collateral posted as a percentage of CDO loss in value: 73.9%.
AIG counterparty: 8;
Collateral posted as a percentage of CDO loss in value: 47.8%.
AIG counterparty: 9;
Collateral posted as a percentage of CDO loss in value: 136.3%.
AIG counterparty: 10;
Collateral posted as a percentage of CDO loss in value: 103.8%.
AIG counterparty: 11;
Collateral posted as a percentage of CDO loss in value: 44.1%.
AIG counterparty: 12;
Collateral posted as a percentage of CDO loss in value: 67.3%.
AIG counterparty: 13;
Collateral posted as a percentage of CDO loss in value: 175.3%.
AIG counterparty: 14;
Collateral posted as a percentage of CDO loss in value: 197.4%.
Source: GAO analysis of FRBNY and SEC data.
Notes: Counterparty collateralization is calculated as collateral
posted as a percentage of loss in CDO value. Loss in CDO value is
calculated as notional, or par, value, less fair market value. Fair
market value is the amount paid by ML III to acquire the CDOs, based
on valuations as of October 31, 2008. The October 24 date for
collateral posting is the date closest to the October 31 valuation
date for which information was available. FRBNY officials noted that
during this period, the counterparties did not know about the upcoming
ML III vehicle. Only 14 of 16 ML III counterparties shown here,
because two counterparties did not have collateral posting agreements.
Counterparty names omitted because analysis is based on some nonpublic
information.
[End of figure]
For example, as shown in the figure, as of October 24, a number of
counterparties were at or near full collateralization, as collateral
posted was at or near 100 percent of the decline in CDO values. Some
of the counterparties had actually collected more collateral than
value lost. Others, however, had collected less than half the CDO
value lost. In all, the amounts collected varied by more than a factor
of four, ranging from a low of about 44 percent to a high of about 197
percent. We found the same pattern of differences among the
counterparties when considering total collateral requested by each
counterparty, not all of which AIG may have posted.[Footnote 108]
FRBNY officials offered several caveats for our analysis but agreed
with the basic methodology of comparing collateral posted to loss in
CDO value.[Footnote 109] They said that overall, despite what
collateral postings might have been at a particular point, the
collateral posting process was working as intended, and amounts posted
grew in advance of the announcement of ML III.
An issue factoring into the collateral situation was disputes over the
amount of collateral AIG should have posted with its counterparties.
Collateral postings were based on declines in CDO values, and there
were disagreements over what the proper valuations should be. To the
extent that lower valuations (more CDO value lost) produced greater
collateral postings, counterparties had an interest in seeking lower
valuations. Similarly, to the extent that higher valuations (less CDO
value lost) meant smaller collateral postings, AIG had an interest in
seeking higher valuations. According to information we reviewed, on a
CDO portfolio of $71 billion (a preliminary portfolio somewhat
different from the final ML III portfolio), AIG and its counterparties
had valuation differences totaling $4.3 billion. Among a group of 15
counterparties, 9 had valued their assets differently than AIG. FRBNY
officials told us they viewed the amount of collateral in dispute as
relatively minor, but counterparties told us they viewed disputed
amounts as significant.
Varying AIG exposure due to credit quality of underlying assets.
Analysis conducted by an FRBNY advisor indicated that CDOs the
counterparties sold to ML III were expected to incur widely varying
losses in value during periods of economic stress. These differences
arose from the varying quality of assets underlying the CDOs. FRBNY
officials stressed to us that such differences in quality were
reflected in the fair market value that ML III paid for the CDOs and
that counterparties held collateral based on declines in CDO values.
From the perspective of individual counterparties, these differences
illustrate dissimilar circumstances among the counterparties in the
time before ML III was established. Figure 5 shows, in descending
order, that the amount of value expected to be lost in each
counterparty's CDO portfolio during extreme economic stress ranged
from a high of 75 percent to a low of 1 percent. Eleven of the 16
counterparty CDO portfolios were expected to lose at least 50 percent
of their value during such periods of extreme stress.
Figure 5: Differences in Expected Losses by Counterparty for Extreme
Stress, as of November 5, 2008:
[Refer to PDF for image: illustrated table]
AIG counterparty: 1;
Expected CDO loss in value: 75%.
AIG counterparty: 2;
Expected CDO loss in value: 71%.
AIG counterparty: 3;
Expected CDO loss in value: 69%.
AIG counterparty: 4;
Expected CDO loss in value: 68%.
AIG counterparty: 5;
Expected CDO loss in value: 67%.
AIG counterparty: 6;
Expected CDO loss in value: 67%.
AIG counterparty: 7;
Expected CDO loss in value: 65%.
AIG counterparty: 8;
Expected CDO loss in value: 59%.
AIG counterparty: 9;
Expected CDO loss in value: 59%.
AIG counterparty: 10;
Expected CDO loss in value: 54%.
AIG counterparty: 11;
Expected CDO loss in value: 51%.
AIG counterparty: 12;
Expected CDO loss in value: 49%.
AIG counterparty: 13;
Expected CDO loss in value: 42%.
AIG counterparty: 14;
Expected CDO loss in value: 26%.
AIG counterparty: 15;
Expected CDO loss in value: 15%.
AIG counterparty: 16;
Expected CDO loss in value: 1%.
Source: FRBNY advisor analysis.
Note: Counterparty names omitted because analysis is based on some
nonpublic information.
[End of figure]
FRBNY's advisor estimated, for instance, that counterparty 1's CDO
holdings would lose 75 percent of their notional value during extreme
stress. By contrast, counterparty 16's CDO portfolio was projected to
lose only 1 percent of its value. The advisor's analysis also
indicated a wide range of expected losses for the base and stress
economic cases. For the base case, projected losses ranged from 0
percent to 52 percent of CDO portfolio value. For the stress case,
expected losses ranged from 0 percent to 67 percent.
Another indicator of differing asset quality can be seen in widely
varying credit ratings among the CDOs that counterparties sold to ML
III. An FRBNY advisor examined CDO credit ratings, grouping them into
11 categories. Figure 6 focuses on 3 of those 11 categories, showing
the percentage of each counterparty's holdings that fell into the
highest-, middle-, and lowest-rated groupings.
Figure 6: Differences in CDO Credit Ratings by Counterparty, as of
October 29, 2008:
[Refer to PDF for image: vertical bar graph]
Counterparty: 1;
Highest rating: 15%;
Middle Rating: 8%;
Lowest Rating: 17%.
Counterparty: 2;
Highest rating: 40%;
Middle Rating: 7%;
Lowest Rating: 20%.
Counterparty: 3;
Highest rating: 13%;
Middle Rating: 7%;
Lowest Rating: 13%.
Counterparty: 4;
Highest rating: 22%;
Middle Rating: 11%;
Lowest Rating: 16%.
Counterparty: 5;
Highest rating: 39%;
Middle Rating: 4%;
Lowest Rating: 36%.
Counterparty: 6;
Highest rating: 98%;
Middle Rating: 0%;
Lowest Rating: 0%.
Counterparty: 7;
Highest rating: 30%;
Middle Rating: 8%;
Lowest Rating: 21%.
Counterparty: 8;
Highest rating: 38%;
Middle Rating: 5%;
Lowest Rating: 25%.
Counterparty: 9;
Highest rating: 0%;
Middle Rating: 0%;
Lowest Rating: 23%.
Counterparty: 10;
Highest rating: 19%;
Middle Rating: 7%;
Lowest Rating: 25%.
Counterparty: 11;
Highest rating: 3%;
Middle Rating: 6%;
Lowest Rating: 20%.
Counterparty: 12;
Highest rating: 96%;
Middle Rating: 0%;
Lowest Rating: 0%.
Counterparty: 13;
Highest rating: 21%;
Middle Rating: 6%;
Lowest Rating: 22%.
Counterparty: 14;
Highest rating: 21%;
Middle Rating: 10%;
Lowest Rating: 18%.
Counterparty: 15;
Highest rating: 45%;
Middle Rating: 5%;
Lowest Rating: 21%.
Counterparty: 16;
Highest rating: 33%;
Middle Rating: 5%;
Lowest Rating: 13%.
Source: GAO analysis of FRBNY advisor data.
[End of figure]
In general, the analysis shows a relatively level amount of assets in
the middle-rated category, with variance in the best and lowest
ratings. For example, counterparty 5 had about 40 percent of its
holdings in the highest-rated category, with about as much in the
lowest-rated group. But counterparty 15 had about twice as much in the
highest category as the lowest. One counterparty had 98 percent of its
CDO portfolio in the top rating category, while another had none.
Eleven counterparties' CDO portfolios contained "nonrated" positions,
which meant that the credit quality of those assets was unknown and
their risk potentially higher. All else being equal, CDOs with lower
credit ratings would be expected to produce higher losses compared to
more highly rated positions.
In addition, the FRBNY advisor also noted differences among the
counterparties' situations shortly before ML III was announced. For
example, according to records we reviewed, the advisor noted that in a
nonstressed economic environment, one counterparty's portfolio was of
higher quality, and that the counterparty expected there would be
recoveries in value of the assets. For another counterparty, the
advisor noted that its portfolio, overweighted with subprime assets,
was forecast to experience higher losses in all economic scenarios,
and disproportionately worse performance under extreme stress. In
another case, the advisor noted that based on the counterparty's
situation, it would likely have been satisfied with its position
without ML III participation.
Another difference among AIG counterparties' positions prior to their
participation in ML III was that some had obtained hedge protection on
AIG generally or had obtained protection specifically on their AIG CDS
positions. Therefore, their overall risk posture was different from
that of counterparties that had not obtained such hedge protection.
FRBNY officials told us they agreed that the counterparties and their
CDO holdings were not similarly situated. The officials said that the
counterparties generally started out in similar positions, where each
had CDS protection on the notional, or par, values of their CDO
holdings. As the financial crisis intensified, the value of the CDOs
declined, some more than others, and as a result, the counterparties'
relative positions diverged. The crisis was the differentiator, they
said. As the value of the underlying assets changed, the value of
AIG's CDS protection became different, the officials said. Despite the
counterparties' dissimilar situations, FRBNY officials said the goal
was to make sure the counterparties agreed to terminate their CDS
contracts in order to stem liquidity pressure on AIG, and the approach
they took, based on par value, was the best way to accomplish this
given constraints at the time. They said that while some underlying
CDOs may have been of differing quality, these CDOs also had the
benefit of AIG's CDS protection, which promised to protect their value.
The counterparties' differing situations and varying perceptions of
the benefit of ML III participation might have offered an opportunity
to lower the amount FRBNY lent to ML III if FRBNY had been able to
negotiate individually with the counterparties based on their
individual circumstances. However, FRBNY officials told us that trying
to negotiate tailored agreements by counterparty would have been
unworkable and too time consuming given the pressure of the financial
crisis. According to the officials, trying to determine the economic
implications of each counterparty's position would have been
speculative, as different parties would have made different arguments
about the costs or benefits of the ML III transaction based on their
individual circumstances. Further, they said that taking note of such
positions would have led to different deals with different parties on
the basis of how each had chosen to manage risk. While negotiations
might have been possible, they would have been long and complicated
and there was no time for such talks.[Footnote 110]
In reaching agreement with the AIG counterparties on ML III, FRBNY
provided counterparties with varying opportunities to negotiate some
terms. FRBNY officials said that after the first set of eight
counterparties agreed to participate in ML III on the par value basis,
FRBNY provided transaction documents to them and then negotiated some
details with them.[Footnote 111] Over the course of the weekend
preceding November 10, 2008, ahead of the release of AIG's quarterly
earnings report, FRBNY had separate conversations with the eight
counterparties representing the most significant exposure for AIG.
FRBNY officials told us that these counterparties had the opportunity
to suggest amendments to contract language, and FRBNY incorporated
some of their comments into the final contracts. According to FRBNY
and counterparties we spoke with, the negotiated items generally
involved clarifications and technical items, not material economic
terms. While in principle, ML III was an easy transaction to describe,
there were important details to be worked out, involving such matters
as timing and delivery of the CDOs at issue, FRBNY officials told us.
After agreements were reached with the first group, FRBNY contacted
the next group of counterparties, whose holdings FRBNY officials said
were not significant compared to those of the first group. FRBNY
officials told us that ML III needed to have the same contract with
all the counterparties. According to our interviews, counterparties in
the second group asked for changes, but FRBNY declined. For example,
one counterparty told us it wanted to make procedural changes and
clarify certain terms. FRBNY would not do so, saying that other
counterparties with larger exposures had already commented on the
terms. FRBNY made clear it was up to the counterparty to decide
whether it wanted to engage on the terms offered, executives of the
counterparty told us. Our review also identified at least one instance
where a counterparty in the first group of eight was allowed to amend
contract language after signing ML III agreements. FRBNY characterized
the changes as technical and clarifying.
The Federal Reserve's Actions Were Generally Consistent With Existing
Laws and Policies, but They Raised a Number of Questions:
The actions of the Federal Reserve System in providing several rounds
of assistance to AIG involved a range of laws, regulations, and
procedures. First, we found that while the Federal Reserve Board
exercised its broad emergency lending authority to aid AIG, it did not
make explicit its interpretation of that authority and did not fully
document how its actions derived from it. Second, after government
intervention began, FRBNY played a role in the federal securities
filings that AIG was required to make under SEC rules. We found that
although FRBNY influenced AIG's filings, it did not direct the
company's decisions about what information to file for public
disclosure about key details of federal aid. Finally, in providing
assistance to AIG, FRBNY implemented vendor conflict-of-interest
procedures similar to those found in federal regulations, but granted
a number of waivers to conflicts that arose. In addition, we
identified a series of complex relationships involving FRBNY, its
advisors, AIG counterparties, and service providers to CDOs in which
ML III invested that grew out of the government's intervention.
The Federal Reserve Exercised Its Broad Emergency Lending Authority to
Aid AIG but Did Not Fully Document Its Decisions:
When the Federal Reserve Board approved emergency assistance for AIG
beginning in September 2008, it acted pursuant to its authority under
section 13(3) of the Federal Reserve Act. At the time, section 13(3)
authorized the Federal Reserve Board, in "unusual and exigent
circumstances," to authorize any Reserve Bank to extend credit to
individuals, partnerships, or corporations when the credit is endorsed
or otherwise secured to the satisfaction of the Reserve Bank, after
the bank obtained evidence that the individual, partnership, or
corporation was unable to secure adequate credit accommodations from
other banking institutions.[Footnote 112] The Reserve Bank making the
loan was to establish the interest rate in accordance with section
14(d) of the Federal Reserve Act, which deals with setting of the
Federal Reserve discount rate.[Footnote 113]
In authorizing assistance to AIG, the Federal Reserve Board
interpreted its broad authority under section 13(3) as giving it
significant discretion in satisfying these conditions.[Footnote 114]
The statute does not define "unusual and exigent circumstances," and,
according to our review, the Federal Reserve Board believes it has
substantial flexibility in assessing whether such circumstances exist.
The statute also does not define an inability "to secure adequate
credit accommodations from other banking institutions" or set forth
any standards for Reserve Banks to use in making this determination.
As a result, Federal Reserve Board staff have stated that the Federal
Reserve Board would be accorded significant deference in defining this
standard. The Federal Reserve Board notes that its Regulation A--which
governs extensions of credit by Reserve Banks, including emergency
credit--does not require any specific type of evidence and bases the
finding about credit availability on the "judgment of the Reserve
Bank."[Footnote 115]
As noted, the statute authorizes Reserve Banks engaging in section
13(3) emergency lending to establish interest rates in accordance with
section 14(d) of the Federal Reserve Act. Section 14(d), which
authorizes Federal Reserve banks to establish rates for discount
window lending, is implemented by Regulation A.[Footnote 116] Federal
Reserve Board staff have stated that while Regulation A contains
provisions relating to the rate for emergency credit from Reserve
Banks, these provisions do not limit its power to authorize lending
under section 13(3) in other circumstances and under other limitations
and restrictions. The Federal Reserve Board's rationale is that
section 13(3) further allows it to authorize a Reserve Bank to extend
credit to an individual, partnership, or corporation "during such
periods as the said board may determine" and "subject to such
limitations, restrictions, and regulations as the [Board] may
prescribe." As a result, the Federal Reserve Board has stated that it
has complete statutory discretion to determine the timing and
conditions of lending under section 13(3). Federal Reserve Board
officials told us that the interest rate the Reserve Bank recommends
to the Federal Reserve Board is based on the facts and circumstances
of a particular instance of lending, and that the rate need not be the
discount rate itself. Section 14(d) has never been viewed as linking
the interest rate on section 13(3) lending to the then-prevailing
discount rate, a Federal Reserve Board official told us.
The Federal Reserve Board views the section 14(d) rate-establishing
provision as procedural, an official told us, because the Reserve Bank
extending the loan proposes the rate and the Federal Reserve Board
must approve it. The official said that more analysis on rates takes
place at the Reserve Bank level than at the Federal Reserve Board.
Factors taken into account when setting rates include risk and moral
hazard. For example, one FRBNY official described the Revolving Credit
Facility as being akin to debtor-in-possession financing--that is, it
has a high interest rate, aggressive restrictions on AIG's actions, a
short term, and a substantial commitment fee. These features were
consistent with section 13(3), the official said, because if a loan is
risky, there must be sufficient protection for the Reserve Bank making
it.
Section 14(d) also directs that rates be set "with a view of
accommodating commerce and business." Federal Reserve Board officials
told us their view is that if the section 13(3) requirements for such
factors as unusual and exigent circumstances and inability to obtain
adequate financing from other banking institutions are met, then the
section 14(d) directive of "with a view of accommodating commerce and
business" is automatically satisfied.
Rates on the Federal Reserve Board's section 13(3) lending to aid AIG
have varied, as shown in examples in table 6.
Table 6: Rates on Selected Federal Reserve AIG-Related Lending:
AIG-related lending: Revolving Credit Facility;
Interest rate: 3-month LIBOR +8.5 percentage points;
Rationale for rate: Impose terms sufficiently high to provide
incentive for company to repay assistance, whether it borrowed all
available or not.
AIG-related lending: Maiden Lane III;
Interest rate: 1-month LIBOR +1 percentage point;
Rationale for rate: Hedge interest-rate risk by matching interest rate
on loan with rates paid on CDOs held in ML III portfolio.
AIG-related lending: For securitization of certain cash flows
(approval granted but lending not implemented);
Interest rate: Not set when loan approved (subject to further
analysis);
Rationale for rate: Set rate at level to assure "reasonable
likelihood" of repayment.
Source: GAO analysis based on Federal Reserve Board records and
interviews with officials.
Notes: Rate on Revolving Credit Facility was later revised twice. In
addition to items listed in the table, other AIG-related emergency
lending approved was the Securities Borrowing Facility, October 2008,
which was terminated with Maiden Lane II; and Maiden Lane II, November
2008.
[End of table]
Internal correspondence we reviewed discussed an FRBNY rationale for
setting interest rates, noting that different rates could be expected
based on the approach officials were taking. Under this approach,
FRBNY set rates for its lending to SPVs that provided assistance to
AIG according to risk and matching of the interest rate to
characteristics of assets that were related to a particular loan. For
example, FRBNY loan facilities held securities with floating rates
that paid interest monthly based on the 1-month LIBOR rate. Hence,
officials concluded that using the 1-month LIBOR rate as a base for
the interest rates associated with emergency loans to those facilities
was appropriate.[Footnote 117] In other cases, considerations were
different. For the restructuring of the Revolving Credit Facility, the
rationale for reducing the interest rate included stabilizing AIG,
boosting its future prospects, and satisfying credit rating agency
concerns. For the final, unused emergency lending facility, which
dealt with securitizing cash flows from certain insurance operations,
the rationale advanced was AIG's ability to pay.
The statute also does not impose requirements on the amount or type of
security obtained by a Reserve Bank for section 13(3) lending, other
than requiring that the loan be secured "to the satisfaction" of the
lending bank. The Federal Reserve Board has stated that the absence of
objective criteria in the statute leaves the extent and value of the
collateral within the discretion of the Reserve Bank making the loan.
As one Federal Reserve Board official told us, the security accepted
by the Reserve Bank could range from equity stock to anything with
value. As with interest rates, the security on emergency lending
associated with AIG assistance has varied. For example, the Revolving
Credit Facility was secured with assets of AIG and of its primary
nonregulated subsidiaries, and ML III used the CDOs purchased from AIG
counterparties as security for the SPV. For the facility approved but
not implemented, the security would have been cash flows from certain
AIG life insurance subsidiaries.
Although the statute has no documentation requirements, we requested
documentation of the Federal Reserve Board's interpretation of its
section 13(3) authority generally, as well as for each of its five
decisions to extend aid to AIG in particular. While the Federal
Reserve Board provided some documentation, it did not have a
comprehensive analysis of its legal authority generally under section
13(3), and it did not maintain comprehensive documentation of its
decisions to act under that authority to assist AIG. In particular, we
found the Federal Reserve Board's interpretation of its emergency
lending authority to be spread across various memorandums, with
limited analysis and varying degrees of detail. For the specific
decisions to assist AIG, the documentation provided some support
underlying use of the section 13(3) authority, but such analysis was
absent in some cases and incomplete in others. For example, for the
Revolving Credit Facility, Federal Reserve Board minutes and other
records we reviewed noted that the discussion of terms included
collateralizing the loan with all the assets of AIG and of its primary
nonregulated subsidiaries but did not include documentation of FRBNY's
determination that the loan was secured to its satisfaction. For ML II
and ML III, there was no documentation of how the interest rates on
the loans to each vehicle were established.[Footnote 118] For the
proposed facility to securitize life insurance subsidiary cash flows,
information we reviewed stated that it was well established that AIG
was unable to secure adequate credit accommodations from other sources
and that, with a projected fourth quarter 2008 loss exceeding $60
billion, it was unlikely to find adequate credit accommodations from
any other lender. However, there was no documentation that AIG was, in
fact, unable to secure adequate credit from other banking institutions.
Federal Reserve Board officials underscored that section 13(3) loans
by nature are done on a fast, emergency basis. They told us the Board
does not assemble and maintain documentary support for its section
13(3) lending authorizations. According to the officials, such
information, while not specifically identified, can generally be found
among the overall records the agency keeps and could be produced if
necessary, much as documents might be produced in response to a
lawsuit. Further, the officials told us, any necessary evidence or
supporting information was well understood by the Federal Reserve
Board and FRBNY during the time-pressured atmosphere when section
13(3) assistance was approved for AIG, beginning in September 2008 and
continuing into 2009. As a result, it was not necessary to compile a
formal assembly of evidence, the officials told us.
As noted previously, recent legislation has amended section 13(3)
since the Federal Reserve Board approved emergency lending for AIG. In
the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act), Congress limits future use of section 13(3) lending to
participants in programs or facilities with broad-based eligibility
and restricts assistance to individual companies under specified
circumstances.[Footnote 119] The act also mandates greater disclosure
about section 13(3) lending, requiring the Federal Reserve Board to
establish, by regulation and in consultation with Treasury, the
policies and procedures governing such emergency lending. In addition,
the establishment of emergency lending programs or facilities would
require prior approval of the Secretary of the Treasury. The Federal
Reserve Board is also required to report to Congress on any loan or
financial assistance authorized under section 13(3), including the
justification for the exercise of authority; the identity of the
recipient; the date, amount and form of the assistance; and the
material terms of the assistance.
As part of our recent review of the Federal Reserve System's
implementation of its emergency lending programs during the recent
financial crisis, we identified instances where the Federal Reserve
Board could better document certain decisions and processes.[Footnote
120] As a result, we recommended that the Federal Reserve Board set
forth its process for documenting its rationale for emergency
authorizations and document its guidance to Reserve Banks on program
decisions that require consultation with the Federal Reserve Board.
[Footnote 121] These actions will help address the new reporting
process required by the Dodd-Frank Act and better ensure an
appropriate level of transparency and accountability for decisions to
extend or restrict access to emergency assistance.
The Federal Reserve Influenced AIG's Securities Filings About Federal
Aid but Did Not Direct the Company on What Information to File:
During the financial crisis, questions arose about FRBNY's involvement
in AIG's exclusion of some ML III-related information from its federal
securities filings--counterparty transaction details and the
description of a key ML III design feature.
In December 2008, after ML III was created, AIG filed two Form 8-K
statements with SEC related to ML III, following consultations with
FRBNY.[Footnote 122] The filings included the Shortfall Agreement but
not the agreement's Schedule A attachment, which contained ML III
counterparty and CDO deal information. As noted earlier, under the
Shortfall Agreement, ML III transferred about $2.5 billion to AIGFP
for collateral adjustment purposes. This amount was based on what
FRBNY officials described as excess collateral that AIGFP had posted
to the counterparties, based on fair market values determined for the
CDOs in the ML III portfolio.
SEC noted the Schedule A omission and told AIG that under agency
rules, it must include the schedule for public disclosure or request
confidential treatment of the information in it.[Footnote 123]
Subsequently, AIG filed a confidential treatment request (CTR) for the
information.[Footnote 124]
FRBNY became involved in AIG's ML III filings after the company had
failed to consult FRBNY or its advisors on an earlier company filing
on the Revolving Credit Facility, which contained inaccurate
information about details of the facility. FRBNY objected to the
information, and AIG corrected its filing and agreed to consult on
future filings in advance. The ML III agreement contained a
confidentiality clause in which AIG generally agreed to keep
confidential nonpublic information and to provide notice of any
proposed disclosure. AIG executives told us that they expected FRBNY,
given its role in assisting the company, to review securities filings
and other information involving the Federal Reserve System. FRBNY
officials told us they concurred that if counterparty information was
to be released, it would be reasonable for FRBNY, as a co-venturer, to
have the ability to express an opinion.
We found that FRBNY, through its counsel, in November 2008 told AIG it
did not believe the Shortfall Agreement needed to be filed at the
time.[Footnote 125] When that effort was unsuccessful, and AIG moved
to file the agreement nonetheless, FRBNY then urged that the Schedule
A counterparty information be omitted from the company's filings.
FRBNY was also influential in shaping AIG's arguments to SEC in
support of the company's request to keep the counterparty information
confidential. In particular, FRBNY and its advisers made what they
described as significant comments and edits to AIG filings regarding
the information claimed as confidential, according to FRBNY officials
and correspondence we reviewed. After AIG filed its CTR and SEC
officials had reviewed and commented on it, FRBNY remained active in
pursuing the CTR matter. Officials discussed making direct contact
with SEC on the information they did not want the company to disclose.
When SEC requested a telephone conference with the company to discuss
the issues, FRBNY officials and its counsel began considering what
information FRBNY should present to SEC, after first checking with AIG
about the matter.
FRBNY's public arguments for confidentiality were twofold: that the
counterparty information was commercially sensitive for the parties
involved but did not provide material information to investors, and
that disclosure could hurt the ability to sell ML III assets at the
highest price, potentially to the detriment of taxpayers and AIG. In
addition to these publicly stated reasons, FRBNY staff in internal
correspondence also discussed other rationales for withholding
Schedule A information. One was unspecified policy reasons, which
officials later told us may have referred to the general practice of
keeping the identities of discount window borrowers confidential.
Another was that disclosure could attract litigation or Freedom of
Information Act requests. A third such rationale was that seeking
confidential treatment for all of Schedule A, and not just portions,
could be a useful negotiating strategy because seeking protection for
the entire document could make SEC more likely to grant such a
request. FRBNY officials told us these other rationales were opinions
voiced during internal discussions before FRBNY took a formal
position. According to FRBNY officials, there was also concern that
release of the information for ML III could lead to demands for
release of similar information for other Federal Reserve System
emergency lending facilities--ML II, which was created to deal with
problems in AIG's securities lending program, and Maiden Lane, a
vehicle created in March 2008 to facilitate JPMorgan Chase & Co.'s
merger with Bear Stearns.[Footnote 126]
As part of its involvement, FRBNY participated in three teleconference
calls with SEC officials about AIG's CTR filing, according to SEC
records and officials. On January 13, 2009, the day before AIG filed
its request with SEC, FRBNY officials at their request spoke with SEC
to explain the ML III transaction. Another call came on March 13,
2009, when representatives of AIG and FRBNY contacted SEC to say that
AIG intended to file an amended CTR in response to SEC comments on the
original request. The third call, on April 22, 2009, took place at
SEC's request to discuss AIG's competitive harm arguments. SEC, AIG,
and, at AIG's request, FRBNY participated in that call. According to
SEC, discussions with FRBNY were at the staff level.
While SEC was reviewing AIG's CTR, the company considered dropping its
request, thus making all the contested information public. However,
FRBNY officials convinced the company not to do so. By that point,
FRBNY was willing to have some information released, such as
counterparty names and amounts paid, but did not want to release other
material, such as information related to individual securities,
according to correspondence we reviewed. The specific concern was that
release of security-specific information could allow market
participants to identify ML III holdings. FRBNY officials told us they
made their opinion known to AIG, and that such communication was
appropriate given that FRBNY was a major creditor to ML III. AIG
concurred with FRBNY's concerns, according to an FRBNY communication.
[Footnote 127]
According to interviews and information we reviewed, underlying
FRBNY's desire that AIG not file sensitive ML III information with SEC
was concern that such information could then be requested by Congress
and ultimately be made public. This was because SEC rules require that
applicants for CTRs consent to furnishing the information claimed as
confidential to Congress, among others. SEC officials told us that
although there are no records of Congress requesting such information,
their best recollection is that Congress has never sought information
filed in a CTR with the agency.[Footnote 128]
SEC's handling of AIG's confidentiality request was routine, SEC
officials told us, albeit under unusual circumstances. SEC officials
told us they viewed FRBNY's involvement with the agency as that of a
counterparty to an agreement with a company required to make filings.
In such a situation, it is not common for a counterparty to contact
SEC, officials told us. In addition, FRBNY's participation was more
active than would be expected of a counterparty, they said. Officials
said the agency processed AIG's CTR using its normal CTR review
process, and that SEC's review of the request was prompt. But
circumstances were unusual for several other reasons, SEC officials
told us. First, the AIG filings had been targeted for heightened
scrutiny as part of special review efforts arising out of the
financial crisis and government aid to private companies. These
efforts involved continuous review of selected companies' filings.
Second, FRBNY--which FRBNY officials characterized as a federal
instrumentality--was an involved party. Third, in response to FRBNY
concerns, SEC allowed a special drop-off procedure for the CTR aimed
at protecting the information from disclosure.[Footnote 129] This
action came after SEC had declined FRBNY requests for special ways to
provide the information for SEC review, such as by SEC officials going
to FRBNY offices to review relevant material or FRBNY officials
showing SEC the information at SEC headquarters but outside the normal
filing system. Finally, the case reached SEC's associate director
level and eventually the SEC Chairman. Officials told us that due to
AIG's high public profile, the Chairman was advised immediately before
the CTR determination on the Schedule A information. SEC officials
told us this was not typical. It is rare for SEC staff to brief the
Chairman on a CTR determination, they said, but that was done in this
case due to anticipated publicity for the matter.
AIG's original CTR sought confidential treatment for all of the
Schedule A information. On May 22, 2009, SEC granted the company's
request, but only in part.[Footnote 130] SEC officials said AIG's
initial CTR was too broad, and the agency, through its review process,
narrowed the scope of the request. As part of its review, SEC
officials provided AIG with detailed comments and questions after
reviewing its request and also monitored information that was already
publicly available to determine if AIG's CTR should be amended to
reflect that availability.
SEC officials said that notwithstanding FRBNY's unusual involvement,
they examined the case from the usual standpoint of investor
protection, in which the key issue was harm to AIG. Any harm to the
Federal Reserve System was not an SEC issue, officials told us. The
agency determined that the following elements of the Schedule A
information should not be treated confidentially, and thus should be
disclosed:
* counterparty names;
* amount of cash collateral posted;
* CDO pricing information that reflected the securities' loss in
market value;
* complete Schedule A information for 10 CDOs, including CUSIP
identifier, tranche name, and notional value, as related information
had previously been made public;[Footnote 131]
* totals for notional value, collateral posted, and revised values
based on market declines for all CDOs; and:
* all Schedule A titles and headings.
Except for the 10 CDOs cited, SEC permitted confidential treatment of
the following information for each of the other CDOs listed in
Schedule A: CUSIP number, tranche name, and notional value. However,
the SEC action eventually became moot, as on January 29, 2010, AIG
amended its 8-K filings to fully disclose Schedule A.[Footnote 132]
We also found that the desire to keep Schedule A-type information
confidential was not a new position for AIG. Before ML III and any
government assistance, AIG had sought protection for similar
information on the basis that it was confidential business
information. Specifically, in response to an unrelated request for
information from SEC, AIG in August 2008 requested that CDO-related
information be kept confidential.[Footnote 133]
In addition to Schedule A, another disclosure issue arose later, after
the CTR matter, out of FRBNY's involvement in AIG's securities filings
regarding the description of a key ML III design feature. An early
draft of an AIG securities filing for December 2008 explaining the ML
III transaction contained this sentence:
"As a result of this transaction, the AIGFP counterparties received
100 percent of the par value of the Multi-Sector CDOs sold and the
related CDS have been terminated."
At the request of FRBNY's outside counsel, AIG omitted this language
from its filing, company executives told us.[Footnote 134] This
omission led to criticism that FRBNY was seeking to conceal
information about payments to AIG's counterparties.[Footnote 135] AIG
executives told us the company omitted this language because of
concerns that it misrepresented the transaction, as ML III itself was
not paying par value. Instead, as noted, ML III paid an amount that,
when combined with collateral already posted by AIG to the
counterparties, would equal par value (or near par value). In internal
correspondence, FRBNY also said "par" was inaccurate, as
counterparties paid financing charges and had to forgo some interest
earnings. Thus, the amount received was less than par when all costs
were considered; in some cases, the difference was in the tens of
millions of dollars.
We found that two units of SEC--the Division of Corporation Finance
and the New York Regional Office--examined the deletion of the par
value statement and concluded there was no basis for an enforcement
action for inadequate disclosure. SEC staff considered whether AIG's
filing provided enough information for investors to see that the sum
of the collateral counterparties kept and the payments from ML III
amounted to 100 percent of value. SEC has not brought any enforcement
action concerning this issue.
In February 2010, FRBNY issued a memorandum formalizing its process
for reviewing AIG's securities filings. The memorandum emphasizes that
AIG is solely responsible for the content of its filings, and that any
FRBNY review is to promote accuracy or protect taxpayer interests. It
also specifies material to be subject to review.
Ultimately, according to both AIG and FRBNY, the company retained
responsibility for its own filings. Based on our review, we found that
while FRBNY's involvement was influential, it was not controlling. AIG
did not comply with all FRBNY requests about information in its
filings. Also, later in the process, after Schedule A information was
released publicly, an AIG executive reported to an SEC official that
FRBNY had told the company to make its own decision on whether to
disclose full Schedule A information in filings with SEC. According to
AIG executives, there was no occasion when AIG strongly disagreed with
a course advocated by FRBNY but adopted FRBNY's position nonetheless.
SEC enforcement staff found that AIG exercised independent judgment.
The staff examined correspondence related to AIG filings, and their
review showed that although FRBNY had a viewpoint it was not reluctant
to express, AIG nevertheless remained actively involved in the process
and exercised its own independent judgment on what its filings should
say. More broadly, although FRBNY was aware of criticism that ML III
funds were provided to unnamed counterparties or foreign institutions,
we found no evidence that FRBNY urged AIG to withhold information in
order to conceal identities or nationalities of the counterparties.
According to FRBNY officials, FRBNY's involvement with AIG illustrated
the dual role of a central bank as a public institution that sometimes
must also carry out private transactions as a private market
participant. In our review, we considered whether FRBNY's involvement
in AIG's securities filings was consistent with what might be expected
in the private-sector under similar circumstances. We found that in
broad terms, FRBNY's activities appear to be consistent with actions
of a significant business partner.
The government assumed multiple roles in assisting AIG. Through its
arrangement for initial aid, a government vehicle became the company's
majority equity investor.[Footnote 136] Its emergency lending also
made it a significant creditor to AIG. In addition, FRBNY was a joint
venturer with AIG in ML III. In the private-sector, any of these roles
could provide a basis for involvement in a company's affairs. Majority
shareholders can have significant influence--for example, by naming
the board, which exercises control over significant aspects of a
company's business. A company might consult with a majority owner on
business decisions and might share draft securities filings. Creditor
involvement in company affairs can be extensive, particularly in times
of stress. Credit agreements can include detailed affirmative and
negative covenants--requirements to take, or refrain from, certain
actions--through which creditors can shape and constrain financing,
management, and strategic decisions. Agreements often require
corporations to provide extensive financial information to the
creditor. In the case of joint venturer, the academic research we
reviewed does not discuss the influence that private-sector
counterparties may have over each others' SEC filings. However,
individuals with whom we spoke indicated sharing draft filings in a
merger and acquisition context is common. Parties to a joint venture
may share draft filings as well.
The circumstances of Federal Reserve System aid to AIG preclude a
direct private-sector comparison for several reasons. Majority
ownership of large public companies is unusual. The trust agreement
for the government's AIG holdings placed limitations on the trust's
role as shareholder. In addition to any assistance relationship with
AIG, the government, via OTS, has also had a regulatory relationship
with the company. The government also had goals in the AIG
intervention beyond those of typical private-sector actors: attempting
to stabilize financial markets and the broader economy. Nevertheless,
through its various actions, the government provided significant
resources to AIG and took on significant risk in doing so. A private
party in similar circumstances could be expected to become involved in
company affairs.[Footnote 137]
While FRBNY Implemented Updated Vendor Conflict-of-Interest Procedures
in Providing AIG Assistance, Aid Gave Rise to Complex Relationships
that Posed Challenges:
To provide emergency assistance that the Federal Reserve Board
approved for AIG, FRBNY contracted for financial advisors to perform a
range of activities for the Revolving Credit Facility and ML
III.[Footnote 138] FRBNY retained its principal financial advisors for
the Revolving Credit Facility and ML III in September and October
2008. According to FRBNY officials, they awarded contracts for at
least two of the advisors without competitive bidding, due to exigent
circumstances.[Footnote 139] They said there was insufficient time to
bid the services competitively as advisors were needed to quickly
begin setting up the program.
For the Revolving Credit Facility, the principal financial advisors
were Ernst & Young and Morgan Stanley, which were engaged for these
main duties:
* structuring the loan documentation between FRBNY and AIG after the
company accepted FRBNY's initial loan terms on September 16, 2008;
* providing advisory services for AIG asset sales;
* performing valuation work on AIG securities posted as collateral to
secure the Revolving Credit Facility;
* calculating AIG cash flow projections to monitor the company's use
of cash, plus actual and predicted draws on the Revolving Credit
Facility;
* advising FRBNY on how to address rating agency and investor
concerns; and:
* monitoring Revolving Credit Facility requirements on information AIG
must provide to FRBNY to identify any instances where AIG did not
comply.
For ML III, FRBNY's three primary financial advisors have been Morgan
Stanley, Ernst & Young, and BlackRock, Inc., which were engaged for
these main duties:
* developing alternate designs for ML III;
* identifying CDO assets for inclusion in ML III;
* valuing CDO securities under economic stress scenarios;
* advising FRBNY on how to structure the transaction to address rating
agency and investor concerns; and:
* managing the ML III portfolio for FRBNY.[Footnote 140]
FRNBY has also contracted for two other vendors to provide key
services for ML III: Bank of New York Mellon performs accounting and
administration for the ML III portfolio, and another vendor, Five
Bridges Advisors, conducts valuation assessments.
One of the factors FRBNY considered when selecting vendors was
potential conflicts of interest. In general, potential and actual
conflicts of interest can arise at either the personal or
organizational levels. A personal conflict could arise, for example,
through the activities of an individual employee, whereas an
organizational conflict could arise through the activities of a
company or unit of a firm. Our work focused on potential
organizational conflicts of interest that involved the Revolving
Credit Facility and ML III. When FRBNY engaged its Revolving Credit
Facility and ML III advisors, FRBNY had its Operating Bulletin 10 as
guidance, which applies to vendor selection but did not include
provisions on vendor conflicts.[Footnote 141] By contrast, Treasury,
which has also engaged a number of vendors in implementing TARP, in
January 2009 issued new interim guidelines for its management of TARP
vendor conflicts of interest. The Treasury regulations provide that a
"retained entity"--generally, an individual or entity seeking or
having a contract with Treasury--shall not permit an organizational
conflict of interest unless the conflict has been disclosed to
Treasury and mitigated under an approved plan, or unless Treasury has
waived the conflict.[Footnote 142]
However, even though FRBNY guidance did not have provisions on vendor
conflicts, FRBNY officials told us that they held internal discussions
to identify potential advisor conflicts that could arise. FRBNY also
identified some activities, such as providing advisory services, as
presenting a greater risk of conflict than other activities, such as
administrative services where there is no discretionary or advisory
role. As a result, FRBNY subjected the advisors to greater conflict of
interest scrutiny. Based on its internal discussions, FRBNY identified
a number of potential conflicts, including two main types of conflicts
for advisors other than its investment advisor:
* instances in which AIG or its subsidiaries seek entities serving as
FRBNY advisors to assist them, for matters in the past, present, or
future; and:
* instances in which potential buyers of AIG assets seek entities
serving as FRBNY advisors to assist them, for matters in the past,
present, or future.
Without specific conflict policies for its advisors in its established
guidance, FRBNY relied upon contract protections and what officials
said was day-to-day vendor management to address certain conflict
situations. For example, one advisor's agreement with FRBNY provided
that when a potential buyer of AIG assets, also known as a "buy-side"
firm, sought transaction advisory services from the advisor, the
advisor was to determine if it could perform all services for each
party objectively and without compromising confidential information.
Upon determining it could be objective, the advisor was to notify
FRBNY and AIG of the names of each potential buyer and provide an
opportunity for FRBNY and AIG to discuss the scope of services the
advisor would provide to the would-be buyer. Another advisor's
agreement similarly provided for seeking FRBNY's consent before
entering into transactions that would create a conflict. Contractual
conflict mitigation procedures included separation of employees
conducting work for FRBNY from those doing buy-side advisory work, as
well as information barriers to prevent sharing of confidential
information between FRBNY engagements and the advisor's other work.
One advisor's engagement agreement also had a provision giving FRBNY
the right to audit the advisor's performance and determine whether it
was in compliance with requirements. According to FRBNY, it performed
conflict of interest reviews of four advisors providing AIG-related
services.[Footnote 143]
Similarly, the ML III investment management agreement of November 25,
2008, by and among FRBNY, ML III, and BlackRock, noted potential
conflicts and provided mitigation procedures involving employee
separation of duties and information barriers. Among other things,
BlackRock employees engaged for ML III are not permitted to perform
managerial or advisory services related to ML III assets for third
parties or to provide valuation services for third parties for those
assets without FRBNY's consent. BlackRock is also barred from
recommending or selecting itself as a replacement collateral manager
for any ML III CDO.[Footnote 144] Further, it cannot knowingly
purchase for ML III any asset from a portfolio for which it serves as
an investment advisor or knowingly sell any ML III assets to
portfolios for which it serves as an investment advisor. However,
BlackRock may aggregate trading orders for ML III-related transactions
with similar orders being made simultaneously for other accounts the
advisor manages, if aggregating the orders would benefit FRBNY.
[Footnote 145]
In addition to the contract provisions, in December 2008 FRBNY asked
its Revolving Credit Facility advisors to disclose potential and
actual conflicts arising from their duties and to provide a
comprehensive plan to mitigate such conflicts. The mitigation plan was
to include implementation steps, conflict issues that were reasonably
foreseeable, and identification of how the advisor would notify FRBNY
of conflicts identified in the course of their duties. FRBNY requested
this information to assist it in developing an approach to managing
conflicts related to AIG assistance and other Federal Reserve System
emergency facilities created to address the financial crisis.[Footnote
146] In response, the advisors provided general information on their
conflict-of-interest policies and procedures, according to FRBNY
officials. Officials told us that FRBNY did not make the same request
of one of its ML III advisors because FRBNY had been working with the
advisor on a frequent basis for some time and the officials felt they
understood the advisor's conflict issues and policies.
Over the course of FRBNY assistance to AIG, FRBNY's advisors have
disclosed a number of conflict situations, both when first engaged and
subsequently while performing their duties. These have involved
several kinds of conflicts, which FRBNY has waived or permitted to be
mitigated.[Footnote 147] When signing their agreements with FRBNY, one
advisor disclosed two buy-side advisory engagements that were
underway. FRBNY permitted the arrangements, provided that employee
separation and information barriers be created and that the advisor
not provide FRBNY with advisory services related to certain potential
AIG divestitures. However, FRBNY's consent still allowed some
potential sharing of information between separate employee teams at
the advisor. Two advisors had teams providing advisory services to
AIGFP when FRBNY engaged them. Both FRBNY and AIG agreed to waive the
potential conflicts. One advisor was working on a broad range of
advisory and tax services for AIG. Another was involved in analysis of
certain AIG CDOs and the RMBS portfolio associated with AIG's
securities lending program. One ML III advisor reported that it was a
collateral manager for certain CDOs in which ML III was an investor,
and it was allowed to continue subject to conditions.[Footnote 148]
FRBNY officials told us their general approach to conflict issues such
as these was to rely on information barriers, which are intended to
prevent sensitive information from being shared among people or teams,
and to avoid having the same people work in potentially conflicting
roles, such as both buy-side and sell-side engagements. We note,
however, that such precautions involve a trade-off: all else equal,
these measures may protect against conflicts, but they can also
preclude application of skills or resources that would otherwise be
available.
FRBNY and its advisors also set up regular communications for
addressing conflicts. For example, one advisor would provide FRBNY
with a weekly list of projects requested by AIG subsidiaries or
potential acquirers of AIG assets. After considering whether it could
accept the project, the advisor would seek waivers from FRBNY when
necessary. FRBNY officials told us that they discussed the projects,
addressed concerns, and raised questions as needed. The advisor would
also get approval of the project proposals from AIG. Another advisor
likewise presented potential project requests to FRBNY as they arose.
This process was written into a new engagement letter in November
2010. Conflict provisions for another advisor included advisor
identification of conflict situations to FRBNY and use of appropriate
trading limitations.
As part of its conflict management process, FRBNY commissioned
compliance reviews for several Revolving Credit Facility and ML III
advisors in order to assess the advisors' policies and identify
potential conflicts. One review found several instances in which the
advisors allowed employees to work on an engagement for an AIG
subsidiary, but these situations were disclosed to FRBNY and the staff
in question were reassigned. Another review that covered several
Federal Reserve System lending facilities noted that the ML III
investment management agreement did not require conflict policies and
procedures tailored specifically for ML III. Due to the complexity of
ML III assets and the presence of third parties that could influence
the portfolio, the report said that FRBNY should consider requiring an
advisor to revise its policies and procedures to address unique issues
raised by ML III, including potential conflicts and mitigating
controls. As discussed later, in May 2010, FRBNY implemented a new
vendor management policy to serve as a framework to minimize
reputational, operational, credit, and market risks associated with
its use of vendors.
FRBNY Has Granted a Number of Waivers to Its Conflict Prohibitions:
Our review of advisor records showed that FRBNY's Revolving Credit
Facility advisors have requested at least 142 waivers for AIG-related
projects and buy-side work. FRBNY has granted most of these waiver
requests. According to FRBNY officials, overall figures on conflict
waiver requests and outcomes are not available because FRBNY did not
begin tracking the requests until about January 2010, about 16 months
after government assistance began.
According to the records, one advisor made at least 132 conflict
waiver requests to FRBNY for the period of 2008 to 2011.[Footnote 149]
The work requested covered an array of advisory projects involving AIG
business units. The records did not indicate how many requests FRBNY
granted consent for, but according to FRBNY officials, FRBNY granted a
large majority of them on the condition of employee separation and
information barriers.
Another advisor initially made 10 conflict waiver requests but later
dropped one. The remaining nine requests covered at least the 2009-
2011 period, with five related to work requested by AIG and four
related to work on behalf of potential buyers of AIG assets. The AIG
projects were for such matters as assisting with asset sales and
raising funds for subsidiaries. The buy-side projects related to
acquisition and financing of AIG assets. FRBNY granted four waiver
consents for AIG-related work and two for buy-side transactions. For
example, according to FRBNY, it denied one of the conflict waivers in
an instance where the advisor provided FRBNY with sell-side advice and
deal structuring for a potential AIG asset sale. The advisor requested
a waiver to participate in financing to assist the buy-side client to
the transaction. According to FRBNY, officials decided that the
advisor had been too involved in providing FRBNY with advice and thus
turned down the waiver request. In another case, the advisor was in a
situation where it had multiple roles involving an AIG subsidiary. One
unit of the advisor recommended AIG sell the subsidiary, while another
recommended AIG conduct an initial public offering of stock. The
advisor was providing FRBNY with advice at the same time it was
advising a potential purchaser. The conflict issue became moot when
the sale idea was abandoned, but before that, FRBNY had decided not to
allow a conflict waiver, officials told us.
In cases such as these, FRBNY officials said they considered
separation of duties to be a significant mitigating factor, because
individuals with access to AIG-related information would not be
staffed to other potentially conflicting engagements.
Overlapping Interests of FRBNY and AIGFP Have at Times Created
Competing Interests:
FRBNY's interests as an ML III creditor and its interest in the health
of AIG have created competing interests because the interests of ML
III and AIGFP overlap: (1) AIGFP owns tranches in the same CDOs in
which ML III owns tranches[Footnote 150] and (2) AIGFP has been an
interest rate swap counterparty to certain CDOs in which ML III is an
investor.[Footnote 151] These interests have resulted in circumstances
where ML III and AIGFP have either worked together or instead have had
conflicts due to divergent interests. FRBNY has identified instances
in which decisions made that reflect the overlapping interests could
have led to a total of as much as $727 million in losses or foregone
gains for ML III. However, ML III gains could have come at the expense
of AIGFP, the health of which is also of interest to the Federal
Reserve System.
In December 2009, FRBNY's Investment Support Office documented 10 such
instances in 2008 and 2009, including the following:
* In three instances, the ML III portfolio lost a total of $72.5
million, with AIGFP gaining at least $59.3 million. For example, in
one instance, ML III and AIGFP together held voting rights to control
a CDO. A default occurred, and FRBNY's ML III advisor sought AIGFP's
consent to "accelerate" the CDO, a process that would have directed
cash flows to the benefit of both ML III and AIGFP. However, AIGFP
declined to cooperate because it was in a dispute with the CDO manager
on another transaction. FRBNY believed AIGFP did not want to
antagonize the manager by voting to accelerate the CDO, which would
have reduced the manager's fee income.
* In three instances, ML III saw total gains of $5.6 million. For
example, in one instance, AIGFP agreed to vote with ML III to direct a
CDO trustee to terminate a CDO manager and replace it with a new
manager at reduced cost.
* In two instances, FRBNY refrained from taking action, in its role as
managing member of ML III, for the benefit of AIGFP. This resulted in
foregone ML III gains of up to $660 million. At issue was potential
termination of interest rate swap protection AIGFP provided on certain
CDOs in which ML III was an investor.[Footnote 152] FRBNY's Risk
Advisory Committee considered the issue in February 2009, deciding
that ML III should refrain from exploring termination of the interest
rate swaps, because there was a potential loss at AIGFP that would not
be offset by the gain to ML III, and because there was concern that
terminating the swap protection could have encouraged other market
participants to do the same, to AIGFP's detriment, the committee
indicated. The $660 million was a maximum potential gain for ML III,
assuming the swap termination would have been successful, FRBNY
officials told us, although they expected AIG to vigorously oppose any
attempts to terminate.
Overall, FRBNY officials told us that if different choices had been
made in these instances, then AIGFP rather than ML III would have
suffered losses, which would have had direct and indirect implications
for the Federal Reserve System and the larger public interest.
Assistance Gave Rise to Complex Relationships among the Parties:
We also reviewed a number of other relationships that resulted from
FRBNY's assistance to AIG. These involve (1) the continuing
involvement of AIG's CDS counterparties with CDOs in which ML III is
an investor; (2) other relationships among parties involved in AIG
assistance, such as FRBNY vendors and advisors; (3) regulatory
relationships; and (4) cross-ownership interests. Figure 7 depicts a
number of these situations, which are discussed in further detail in
the sections following.
Figure 7: Roles and Relationships among the Federal Reserve, Its
Advisors, and Other Parties:
[Refer to PDF for image: illustration]
Advisor relationships:
Federal Reserve:
Receives guidance and assistance form Federal Reserve Advisors in
designing and providing aid to AIG.
Federal Reserve Advisors:
Give guidance and assistance to Other interested parties:
* Potential buyers of AIG assets;
* Advising AIG or AIG Financial Products unit.
Federal Reserve:
Oversees two of its advisors.
Relationships centering on Maiden Lane III:
Federal Reserve:
Major creditor (using emergency lending authority); Maiden Lane III
structure selected in part to avoid relationship between Federal
Reserve and AIG counterparties.
AIG counterparties:
Sale of CDOs (in effort to avoid relationship with Federal Reserve) to
Maiden Lane III vehicle;
Services (maintaining relationship to Maiden Lane III);
Maiden Lane III vehicle:
Reinvests funds with one AIG counterparty.
Federal Reserve Advisors:
Services to Maiden Lane III vehicle: Portfolio of CDOs.
Service contracts with AIG counterparties.
Cross-ownership between Federal Reserve Advisors and AIG
counterparties.
Cross-ownership with Service providers to Maiden Lane III vehicle.
Ownership interest (an AIG counterparty held an ownership interest in
a Federal Reserve advisor).
Source: GAO summary, based on interviews with participants, and review
of records from the Federal Reserve Board, FRBNY, an FRBNY advisor,
SNL Financial, and SEC.
[End of figure]
Links to AIG counterparties. Our review identified continuing indirect
relationships between FRBNY and the AIG counterparties that sold CDOs
to FRBNY's ML III vehicle. The AIG counterparties have acted as
trustees and collateral managers to CDOs in which ML III is an
investor. They have also been interest rate swap counterparties to
these ML III CDOs and had other continuing relationships. For example,
our review of public data and information obtained from an FRBNY
advisor showed that five AIG counterparties have provided either CDO
trustee or collateral manager services to CDOs in which ML III is an
investor. The AIG counterparties thus continued to have involvement
with ML III and FRBNY via FRBNY's management of the assets in ML III.
For trustee services, our analysis identified four AIG counterparties
that sold assets to ML III that were trustees for CDOs in which ML III
is an investor. These counterparties accounted for 66 percent of the
trustees for CDOs in which ML III invests.[Footnote 153] For example,
Bank of America, which sold CDOs with a notional value of $772 million
to ML III, was trustee for 71, or 40 percent, of the CDOs in which ML
III invests. Trustee duties involve interaction with the ML III
investment manager, BlackRock; the ML III administrator, Bank of New
York Mellon; and by extension, FRBNY. FRBNY officials said the fact
that counterparties act as trustees shows that the trustee business is
highly concentrated, meaning that such relationships are difficult to
avoid. They also said they see little conflict because the job of a
trustee is largely ministerial. Table 7 provides a breakdown of the
trustees of CDOs in which ML III is an investor, showing AIG
counterparties among them.
Table 7: ML III CDO Trustees that Were Also AIG Counterparties:
AIG counterparty: Bank of America;
Percentage of ML III CDOs for which counterparty is trustee: 40%.
AIG counterparty: Wachovia;
Percentage of ML III CDOs for which counterparty is trustee: 16%.
AIG counterparty: Deutsche Bank;
Percentage of ML III CDOs for which counterparty is trustee: 9%.
AIG counterparty: HSBC;
Percentage of ML III CDOs for which counterparty is trustee: 1%.
AIG counterparty: Other;
Percentage of ML III CDOs for which counterparty is trustee: 34%.
Source: GAO analysis of CDO service provider data.
Notes: "Other" category reflects noncounterparty trustees. Figure for
Wachovia includes Wells Fargo & Co., which acquired Wachovia.
[End of table]
Our analysis also identified an additional AIG CDS counterparty--
Societe Generale, which sold CDOs with a notional value of $16.4
billion to ML III--as accounting for 31, or 17 percent, of all
collateral managers in the ML III portfolio.[Footnote 154] As
described previously, in the case of AIGFP's dispute with a collateral
manager, issues can arise with collateral managers. FRBNY officials
told us that collateral managers work for a CDO and its trustee, not
the CDO investors, and that investors have no right to direct the
collateral manager. However, some CDOs permit investors with
sufficient voting rights to direct a trustee to replace a collateral
manager if certain conditions have been met, officials said.
Another area of continuing relations involves interest rate swap
counterparties. As described earlier, interest rate swaps help manage
interest rate risk. Through December 31, 2008, three AIG
counterparties had a total of five swap arrangements with CDOs in
which ML III was an investor. To the extent that these swap
counterparties' interests diverge from ML III's interests, similar to
the AIGFP swap case discussed previously, issues can arise.
According to FRBNY and an advisor, AIG counterparties that sold CDOs
to ML III have also been involved with AIG's asset sales, the proceeds
of which have paid down federal assistance, such as the Revolving
Credit Facility. For example, one counterparty was involved in the
divestiture of AIG's ALICO, Star, and Edison life insurance
subsidiaries. Additionally, four other counterparties provided
advisory services to AIG, according to the advisor. FRBNY officials
told us they did not view such assistance in asset sales as raising an
issue.
Another continuing relationship arose temporarily through placement of
ML III cash in an investment account offered by an AIG counterparty.
For example, according to a December 2008 advisor memorandum, in
November and December 2008, ML III's portfolio holdings generated cash
flows of approximately $408 million, which were placed in the AIG
counterparty's investment fund. Later, according to FRBNY, it moved
most cash into U.S. Treasury bills, using the counterparty's fund as a
short-term holding account. FRBNY officials said the relationship was
not a concern, and that they chose the fund because it had flexibility
for withdrawals and offered the best return.
Advisor or vendor relationships. FRBNY advisors or vendors have also
acted as service providers to CDOs in which ML III is an investor. For
example, as noted previously, one ML III advisor reported to FRBNY
that it was collateral manager for CDOs in which ML III was an
investor. Specifically, the advisor managed other investor accounts
that held 11 CDOs managed by other parties and in which ML III held a
senior interest.[Footnote 155] According to FRBNY, the notional value
of the assets was approximately $539 million. The advisor also managed
one ML III CDO for which ML III held the super senior tranche, which
had a notional value of about $800 million. The advisor sought a
conflict waiver, and FRBNY consented, stipulating that the advisor
would not make management decisions or take a position contrary to the
interests of ML III and that the advisor would immediately seek to
sell the CDO positions in question where permissible.
Our review also identified instances in which this advisor has managed
other ML III-related CDO assets that it said presented a potential for
conflicts and where the advisor did not seek waivers from FRBNY. At
the time ML III was established, the advisor was investment manager
for clients owning approximately eight junior tranches in CDOs for
which ML III held the senior tranches. FRBNY officials said that under
the structure of the assets, neither the advisor nor ML III is able to
influence the CDO holdings.
We also found that the ML III administrator, Bank of New York Mellon,
has also been a trustee for individual CDOs in which ML III is an
investor. This means Bank of New York Mellon has had interests that
could diverge. Bank of New York Mellon has been the trustee for 50
CDOs in which ML III is an investor, or 28 percent of all trustees,
according to our analysis. As an individual CDO trustee, Bank of New
York Mellon is involved in such tasks as performing compliance tests
on the composition and quality of CDO assets; identifying CDO events
of default; and liquidating CDOs upon events of default at the
direction of CDO holders, subject to certain conditions.[Footnote 156]
As the administrator for the overall ML III portfolio, Bank of New
York Mellon's income would depend on the CDO assets held in the ML III
portfolio. But as noted previously, as trustee to individual CDOs, it
could be called upon to determine if CDOs are in default, which can
lead to liquidation if requisite conditions are met.[Footnote 157]
Such liquidations could reduce overall portfolio assets, and hence,
the administrator's income.[Footnote 158] FRBNY officials said that
this divergence of incentives is inherent in the CDO trustee business,
and they emphasized that as the ML III administrator, Bank of New York
Mellon had no authority to make ML III decisions.
According to FRBNY, Bank of New York Mellon performed custodial and
administrative services and had no discretion, and thus was considered
to present a low conflict risk. In the case of an ML III advisor
managing individual CDOs, or related assets, FRBNY officials told us
they examined individual situations as necessary.
Finally, our review also identified other relationships. For example,
an ML III advisor has had service contracts with the AIG
counterparties that sold CDOs to ML III. FRBNY officials told us they
did not consider these relationships to be of concern because the
advisor was not involved in direct negotiations with counterparties
with respect to ML III purchases of CDOs. Also, there are one or two
instances where interests in Maiden Lane--the vehicle for another
Federal Reserve System emergency program--hold tranches of CDOs in ML
III, FRBNY officials told us. In some cases, the interests of Maiden
Lane LLC and ML III could diverge, similar to the situations described
earlier relating to AIGFP and ML III. According to FRBNY, it manages
from the standpoint of its overall loans for assistance. FRBNY
officials also said that it would be rare that a loss to Maiden Lane
LLC would be greater than the gain to ML III.
According to FRBNY officials, they would have avoided any involvement
with the various parties if practicable. They said that the
relationships we identified, the majority of which stemmed from
arrangements that existed before ML III was established, reflected
areas that did not raise concern. From FRBNY's perspective, after
AIG's counterparties no longer owned the CDO positions sold to ML III,
those counterparties had no ongoing interest in ML III's structure or
interactions with FRBNY related to ML III. FRBNY officials said that
positions that ML III held in the CDOs came with the rights and
obligations the CDO structure itself stipulated, as well as the
trustees and collateral managers then involved--all of which predated
FRBNY's involvement. They acknowledged that FRBNY's ML III investment
manager presented the potential for conflict but said that adequate
measures were taken to avoid actual conflicts.
Regulatory relationships. The Federal Reserve System oversees two of
FRBNY's advisors, which means that while FRBNY has been receiving
advice from the advisors, it also has been responsible for oversight
of them.[Footnote 159] According to FRBNY, it has maintained its AIG
monitoring team separately from staff who perform supervisory duties.
The AIG monitoring staff has no contact with those involved in
supervision, officials told us. In addition, officials told us that
FRBNY policy requires bank supervisory information to be kept separate
from other operations, including separate computer systems.[Footnote
160]
As an example of attention to separation of supervisory duties, FRBNY
officials cited the case of MetLife, which in 2010 acquired AIG's
ALICO unit. MetLife is a bank holding company regulated by the Federal
Reserve System. At the time of the acquisition, there were inquiries
from an FRBNY MetLife team to the AIG team. When that happened,
officials said they immediately put in place an information barrier to
make clear that supervisory decisions would not be affected by
information the AIG team had. Officials saw the matter as a serious
potential conflict because FRBNY had an interest in seeing the
acquisition being completed, as that would aid repayment of federal
lending, while at the same time, it had a supervisory responsibility
for MetLife.
Cross-ownership. Cross-ownership occurs when parties have ownership
interests in each other--for example, if a company owns stock in
another firm and that firm owns stock in the first company. According
to academic literature we reviewed, such reciprocal ownership can
create mutual interests among the parties or interests that might not
have been present absent the ownership, which can diminish
independence between the parties. Our review found that a number of
AIG CDS counterparties, FRBNY advisors, and service providers to CDOs
in which ML III is an investor have held cross-ownership interests in
each other, both at the time ML III was established and more recently.
For example, we found that as of December 31, 2008--the end of the
quarter during which ML III was planned and formed--FRBNY ML III
advisor Morgan Stanley had stock holdings in nine AIG CDS
counterparties totaling at least $1.4 billion.[Footnote 161] Among
those nine counterparties, four have been service providers to CDOs in
which ML III is an investor (such as trustees or collateral managers,
as discussed previously). Morgan Stanley's largest counterparty
holding was Bank of America, valued at $925 million. At the same time
Morgan Stanley held its equity ownership in these nine counterparties,
the nine counterparties had equity ownership in Morgan Stanley valued
at about $1.1 billion, our review found. The counterparties' ownership
ranged from a low of $6.7 million for counterparty HSBC to a high of
$384.2 million for Goldman Sachs.[Footnote 162]
Similarly, and more recently, we identified cross-ownership between
AIG CDS counterparties and FRBNY ML III advisor BlackRock. In
particular, we found that 12 counterparties owned BlackRock stock
worth at least $998 million, based on information available as of
April 2011--3.8 percent of BlackRock's outstanding shares. Among these
12 firms, 5 have been service providers to CDOs in which ML III is an
investor. The largest AIG CDS counterparty owner of BlackRock stock
was Barclays, with holdings valued at $603 million. At the same time
these 12 counterparties owned BlackRock stock, BlackRock had equity
ownership interests in them worth $44.3 billion. BlackRock's ownership
ranged from a low of $248 million for Calyon (later renamed Credit
Agricole) to a high of $8.4 billion for HSBC.
BlackRock and Merrill Lynch, an AIG CDS counterparty, have had
business interests in addition to investment interests. In September
2006, BlackRock merged with the investment management unit of Merrill
Lynch. Later, Merrill Lynch became one of the largest recipients of ML
III payments. At year-end 2008, Merrill Lynch owned about 44 percent
of BlackRock's common stock. In September 2008, Bank of America
announced its acquisition of Merrill Lynch. Bank of America was also
an AIG CDS counterparty that received payments from ML III. According
to BlackRock's 2008 year-end SEC filing, Merrill Lynch would vote its
BlackRock shares according to the recommendation of BlackRock's board
of directors.[Footnote 163]
Similarly, we found that cross-ownership extends to FRBNY advisors and
service providers (that is, CDO trustees and collateral managers) for
CDOs in which ML III is an investor. For example, we found that 15 of
52 CDO service providers owned BlackRock stock valued at $624 million,
based on information available as of April 2011, with holdings equal
to 2.4 percent of BlackRock's outstanding shares. Among these
providers, for example, was State Street Global Advisors, which had
the largest BlackRock stake, worth $300 million, or 1.2 percent of
BlackRock's outstanding shares. At the same time, BlackRock held State
Street stock worth $293 million, or 1.1 percent of shares outstanding.
FRBNY officials told us that they had not considered the cross-
ownership issue, either before or after executing ML III, but that by
itself, it was not of concern. First, they distinguished BlackRock
from other entities, saying BlackRock is an investment management
company that owns securities on behalf of clients, which accounts for
most of the holdings we identified. However, we note that BlackRock
would still have an interest in the performance of client holdings
from the standpoint of management fees and client satisfaction with
investment performance. Second, the officials said that entities have
subdivisions, such as affiliates or subsidiaries; therefore,
relationships among parties are not necessarily as linked as they
might appear. For example, they distinguished between BlackRock
Solutions, the portion of BlackRock that has been FRBNY's advisor, and
other operations of BlackRock, Inc., the BlackRock corporate entity.
However, according to BlackRock federal securities filings, BlackRock
Solutions is not a distinct subsidiary of the parent, and instead
operates as a "brand name" for certain services the company provides.
While different units could nonetheless be affiliated within an
overall corporate structure, the relevance or impact of any such
affiliations is not clear, FRBNY officials said. Overall, FRBNY
officials compared the cross-ownership issue to the former large
investment banks, which could provide both advisory services and sales
and trading functions. The officials noted that while there were
considerable interconnections of interests, the point at which they
become unacceptable is not clear.
Overall, while our review indicated FRBNY devoted attention to
conflict of interest matters involving assistance to AIG, FRBNY's
decision to rely on private firms for key assistance in designing and
executing aid to the company introduced other challenges. For example,
FRBNY established conflict of interest standards that permitted
waivers, and it has granted a number of waiver requests. But because a
system for tracking conflict waiver requests was not implemented until
about 16 months after assistance began, FRBNY officials cannot provide
a comprehensive account of such requests and their dispositions. Also,
the relationships we identified among FRBNY, its advisors, and the AIG
CDS counterparties raise questions in light of officials' statements
that one goal was to avoid continuing relationships with firms
involved in AIG assistance. Given the time pressure of the financial
crisis and FRBNY's decision to rely upon private firms, FRBNY had to
develop policies and procedures on an ad hoc basis. While FRBNY was
attuned to conflict of interest issues, its procurement policy did not
address vendor or other nonemployee conflicts of interest.[Footnote
164] As FRBNY officials told us, it is not necessarily clear at what
point interrelations between parties becomes a matter for concern.
In our recent report on the Federal Reserve System's emergency lending
programs, which included assistance to AIG, we found that the
emergency programs brought FRBNY into new relationships with
institutions that fell outside of its traditional lending activities,
and that these changes created the possibility for conflicts of
interest for vendors, plus FRBNY employees as well. FRBNY used vendors
on an unprecedented scale, both in the number of vendors and the types
of services provided. FRBNY created a new vendor-management policy in
May 2010, but we found that this policy is not sufficiently detailed
or comprehensive in its guidance on steps FRBNY staff should take to
help ensure vendor conflicts are mitigated. FRBNY staff have said that
they plan to develop a documented policy that codifies practices FRBNY
put in place during the crisis. The lack of a comprehensive policy for
managing vendor conflicts, including relationships that cause
competing interests, could expose FRBNY to greater risk that it would
not fully identify and appropriately manage vendor conflicts of
interest in the event of future crises. In that report, we recommended
that FRBNY finalize this new policy to reduce the risks associated
with vendor conflicts.[Footnote 165] FRBNY officials said they plan to
document a more comprehensive policy for managing vendor conflict
issues.
Initial Federal Reserve Lending Terms Were Designed to Be More Onerous
than Private Sector Financing:
FRBNY officials have said that when they provided the first assistance
to AIG--the $85 billion Revolving Credit Facility--they adopted key
terms of an unsuccessful private-sector lending package. Our review,
however, found that the initial federal lending was considerably more
onerous than the contemplated private deal. After accepting the terms
of government lending--which included restrictions on some company
activities--AIG reduced some investment activities but did not fail to
meet any legal obligations, the company said.
The Revolving Credit Facility Was More Expensive than the Failed
Private Loan Plan and Was Intended to Be Onerous:
FRBNY officials told us that after an agreement could not be reached
on private financing for AIG, they adopted key economic terms of the
private-sector loan syndication plan for the Federal Reserve System's
initial assistance--the Revolving Credit Facility. Our review,
however, showed that the terms of the FRBNY loan were more expensive
in key respects and that the government intended them to be onerous.
The initial cost of the Revolving Credit Facility created financial
challenges for AIG and its ability to repay FRBNY. In response, the
Federal Reserve System twice restructured its loan before the company
fully repaid it in January 2011. According to both FRBNY officials and
AIG executives, it was apparent at the time the Revolving Credit
Facility was offered that restructuring would be necessary, although
Federal Reserve Board officials told us that they believed the $85
billion credit facility had solved the company's problems until
economic conditions deteriorated further.
FRBNY officials told us that some of the Revolving Credit Facility's
initial loan terms were different from those of the failed private-
sector plan but that key economic terms, such as the interest rate and
fees were the same. FRBNY also stated publicly on its website that the
interest rate was the same as the private-sector plan, and an FRBNY
advisor also said that the credit facility's terms were those that had
been outlined in the private-sector plan. FRBNY officials told us that
the Federal Reserve System used the private-sector terms because it
did not have sufficient time to do otherwise prior to extending
government aid, and that in the process, they took a signal from the
private sector on what was appropriate in light of the risk. Given the
situation, according to an FRBNY internal fact sheet, officials
attempted to assess AIG's situation and take into account the terms of
the private-sector lending plan, before finalizing the FRBNY loan
offer to the company.[Footnote 166]
Our review, however, showed that key economic terms of the Revolving
Credit Facility were more expensive than those of the private plan,
until loan terms were subsequently modified. For example, as shown in
table 8, the rate on drawn amounts was two percentage points higher,
and the FRBNY loan included a fee on undrawn amounts, which the
private-sector plan did not. Apart from the financial terms, the
Revolving Credit Facility also provided a longer term than the private
plan.
Table 8: Comparison of the Terms of the Private Lending Plan and
Federal Reserve Revolving Credit Facility:
Loan term: Amount;
Private plan: $75 billion;
Original Revolving Credit Facility: $85 billion;
November 2008 restructuring: $60 billion;
March 2009 restructuring: Announcement of future reduction;
later set at $35 billion in December 2009.
Loan term: Maturity;
Private plan: 18 months;
Original Revolving Credit Facility: 24 months;
November 2008 restructuring: 5 years;
March 2009 restructuring: 5 years.
Loan term: Rate on drawn amounts[A];
Private plan: LIBOR +6.5%, with 3.5% LIBOR floor;
Original Revolving Credit Facility: LIBOR +8.5%, with 3.5% LIBOR floor;
November 2008 restructuring: LIBOR +3.0%, with 3.5% LIBOR floor;
March 2009 restructuring: LIBOR +3.0% (elimination of floor amount).
Loan term: Rate on undrawn amounts;
Private plan: none;
Original Revolving Credit Facility: 8.5%;
November 2008 restructuring: 0.75%;
March 2009 restructuring: 0.75%.
Loan term: Commitment fee;
Private plan: 5.0%;
Original Revolving Credit Facility: 2.0%[B];
November 2008 restructuring: n/a;
March 2009 restructuring: n/a.
Loan term: Other fee;
Private plan: 1% at 6 months, 1% at 12 months;
Original Revolving Credit Facility: none;
November 2008 restructuring: none;
March 2009 restructuring: none.
Loan term: Default rate;
Private plan: none;
Original Revolving Credit Facility: Normal rate +2.0%;
November 2008 restructuring: Normal rate +2.0%;
March 2009 restructuring: Normal rate +2.0%.
Sources: FRBNY, GAO review of Federal Reserve System records.
[A] Rate on private plan stated generally as LIBOR; FRBNY loan
specified 3-month LIBOR.
[B] AIG received $500,000 credit on FRBNY commitment fee, related to
payment for preferred shares.
Note: n/a = not applicable.
[End of table]
In an e-mail sent to the then-FRBNY President about a month after the
Revolving Credit Facility was authorized, an FRBNY official cited the
interest rate as being high and expressed concern about the Federal
Reserve Board imposing such a rate in approving the lending.[Footnote
167] In our review, FRBNY officials could explain only the increase in
the base rate, from LIBOR plus 6.5 percentage points to LIBOR plus 8.5
percentage points. The officials said an advisor made that increase,
on the theory that the loan had become more risky since the failed
private-sector attempt. The rationale was that market turmoil had
increased in the day before Federal Reserve Board approval of the
loan, following the Lehman bankruptcy, and that it would be FRBNY
alone, rather than a syndicate of lenders, that would extend the
credit. Otherwise, the officials were unable to provide us with an
explanation of how other original terms for the Revolving Credit
Facility became more expensive, such as the undrawn amount fee. FRBNY
officials also told us there were some reservations internally about
the initial interest rate on the Revolving Credit Facility. As FRBNY
officials described to us, the rate would be high whether AIG used the
facility or not, reflecting the 8.5 percent rate on undrawn amounts.
Despite internal concerns, there were no efforts to seek changes at
the time the loan was approved, FRBNY officials said.
Although FRBNY officials could not fully explain the rate discrepancy
we identified, they told us nonetheless that in general, they intended
the original Revolving Credit Facility terms to be onerous, as a way
to motivate AIG to quickly repay FRBNY and to give AIG an incentive to
replace the government lending with private financing. Without
reconciling the changing terms of the lending, the former FRBNY
President told us that FRBNY provided for appropriately tough
conditions on AIG. An FRBNY advisor also described the terms as
onerous and said the market recognized them as such. Similarly, as
noted, AIG initially objected to the terms, in particular, the
interest rate and the 79.9 percent equity stake the company gave up.
[Footnote 168] Many of the terms of the Revolving Credit Facility
resembled those of bankruptcy financing, FRBNY officials said, and
their objective was to devise terms that reflected the company's
condition, the nature of its business, and the large exposure the
government faced. According to the officials, they had to balance that
AIG would need to maintain its daily business operations against the
exposure FRBNY faced with its loan and the contemplated source of
repayment, namely asset sales. The officials said they also
constructed the economic terms based on what private-sector lenders
would have considered appropriate for the risk involved. An AIG
advisor characterized the loan as aggressive and unprecedented, but
said AIG was in a price-taking position, and that notwithstanding the
high cost, the loan nevertheless allowed AIG to survive.
In addition to the economic terms highlighted in table 8, the credit
agreement for the Revolving Credit Facility also imposed a number of
affirmative and negative covenants, or obligations. Under the terms of
an accompanying security agreement, AIG granted a lien against a
substantial portion of its assets, including its equity interests in
its regulated U.S. and foreign subsidiaries.[Footnote 169] AIG's
insurance subsidiaries did not pledge any assets in support of the
facility, as noted in a Federal Reserve System internal fact sheet,
and the subsidiaries themselves did not act as guarantors of the loan.
[Footnote 170] This arrangement was established because officials
wanted to better ensure that AIG's insurance subsidiaries would be
well capitalized and solvent, according to the fact sheet. The
agreements did not require AIG's foreign subsidiaries to become
guarantors, according to FRBNY. The credit agreement also stipulated
repayment of FRBNY's loan with proceeds from asset sales or the
issuance of new debt or equity.[Footnote 171] In addition, officials
told us there were other restrictions barring AIG from making large
capital expenditures or providing seller financing on asset sales
without FRBNY's consent.[Footnote 172] Finally, the agreement also
included a negative covenant that provided protection for the
government on how AIG could use the government's TARP equity
investment.[Footnote 173]
FRBNY officials told us the loan structure proved durable and achieved
its purpose of providing AIG with needed liquidity while protecting
FRBNY's position as a creditor. In a secured lending facility such as
the Revolving Credit Facility, it is not unusual to negotiate a range
of restrictions to protect the lender, the officials said.
Nonetheless, the structure created challenges for AIG shortly after
its creation. Concerns remained, for example, about the level of AIG's
debt, the rate on the Revolving Credit Facility, and the company's
ability to sell off assets to repay the lending. FRBNY officials told
us that the amount AIG initially withdrew from the Revolving Credit
Facility ($62.5 billion) and how quickly it did so (slightly more than
2 weeks) demonstrated the depth of the company's problems. Thus,
rating agency concerns were not unexpected, although officials said
they were surprised by how quickly those concerns arose. In addition,
Federal Reserve Board staff comments cited an issue with the loan,
namely, that it required AIG to use proceeds of the Revolving Credit
Facility to meet preexisting liquidity needs and not for investment in
assets that would generate returns. Thus, as officials told us, rather
than repaying FRBNY from productive activities funded by the loan, AIG
had to repay the Revolving Credit Facility by selling assets. This
requirement ultimately proved difficult to fulfill given the
challenges AIG faced in carrying out its asset-sales plan.
FRBNY and AIG both told us they understood at the time the Revolving
Credit Facility was established that it was only an interim solution
and that additional assistance, or restructuring of the assistance,
would be required. According to FRBNY officials, the Revolving Credit
Facility was a necessary step to forestall AIG's immediate problems,
and the loan gave them time to consider more targeted solutions. FRBNY
officials also highlighted the uncertainties that remained after the
initial loan, including the condition of the broader economy, as well
as the reactions of AIG's counterparties to Federal Reserve System
assistance. In particular, AIG's securities lending counterparties
were terminating their contracts, resulting in increased draws on the
Revolving Credit Facility early on.[Footnote 174] According to AIG
executives, while the Revolving Credit Facility addressed the
company's immediate liquidity problems, it also created an
unsustainable situation, given the company's high debt levels,
downward pressure on credit ratings, and illiquid markets in which to
sell assets.
While FRBNY and AIG considered the need for additional government
assistance immediately after the Revolving Credit Facility, Federal
Reserve Board officials told us that a number of factors accounted for
why the Federal Reserve Board determined restructuring became
necessary only after economic conditions worsened following
authorization of the initial lending. According to Federal Reserve
Board officials, markets continued to deteriorate in October and
November 2008, resulting in increased cash demands from AIG and
heightened prospects for a downgrade. Market conditions worsened more
than they expected, officials noted, making it necessary to revisit
the terms of the Revolving Credit Facility. In particular, it was
important at that point to make the interest rate less burdensome.
As noted, the Federal Reserve System twice restructured the terms of
the Revolving Credit Facility in order to, among other things, improve
AIG's capital structure and enhance the company's ability to conduct
its asset sales plan. As shown in table 8, the November 2008
restructuring included reductions in the interest rate and the undrawn
amount fee, as well as an extension of the loan's maturity. According
to an FRBNY internal fact sheet from November, the lower interest rate
and commitment fee on undrawn amounts reflected AIG's stabilized
condition and outlook following Treasury's $40 billion TARP investment
in preferred stock. In addition, according to the fact sheet, the
Federal Reserve Board extended the loan's maturity in order to provide
AIG with additional time to sell assets and to repay FRBNY with the
proceeds.[Footnote 175] The restructuring also reduced AIG's degree of
indebtedness and improved its ability to cover interest payments, the
fact sheet said, which were key measures for the marketplace and
rating agencies in assessing AIG's future risk. FRBNY's commitment to
lend to AIG under the Revolving Credit Facility was reduced to $60
billion.
The March 2009 restructuring included, as noted, a further reduction
of the amount available under the Revolving Credit Facility. As part
of this restructuring, FRBNY received preferred interests in two SPVs
created to hold all of the outstanding common stock of two life
insurance holding company subsidiaries of AIG.[Footnote 176] In
addition, officials eliminated the LIBOR floor on the interest rate
for the Revolving Credit Facility, potentially reducing the cost of
the loan. Following these changes, the amount available to AIG under
the Revolving Credit Facility was further reduced. On January 14,
2011, FRBNY announced full repayment of the Revolving Credit Facility
and exchange of the 79.9 percent controlling equity interest in AIG
for common stock. FRBNY officials told us repayment of the loan was,
as expected, the product of AIG asset sales.
After Accepting the Federal Reserve's Loan Terms, AIG Says It
Restricted Some Investment Activities but Otherwise Stayed Current on
Obligations:
After the Federal Reserve Board approved assistance for AIG, questions
arose about the company's treatment of financial counterparties and
its ability to meet its obligations. We examined this issue from the
standpoint of whether, after receiving federal aid, AIG failed to
perform on legally required obligations. FRBNY officials said that
while they monitored company activities as part of oversight following
the rescue, they did not direct AIG on how to treat its
counterparties, and company executives told us they did not fail to
honor existing obligations. However, AIG executives told us that the
company did reduce its investments in certain projects.[Footnote 177]
As noted previously, AIG's loan agreements imposed a number of
restrictions (negative covenants) on the company's activities. For
example, the credit agreement for the Revolving Credit Facility
generally barred the company from creating or incurring new
indebtedness. It also placed restrictions on payment of dividends and
on capital expenditures greater than $10 million. In addition, FRBNY
officials told us other restrictions arose from the credit agreement,
as amended, although they were not explicitly contained in the
agreement. For instance, the AIG parent company ordinarily could
inject capital into subsidiaries that were not guarantors of FRBNY's
loan without FRBNY's consent. However, FRBNY officials said they had
concerns about funds going to AIGFP. Thus, according to the officials,
in a separate letter agreement with the company, they required that
any loan, advance, or capital contribution to AIGFP would require
consent.
Apart from the loan agreements and related items, the Federal Reserve
System and Treasury did not place any additional limitations on AIG's
activities or its use of cash, such as the ability to make loan
payments or to fulfill previously committed obligations, company
executives told us.[Footnote 178] Similarly, short of actual
restrictions, the Federal Reserve System and Treasury did not impose
any limitations that caused AIG to forego activities it otherwise
would have undertaken, the executives said. AIG executives also told
us that AIG did not act, or fail to act, due to restrictions arising
from federal aid. More specifically, the executives said AIG has not
failed to perform any legally required obligations to parties such as
creditors, joint venture partners, and other counterparties. In
particular, AIG's credit agreement with FRBNY stipulates that AIG is
not to be in default of contractual obligations, the executives said.
[Footnote 179]
However, the AIG executives distinguished between the obligations
described in the previous paragraphs and investment-based decisions
not to make additional contributions of capital to certain projects,
or to discontinue payments on certain projects and allow lenders to
foreclose on them, so that the lenders took over the projects under
terms of lending agreements. AIG has made such business decisions,
involving a number of projects, when it judged them to be in the best
interest of the company, its stakeholders, and FRBNY as AIG's lender,
the executives told us. They said that in such instances, AIG has not
had any obligation to continue funding under any contract and had the
ability to make payments if it chose to do so. Citing one real estate
development project as an example, the executives characterized the
situation as a bad real estate decision by the banks involved.
FRBNY became involved in ongoing AIG business activities by attending
meetings of steering committees AIG set up in certain business units,
as one way to obtain information officials felt was necessary to
inform judgments FRBNY needed to make under the credit agreements,
FRBNY officials told us. For instance, FRBNY would ask for information
to understand the company's risk position or utilization of proceeds
from government lending. However, FRBNY did not substitute its
judgment for company executives' judgment, officials told us, and did
not direct AIG's activities. Instead, FRBNY officials told us they
focused on issues of interest as a creditor to the company and, as
such, would probe company assumptions or analyses. Officials told us
that although they did not exercise control, in some instances, AIG
reconsidered ideas after discussions with FRBNY. FRBNY never indicated
whether AIG should not pay a particular lender or counterparty,
officials told us. Instead, FRBNY's interest was broader and involved
evaluating whether a proposed use of capital made sense from a broad
context and in light of competing demands for capital, they said.
FRBNY encouraged AIG to make decisions based on economics, which
sometimes was at odds with narrower interests of managers in
particular business units, FRBNY officials said. AIG executives
characterized this FRBNY review of its corporate initiatives as
constructive, typical of a creditor-borrower relationship, and said
they could not recall an instance when AIG wanted to pursue a course
that they believed made good business sense but FRBNY did not agree.
The AIG Crisis Offers Lessons That Could Improve Ongoing Regulation
and Responses to Future Crises:
As with past crises, the Federal Reserve System's experience with
assisting AIG offers insights that could help guide future government
action, should it be warranted, and improve ongoing oversight of
systemically important financial institutions. Already, the Dodd-Frank
Act seeks to broadly apply lessons learned from the financial crisis
in a number of regulatory and oversight areas. For example, the act
contains oversight provisions in the areas of financial stability,
depository institutions, securities, brokers and dealers, and
financial regulation. In addition, our review of Federal Reserve
System assistance to AIG has identified other areas where lessons
learned could be applied:
* identifying ways to ease time pressure in situations that require
immediate response,
* analyzing collateral disputes to help identify firms that are coming
under stress, and:
* conducting scenario stress testing to anticipate different impacts
on the financial system.
Actions Could Be Taken Earlier to Reduce Time Pressure:
As discussed earlier, time pressure was an important factor in Federal
Reserve System decision making about aid to AIG. For example, the
Federal Reserve Board made its initial decision on the Revolving
Credit Facility against the urgency of expected credit rating agency
downgrades in mid-September 2008, which would have imposed significant
new liquidity demands on the company. Similarly, FRBNY chose among ML
III design alternatives based largely on what could be done quickly.
Time pressure also played a key role in decisions whether federal aid
was appropriate. As noted, the Federal Reserve Board's emergency
lending authority under section 13(3) of the Federal Reserve Act was
conditioned on the inability of borrowers to secure adequate credit
from other banking institutions. In AIG's case, the company and the
Federal Reserve System sought to identify private financing over
several days in September 2008 leading up to the first offer of
government aid to the company. But entities contemplating providing
financing to AIG said the process forced them to compress what
ordinarily would be weeks' worth of due diligence work into only days.
As the scope of the financial crisis and AIG's situation evolved,
potentially large investments were being considered in an environment
of uncertain risk. When FRBNY stepped in to try to arrange bank
financing--at which point AIG's identified financial need had grown
substantially--there was even less time to act, and the Federal
Reserve Board quickly moved to extend its offer of assistance.
[Footnote 180]
While unforeseeable events can occur in a crisis, easing time pressure
could aid future government decision making and the process of seeking
private financing. In AIG's case, the Federal Reserve System could
have eased time pressure two ways. First, it could have begun the
process of seeking or facilitating private financing sooner than it
did--the day before the Federal Reserve Board approved the Revolving
Credit Facility--as warning signs became evident in the months before
government intervention. Second, given the warning signs, it could
have compiled information in advance to assist would-be investors or
lenders. Potential private-sector financiers told us the process would
have benefited from both more time and information.
An example of the kind of information that would be useful in a crisis
can be seen in recent rulemaking by the Federal Reserve Board and the
Federal Deposit Insurance Corporation. As part of Dodd-Frank Act
implementation, the two agencies proposed that large, systemically
significant bank holding companies and nonbank financial companies
submit annual resolution plans and quarterly credit exposure reports.
A resolution plan would describe the company's strategy for rapid and
orderly resolution in bankruptcy during times of financial distress. A
company would also be required to provide a detailed listing and
description of all significant interconnections and interdependencies
among major business lines and operations that, if disrupted, would
materially affect the funding or workings of the company or its major
operations. The credit exposure report would describe the nature and
extent of the company's credit exposure to other large financial
companies, as well as the nature and extent of the credit risk posed
to others by the company.[Footnote 181] Such information was of
interest to those contemplating providing financing to AIG ahead of
federal intervention, as well as to government officials themselves.
This information could also benefit ongoing regulation of financial
entities, whether by the Federal Reserve System or other financial
regulators, but it could be of particular benefit to the Federal
Reserve System, given its broad role in maintaining the stability of
the financial system. Such efforts could also improve the quality of
information that the Financial Stability Oversight Council is now
charged with collecting from, among others, financial regulatory
agencies, pursuant to the Dodd-Frank Act. Under terms of the
legislation, the Federal Reserve Board Chairman is a member of the
Financial Stability Oversight Council, whose purpose is to identify
risks to financial stability that could arise from distress, failure,
or ongoing activities of large, interconnected bank holding companies
or nonbank financial companies; promote market discipline; and respond
to emerging threats to the stability of the U.S. financial system. The
law created an Office of Financial Research within Treasury to support
the Council and its member agencies.
Analyzing Collateral and Liquidity Issues Could Help Identify Warning
Signs:
Requirements to post collateral figured prominently in the
difficulties in AIGFP's CDS business that spurred the creation of ML
III. Leading up to government intervention, AIG was in dispute with
some of its counterparties on the amount of collateral the company was
required to post with them under terms of AIG's CDS contracts. A
number of the counterparties told us that they were in disagreement
with AIG over billions of dollars of collateral they claimed the
company owed them. For example, one counterparty told us it had
contentious discussions with AIG over collateral, and another said it
made multiple unsuccessful demands for payment. Records we reviewed
also indicated that market mechanisms for valuing assets had seized
up, which AIG told us contributed to the disagreements over the amount
of collateral to be posted.
This experience suggests that identifying, monitoring, and analyzing
collateral issues may offer opportunities for enhancing regulators'
market surveillance or developing warning signs that firms are coming
under stress. A large AIG CDS counterparty told us that it was not
clear that regulators appreciated the significance of collateral
disputes involving the company. Collateral disputes can be a warning
sign and usually involve valuation conflicts. While regulators
generally are expected to look for such things as fraud and problems
in economic modeling, whether they are attuned to looking closely at
collateral disputes and the warnings they might yield is not clear,
the counterparty said. In AIG's case, the duration of the dispute and
sharply differing views of values were unusual, the counterparty said.
The idea of tracking collateral issues is gaining some attention among
financial regulators. For example, the Financial Industry Regulatory
Authority has recently issued guidance for broker-dealers that lists
"notable increases in collateral disputes with counterparties" among
factors that could be warning flags for funding and liquidity
problems.[Footnote 182]
More sophisticated monitoring of financial firms' liquidity positions
could likewise be valuable, a former Treasury official who was
involved in AIG assistance told us. Proper assessment of liquidity
requires not just knowing how much cash is available, the former
official said, but also the amount of cash a firm would have available
in the event that all parties with the potential to make calls on the
firm were to do so. In AIG's case, neither the company nor regulators
understood the situation in this way, but this kind of assessment
should be an essential part of future regulatory oversight, the former
official said.
Scenario Stress-Testing Could Increase Analytical Insights:
In general, risk analysis that involves thoughtful stress testing can
allow for better-informed and more timely decision making. For
example, in evaluating elements of federal assistance to AIG, FRBNY
and an advisor analyzed expected performance and outcomes under
varying conditions of economic stress. Similarly, we reported on the
Supervisory Capital Assessment Program that was established through
TARP, which assessed whether the 19 largest U.S. bank holding
companies had enough capital to withstand a severe economic downturn.
Led by the Federal Reserve Board, federal bank regulators conducted
stress tests to determine if these banks needed to raise additional
capital. These experiences underscore the value of stress testing
generally, and the particular circumstances of AIG's difficulties
suggest an opportunity to expand and refine such testing in order to
better anticipate stress in the financial system. In AIG's case, FRBNY
officials cited the company's financial interconnections and the
multifaceted nature of the financial crisis as contributing to the
need for federal assistance. Similarly, the Federal Reserve Board
Chairman has highlighted the risks presented by large, complex, and
highly interconnected financial institutions. More sophisticated
stress testing that incorporates comprehensive measures of financial
interconnectedness and different crisis scenarios could offer the
opportunity to study expected outcomes of financial duress, not only
for a single institution but for a range of institutions as well. Such
testing could allow regulators to better understand the potential
systemic impacts of crises or actions, which, among other things,
could help them in their new role to monitor systemic risk under the
Dodd-Frank Act. The Dodd-Frank Act requires annual or semiannual
stress testing by the Federal Reserve Board or financial companies
themselves, according to type of institution and amount of assets. The
AIG experience underscores the importance of interconnectedness in
such analysis.
Agency and Third Party Comments and Our Evaluation:
We provided a draft of this report to the Federal Reserve Board for
its review and comment, and we received written comments that are
reprinted in appendix II. In these comments, the Federal Reserve Board
generally agreed with our approach and results in examining the
Federal Reserve System's involvement with AIG within the context of
the overall financial crisis at the time, and it endorsed the lessons
learned that we identified in our work. Regarding regulators taking
earlier action to reduce time pressure during a crisis, the Federal
Reserve Board stated that it has established a new division to focus
on market pressures and developments that may create economic
instability, and is otherwise working to identify threats to financial
stability. Regarding the opportunity that collateral disputes may
offer for enhancing regulators' market surveillance or for developing
warning signs that firms are coming under stress, the Federal Reserve
Board stated that it is working with other financial regulators to
implement changes in supervision and regulation of derivatives
markets, including requirements governing collateral posting.
Regarding the notion that risk analysis that involves thoughtful
stress testing--especially focusing on interconnections among
institutions--can allow for better-informed and more timely decision
making, the Federal Reserve Board stated that it has begun development
of an annual stress testing program for large financial firms within
its supervisory purview. In response to our findings that Federal
Reserve System assistance to AIG gave rise to overlapping interests
and complex relationships among the various parties involved, the
Federal Reserve Board said it is exploring opportunities to improve
its approach to potential or actual conflicts of interest that can
arise from such interests and relationships. The Federal Reserve Board
and FRBNY also provided technical comments, which we have incorporated
as appropriate.
In addition, we provided a draft of this report to Treasury for review
and comment, and we also provided relevant portions of the draft to
AIG, SEC, and selected others for their review and comment. We have
incorporated comments from these third parties as appropriate.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after its date. At that time, we will send copies to the Chairman of
the Federal Reserve Board, interested congressional committees, and
others. In addition, this report is available at no charge on the GAO
website at [hyperlink, http://www.gao.gov].
If you or your staff have any questions regarding this report, please
contact me at (202)-512-8678 or williamso@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. GAO staff who made major
contributions to this report are listed in appendix III.
Signed by:
Orice Williams Brown:
Managing Director, Financial Markets and Community Investment:
List of Congressional Requesters:
Spencer Bachus:
Chairman:
Committee on Financial Services:
House of Representatives:
Elijah E. Cummings:
Ranking Member:
Committee on Oversight and Government Reform:
House of Representatives:
Edolphus Towns:
House of Representatives:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
To examine the sequence of events and key participants as critical
decisions were made to provide federal assistance to American
International Group, Inc. (AIG), we reviewed a wide range of AIG-
related documents. We obtained these documents primarily from the
Board of Governors of the Federal Reserve System (Federal Reserve
Board) and the Federal Reserve Bank of New York (FRBNY), including
records they have provided to Congress. These documents included e-
mails, information relating to options and plans for aiding AIG,
research, memorandums, financial statements, and other items. We also
obtained information from congressional testimonies of the former
FRBNY President and officials of the Federal Reserve Board, FRBNY, the
former Secretary of the Department of the Treasury (Treasury), and
former AIG executives. In addition, we reviewed Federal Reserve Board
and FRBNY announcements, presentations, and background materials. We
also reviewed our past work and the work of others who have examined
the government's response to the financial crisis, including the
Congressional Oversight Panel, the Special Inspector General for the
Troubled Asset Relief Program (SIGTARP), and the Financial Crisis
Inquiry Commission. We conducted interviews with many of those
involved in federal assistance to AIG, to obtain information on their
participation in the events leading up to federal assistance for AIG,
as well as their perspectives on the condition of AIG and the
financial markets at the time. From the regulatory sector, we
interviewed Federal Reserve Board and FRBNY officials, a former
Federal Reserve Board Governor, a Reserve Bank President, current and
former officials from state insurance regulatory agencies, SIGTARP
staff, current and former Treasury officials, and an official of the
Federal Home Loan Bank system. From the private sector, we interviewed
current and former AIG executives, representatives from FRBNY
advisors, an AIG advisor, AIG business counterparties, credit rating
agencies, potential private-sector financiers, and academic and
finance experts. In addition, we obtained written responses to
questions from the former Office of Thrift Supervision, the former
FRBNY President, and a former senior Treasury official.
To examine decisions involving the selection and structure of the
Maiden Lane III vehicle (ML III), we obtained and reviewed relevant
documents from the Federal Reserve Board, FRBNY, and others, as noted
earlier. In addition, we reviewed filings submitted by AIG to the
Securities and Exchange Commission (SEC). We also conducted interviews
with parties identified earlier. In addition, we obtained written
responses to questions from the Autorite de Controle Prudentiel, a
French banking regulator. We analyzed the information obtained from
documents and interviews to identify the options for assistance
considered by Federal Reserve System officials. We followed up with
Federal Reserve System officials to understand their rationale for
selecting the as-adopted ML III vehicle. To determine the extent to
which FRBNY pursued concessions from the counterparties, we
interviewed Federal Reserve Board and FRBNY officials and 14 of the 16
counterparties that participated in ML III. Bank of America and
Merrill Lynch were unable to provide information on the concession
issue.
To examine the extent to which key actions taken were consistent with
relevant law or policy, we reviewed AIG-related documents indicated
earlier to identify key actions taken. More specifically, to
understand the Federal Reserve Board's authority to provide emergency
assistance to nondepository institutions and related documentation
issues, we reviewed legislation including the Federal Reserve Act of
1913, as amended, and the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010. We interviewed Federal Reserve Board officials
to obtain their interpretation of the Federal Reserve Board's
authority. Further, to determine FRBNY's involvement in AIG's
securities disclosures on the federal assistance, we reviewed relevant
SEC records and interviewed SEC officials. Relevant documents we
reviewed included e-mails, memorandums, disclosure filings,
regulations and procedures, and material connected with AIG's request
for confidential treatment of ML III-related information. Finally, to
evaluate the effectiveness of FRBNY policies and practices for
managing conflicts of interest involving the firms that provided
services to FRBNY, we reviewed FRBNY vendor agreements and FRBNY's
Operating Bulletin 10, which address procurement issues, as well as
FRBNY's employee Code of Conduct. We also reviewed documentation of on-
site reviews of advisor and vendor firms and obtained documentation
related to waivers granted to the firms.
To determine relations among companies involved with ML III, we
obtained and analyzed equity stock holdings data for the firms. We
conducted interviews with a number of the parties indicated earlier--
in particular, with Federal Reserve Board officials, FRBNY officials
and advisors, SEC officials, a representative of the SEC Inspector
General's office, AIG executives, AIG counterparties, and academic
experts.
To examine criteria used to determine the terms for key assistance
provided to AIG, we reviewed AIG-related documents indicated earlier,
to understand the nature of the assistance and the terms. We compared
the terms of a contemplated private-sector loan syndication deal with
the original terms for FRBNY's Revolving Credit Facility, and we also
discussed differences between the two sets of terms with FRBNY
officials. To review AIG's treatment of various creditors and other
significant parties after receiving federal assistance, we reviewed
the FRBNY credit agreement, as amended, to understand the restrictions
that were applied to AIG. To obtain information on FRBNY's involvement
in AIG's decisions on meeting obligations and making investments, we
conducted interviews with FRBNY officials, AIG executives, and those
involved in AIG-supported real estate development projects.
To identify lessons learned from AIG assistance, we relied generally
on our analysis of information obtained from all the sources cited
earlier and comments obtained from a number of interview subjects. We
inquired generally about what the process of providing assistance to
AIG might suggest for any future government interventions, as well as
specifically about such matters as reducing time pressure in critical
decision making and improving analytical insights into conditions at
individual financial institutions and in financial markets at large.
We conducted this performance audit from March 2010 to September 2011
in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.
[End of section]
Appendix II: Comments from the Board of Governors of the Federal
Reserve System:
Board Of Governors of The Federal Reserve System:
Scott G. Alvarez, General Counsel:
Washington, D.C. 20551
September 27, 2011:
Ms. Orice Williams Brown:
Managing Director:
Financial Markets and Community Investment:
Government Accountability Office:
441 G Street, N.W.
Washington, D.C. 20548:
Dear Ms. Brown:
On behalf of the Board of Governors of the Federal Reserve System
("Board") and the Federal Reserve Bank of New York ("FRBNY"), thank
you for providing us with the opportunity to comment on your draft
report titled "Review of Federal Reserve System Financial Assistance
to American International Group, Inc." ("AIG"). As you know, the Board
and the FRBNY have worked very closely and cooperatively with GAO
throughout this audit and we appreciate the thorough review the GAO
has undertaken.
We believe the report as a whole reflects the GAO's commitment to
accurately and fully telling not just the story of the Federal
Reserve's involvement with AIG, but also the context of the severe
financial crisis that the U.S. economy faced and the Federal Reserve
was trying to address at each stage of that involvement. From the
Federal Reserve's September 16, 2008, extension of an $85 billion
credit line to AIG, through the credit restructurings and Maiden Lane
II and III transactions in 2008-2010 designed to stabilize AIG and
minimize taxpayer risk, to the termination of Federal Reserve aid
after AIG's full repayment of Federal Reserve loans in
January 2011, we believe the GAO's report shows how the Federal
Reserve was successful in safeguarding the taxpayer's investment while
it worked with Treasury and the company to stabilize AIG and minimize
disruption to the economy as a whole.
As the report notes, the Federal Reserve did not have the authority to
supervise AIG. Using publicly available information, the Federal
Reserve tracked AIG's financial condition, in the same way it tracks
the financial condition of many institutions that it does not
supervise. In the fall of 2007, many of the institutions the Federal
Reserve tracked but did not supervise were facing dire situations,
including but not limited to AIG, Lehman Brothers, Merrill Lynch, and
several other investment banks. As the GAO reports, given the failure
of Lehman Brothers and the worsening economic conditions, AIG's
failure, at that moment in time, would likely have sparked a very
dangerous economic chain reaction because of AIG's size,
interconnectedness and activities. When it became clear that no
private sector solution to AIG's growing liquidity problems was
forthcoming, the Federal Reserve decided to extend credit to AIG in
order to avoid a material injury to the U.S. and global financial
systems.
The GAO draws three lessons from its review of the AIG experience that
could improve responses to future crises. These lessons are consistent
with statutory revisions established in the Dodd-Frank Wall Street
Reform and Consumer Protection Act. The first lesson, that actions can
be taken earlier to anticipate problems and reduce time pressures in
developing solutions, is one the Federal Reserve has been acting
diligently to implement. For example, the Board has established a new
division to focus on market pressures and developments that may create
economic instability. We are also working with the Financial Stability
Oversight Board and the other federal financial regulators to identify
threats to financial stability.
The second lesson relates to monitoring and analyzing private sector
disputes about the value and amount of collateral that should be
posted on derivatives contracts. The Board is working with the
Commodity Futures Trading Commission and the Securities and Exchange
Commission to implement a number of changes to the supervision and
regulation of the derivatives market, including requirements governing
collateral posting. We will carefully consider the lessons identified
by the GAO in developing our supervisory programs in this area.
Third, GAO's report underscores the value of stress testing and, in
particular, the value of incorporating financial interconnectedness
into stress tests. In 2009, the Federal Reserve led the successful
simultaneous stress testing of the 19 largest banking organizations in
the U.S. That analysis, commonly referred to as SCAP, helped spur the
largest capital raising program by major banking organizations in the
U.S. The Federal Reserve has since begun development of a program of
annual stress testing of large financial firms within our supervisory
as well purview, as development of early remediation efforts that
require large banking firms to take increasingly stronger steps to
improve their financial conditions when they experience financial
difficulties.
While not identified as a lesson to be learned, GAO notes in its
report that overlapping interests and complex relationships existed
among firms that played advisory or administrative roles with the
Federal Reserve related to AIG. Given the concentrated and
interconnected nature of the financial services market, such
interconnectedness was unavoidable and, as the GAO noted, the FRBNY
took a number of steps to manage those situations that could give rise
to actual or potential conflicts. The Federal Reserve is exploring
opportunities to improve its approach to these matters.
We believe these and the other steps the Federal Reserve and other
federal financial regulators are taking in response to the lessons
learned in the recent financial crisis will help prepare us to address
future crises.
Sincerely,
Signed by:
Scott G. Alvarez:
[End of section]
Appendix III: GAO Contact and Staff Acknowledgments:
GAO Contact:
Orice Williams Brown, (202) 512-8678, or williamso@gao.gov:
Staff Acknowledgments:
In addition to the individual named above, Karen Tremba, Assistant
Director; Tania Calhoun; Daniel Kaneshiro; Marc Molino; Brian
Phillips; Christopher H. Schmitt; Jennifer Schwartz; Wade Strickland;
and Gavin Ugale made major contributions to this report.
[End of section]
Footnotes:
[1] In this report, we distinguish among the Federal Reserve Board,
meaning the Board of Governors of the Federal Reserve System; the
Federal Reserve System, meaning the Federal Reserve Board and at least
one of its regional Reserve Banks; and the Federal Reserve Bank of New
York, which is the regional Reserve Bank for the Second Federal
Reserve District.
[2] Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343,
122 Stat. 3765 (2008), codified at 12 U.S.C. §§ 5201 et seq.
[3] According to the Federal Reserve System, the elements of emergency
lending approved for AIG were:
1. Revolving Credit Facility, September 2008, $85 billion initially
authorized; repaid and closed January 2011.
2. Securities Borrowing Facility, October 2008, $37.8 billion
authorized; terminated with Maiden Lane II.
3. Maiden Lane II, November 2008, $22.5 billion authorized.
4. Maiden Lane III, November 2008, $30 billion authorized.
5. Additional loans to securitize life insurance cash flows, March
2009, $8.5 billion authorized; facility never implemented.
Not all amounts authorized were drawn, and not all programs operated
concurrently. In addition, Treasury made investments in AIG:
1. $40 billion for preferred stock, November 2008.
2. $29.835 billion for preferred stock, warrant to purchase common
stock, April 2009.
See background section for more detailed discussion of the elements of
federal assistance to the company.
[4] For previous GAO reports on AIG assistance, see The Government’s
Exposure to AIG Following the Company’s Recapitalization, [hyperlink,
http://www.gao.gov/products/GAO-11-716] (Washington, D.C.: July 18,
2011); Troubled Asset Relief Program: Third Quarter 2010 Update of
Government Assistance Provided to AIG and Description of Recent
Execution of Recapitalization Plan, [hyperlink,
http://www.gao.gov/products/GAO-11-46] (Washington, D.C.: Jan. 20,
2011); Troubled Asset Relief Program: Update of Government Assistance
Provided to AIG, [hyperlink, http://www.gao.gov/products/GAO-10-475]
(Washington, D.C.: Apr. 27, 2010); and Troubled Asset Relief Program:
Status of Government Assistance to AIG, [hyperlink,
http://www.gao.gov/products/GAO-09-975] (Washington, D.C.: Sep. 21,
2009). For our previous testimony on assistance to the company, see
Federal Financial Assistance: Preliminary Observations on Assistance
Provided to AIG, [hyperlink, http://www.gao.gov/products/GAO-09-490T]
(Washington, D.C.: Mar. 18, 2009).
[5] According to AIG, it has had no consolidated regulator since OTS
regulation ceased. Since then, it has been in discussions with
European regulators concerning consolidated regulation. The company
also said the Dodd-Frank Wall Street Reform and Consumer Protection
Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (Dodd-Frank Act), now
provides two ways in which the Federal Reserve Board could become
AIG's federal regulator: (1) if AIG is recognized as a "savings and
loan holding company" as defined by the Home Owners' Loan Act, or (2)
if the legislation's newly created systemic risk regulator--the
Financial Stability Oversight Council--designates AIG as a company
whose material financial distress, or whose nature, scope, size,
scale, concentration, interconnectedness, or mix of activities, could
pose a threat to the financial stability of the United States.
[6] CDS are bilateral contracts, sold over-the-counter, that transfer
credit risks from one party to another. A seller, which is offering
credit protection, agrees, in return for a periodic fee, to compensate
the buyer if a specified credit event, such as default, occurs. CDOs
are securities backed by a pool of bonds, loans, or other assets.
[7] The Federal Reserve Board is a federal agency. A network of 12
Reserve Banks and their branches carries out a variety of functions,
including operating a nationwide payments system, distributing the
nation's currency and coin, and, under delegated authority from the
Federal Reserve Board, supervising and regulating member banks and
bank holding companies. The Federal Reserve Board oversees the
operations and activities of the Reserve Banks and their branches. The
Reserve Banks, which combine features of public and private
institutions, are federally chartered corporations with boards of
directors. As part of the Federal Reserve System, the Reserve Banks
are subject to oversight by Congress.
[8] In our March 2009 testimony on credit default swaps, we noted that
no single definition exists for systemic risk. Traditionally, systemic
risk was viewed as the risk that the failure of one large institution
would cause other institutions to fail. This micro-level definition is
one way to think about systemic risk. Recent events have illustrated a
more macro-level definition: the risk that an event could broadly
affect the financial system rather than just one or a few
institutions. See GAO, Systemic Risk: Regulatory Oversight and Recent
Initiatives to Address Risk Posed by Credit Default Swaps, [hyperlink,
http://www.gao.gov/products/GAO-09-397T] (Washington, D.C.: Mar. 5,
2009).
[9] A U.S. Bankruptcy Court Examiner's report summarized the failure
of Lehman this way: "Lehman failed because it was unable to retain the
confidence of its lenders and counterparties and because it did not
have sufficient liquidity to meet its current obligations. Lehman was
unable to maintain confidence because a series of business decisions
had left it with heavy concentrations of illiquid assets with
deteriorating values[,] such as residential and commercial real
estate. Confidence was further eroded when it became public that
attempts to form strategic partnerships to bolster its stability had
failed. And confidence plummeted on two consecutive quarters with huge
reported losses, $2.8 billion in second quarter 2008 and $3.9 billion
in third quarter 2008, without news of any definitive survival plan."
[10] In written comments to us, the former FRBNY President summed up
the environment: "The collapse of Lehman Brothers contributed to an
escalating run on banks, including a broad withdrawal of funds from
money market funds. The run on these funds, in turn, severely
disrupted the commercial paper market, which was a vital source of
funding for many financial institutions. Financial firms responded by
shoring up their balance sheets through selling risky assets, reducing
exposure to other financial institutions, and guarding their cash
positions."
[11] The Federal Reserve Board announced that, as a condition of
establishing the initial $85 billion credit facility, a trust
established for the sole benefit of the U.S. Treasury would become the
majority equity investor in AIG.
[12] According to FRBNY, the maximum draw on the Securities Borrowing
Facility was $20.5 billion.
[13] A multisector CDO is a CDO backed by a combination of corporate
bonds, loans, asset-backed securities, or mortgage-backed securities.
[14] In this report, unless otherwise noted, we use "CDS
counterparties," or more generally "counterparties," to refer to the
group of 16 counterparties from which ML III purchased CDOs. This
original group of 16 subsequently changed following corporate
acquisitions.
[15] A special purpose vehicle is a legal entity, such as a limited
partnership, created to carry out a specific financial purpose or
activity.
[16] Cumulative preferred stock is a form of capital stock in which
holders of preferred stock receive dividends before holders of common
stock, and dividends that have been omitted in the past must be paid
to preferred shareholders before common shareholders can receive
dividends.
[17] At this time, the trust established in connection with the
Revolving Credit Facility exchanged its shares of AIG's Series C
preferred stock for about 562.9 million shares of AIG common stock.
The trust subsequently transferred the shares to Treasury. Although
the original Revolving Credit Facility extended to AIG was repaid,
FRBNY continued to have loans outstanding for AIG assistance that were
not made to AIG directly, through ML II and ML III.
[18] Schedule A was an attachment to a contract known as the Shortfall
Agreement, which provided a process for making final collateral
adjustments as part of the ML III process.
[19] State insurance regulators oversee domestic life and property/
casualty insurance companies domiciled in their states. One state
insurance regulator coordinated state regulatory efforts for AIG's
domestic life insurance operations, which we refer to as the "lead
life insurance regulator."
[20] AIG told us that at the time the investments were made, however,
RMBS were not seen as more risky than other investments, as RMBS were
highly rated and highly liquid.
[21] According to AIG, these were off-balance sheet transactions under
then-current disclosure requirements and guidelines, as compared to
public SEC filings and investor presentations.
[22] OTS told us it began convening these meetings for AIG in 2005 as
part of its consolidated supervisory program for the company. U.S.
state insurance regulators, plus key foreign supervisory agencies,
participated in these conferences. During a part of the meeting
devoted to presentations from the company, attendees had an
opportunity to question the company about supervisory or risk issues.
[23] Because the role and actions of OTS with respect to AIG were
beyond the scope of this report, we do not elaborate on OTS's receipt
or handling of this information. Effective July 21, 2011, pursuant to
provisions of the Dodd-Frank Act, OTS was abolished, integrated with
the Office of the Comptroller of the Currency, and its functions
transferred to various federal banking regulators.
[24] See Hearing on Troubled Asset Relief Program Assistance for
American International Group, Congressional Oversight Panel, May 26,
2010.
[25] As AIGFP was not an insurance company, state insurance regulators
did not regulate the subsidiary's CDS and CDO activities.
[26] The lead life insurance regulator told us that following the
supervisory college meeting in November 2007, it did not follow up
with OTS regarding AIG, although in hindsight, it may have been useful
to do so. The regulator's main issue, however, was reporting of AIG
securities lending matters in insurance company financial statements,
not the derivatives issue, the lead life insurance regulator said.
[27] In particular, AIG told us that in response to the growing RMBS
crisis, the company disclosed in public filings and presentations to
investors for the second quarter 2007 (released in the third quarter)
all of its RMBS investments, including investments of the securities
lending program. The company said it also disclosed a growing
differential between its liability to return cash collateral to
borrowers of securities and the fair value of the securities lending
cash collateral investments, which had begun to decline due to the
deteriorating market. Further, the company said it disclosed in its
second quarter 2007 SEC Form 10-Q filing that the securities lending
liability to borrowers was more than $1 billion greater than the fair
value of the securities lending collateral. The company made a similar
disclosure for its third quarter, AIG told us.
[28] AIG told us that in February 2008, in its SEC Form 10-K filing,
the company reported a net unrealized loss on securities lending
collateral of $5 billion and a realized loss of $1 billion, plus a
growing differential--then about $6.3 billion--between its liability
to borrowers and the fair value of the securities lending collateral.
AIG said it also warned investors of potential liquidity risks
stemming from the securities lending program, such as if
counterparties demanded their cash back on short notice.
[29] According to the lead life insurance regulator, as events
unfolded in September 2008, it tried unsuccessfully to meet with AIG
in order to receive a briefing on the company's financial condition
and liquidity needs. According to the regulator, in a meeting with AIG
management on August 12, 2008, officials advised they were becoming
concerned with liquidity of the AIG parent company, but no AIG
executive present was able to address the concern. Given that
officials were relying upon a parent company guarantee to cover losses
in the securities lending program, the regulator said it advised AIG
that for the next in-person meeting--expected in October--it wanted
AIG executives to present information on the parent company's
finances, its liquidity position, all guarantees and possible
collateral calls, and plans to fund those guarantees and collateral
calls if necessary.
[30] The lead life insurance regulator told us it began discussions
with AIG management in February 2008 about plans to wind down the
securities lending program over a 12-24 month period. By September,
AIG had already begun unwinding the program, which was down in value
by 25 percent from a peak of approximately $94 billion--as reported to
us by AIG--the regulator said. In September, as the crisis was
unfolding, the regulator said it began formulating a plan that would
allow for a full wind-down of the program as lending transactions
terminated, which would generally have been over a period of less than
90 days. However, the regulator said it never discussed this plan with
AIG management because the Federal Reserve System stepped in.
[31] A "CDS spread" is a premium that a buyer pays to a seller of
protection. The size of a CDS spread serves as an indicator of market
perception of risk. An increasing CDS spread indicates a heightened
perception of risk.
[32] AIG described the purpose as "general corporate purposes."
[33] FHLBs are regional cooperatives owned by members that include
community banks, credit unions, community development financial
institutions, and insurance companies. FHLBs make loans to members
known as "advances."
[34] The Federal Reserve System's discount window extends credit to
generally sound depository institutions as a short-term source of
funds and as a means to ensure adequate liquidity in the banking
system.
[35] A monoline insurer also provides protection against credit
defaults, as AIG did, but typically is involved only in that line of
business.
[36] In August 2008, AIG made a successful $3.25 billion debt
offering, according to the company's lead life insurance regulator.
[37] Primary dealers are banks and investment dealers authorized to
buy and sell government securities directly with FRBNY. Under the
Federal Reserve's Primary Dealer Credit Facility announced in March
2008, primary dealers could borrow from the Federal Reserve System at
the FRBNY discount rate by pledging eligible collateral.
[38] See testimony for the House Committee on Oversight and Government
Reform, January 27, 2010.
[39] While this report focuses on how the Federal Reserve Board
determined AIG posed a systemic risk, in our September 2009 report on
TARP [hyperlink, http://www.gao.gov/products/GAO-09-975], we discussed
why the Federal Reserve Board made such a determination. Specifically,
the Federal Reserve Board and Treasury said that financial markets and
financial institutions were experiencing unprecedented strains
resulting from the placing of Fannie Mae and Freddie Mac under
conservatorship; the failure of financial institutions, including
Lehman; and the collapse of the housing market. The Federal Reserve
Board said that in light of these events, a disorderly failure of AIG
could have contributed to higher borrowing costs, diminished
availability of credit, and additional failures. They concluded that a
collapse of AIG would have been much more severe than that of Lehman
because of AIG's global operations, large and varied retail and
institutional customer base, and different types of financial service
offerings. The Federal Reserve and Treasury said that a default by AIG
would have placed considerable pressure on numerous counterparties and
triggered serious disruptions in the commercial paper market.
Moreover, AIGFP counterparties would no longer have had protection or
insurance against losses if AIGFP, a major seller of CDS contracts,
defaulted on its obligations and CDO values continued to decline.
[40] AIG's lead life insurance regulator also played a role in the
final events leading up to the emergency Federal Reserve loan on
September 16, 2008. On September 12, the regulator told us, AIG moved
about $1 billion from its life insurance companies to the parent
company, under a preapproved agreement for transferring funds
throughout the company. By September 15, however, the regulator called
a halt to further transfers, saying it needed to better understand the
situation. At that point, AIG discussed needing another $5-7 billion
from the life insurance companies. With a company executive saying AIG
was at risk of default, the regulator told us it reluctantly approved
transfer of $5 billion on September 16. The regulator told us that
this transfer provided AIG with several hours of relief while
arrangements on Federal Reserve System assistance were being
finalized. The money was later returned, following approval of the
Revolving Credit Facility, the regulator said.
[41] In this discussion, "private" financing refers to nongovernment
sources. We do not mean the term in the context of private-versus-
public financing in securities markets or securities regulation; for
example, a private-versus-public offering of securities.
[42] According to AIG executives, a limiting factor as the company
sought private financing was that it had no active securities
registration statement, having exhausted its shelf registration
capacity when raising capital in May 2008. This meant AIG's range of
solutions as its crisis peaked could not include public market
offerings. The executives told us, however, that as a practical
matter, this may not have been a real constraint because it was not
clear that public markets would have been receptive to a debt or
equity offering at the time.
[43] A syndicated bank loan is a loan made by a group of banks to one
borrower.
[44] In the several weeks preceding September 12, 2008, AIG engaged
the investment bank to assist in assessing the company's financial
condition. According to investment bank executives, part of their work
included developing financial scenarios for AIG based on the impact of
different credit rating downgrades. In addition, the executives told
us that from September 12-14, the investment bank briefed Federal
Reserve System and Treasury officials on AIG's situation.
[45] Solvency is having a positive (or zero) net worth, in which the
value of assets exceeds (or equals) liabilities. Liquidity is the
ability to convert assets to cash quickly and readily without
significant loss.
[46] The private equity firm, as well as one former AIG executive,
said the deal also included participation of another private equity
firm whose involvement we were unable to confirm.
[47] In our discussions with AIG executives, they recalled that the
private equity firm was present, but they could not recall the
specific proposal.
[48] A repurchase agreement is a form of short-term collateralized
borrowing.
[49] A guaranteed investment contract is an investment vehicle offered
by insurance companies to pension and profit-sharing plans that
guarantees the principal and a fixed rate of return for a specified
period.
[50] The Primary Dealer Credit Facility was in effect from March 16,
2008 to February 1, 2010. As noted, it provided loans to primary
dealers against eligible collateral.
[51] Moral hazard is, generally, when a party insulated from risk
behaves differently than it would behave if it were exposed to the
risk. More specifically here, it means that market participants would
be encouraged to expect similar emergency actions in future crises,
thereby weakening their incentives to properly manage risks and also
creating the perception that some firms are too big to be allowed to
fail.
[52] See The Federal Reserve Bank of New York's Involvement with AIG,
joint written testimony of Thomas C. Baxter, Executive Vice President
and General Counsel, and Sarah J. Dahlgren, Executive Vice President,
before the Congressional Oversight Panel, May 26, 2010.
[53] Among them, a memorandum sent to the then-FRBNY President on
September 16 from an FRBNY official noted that in the event of
bankruptcy of the AIG parent company, state insurance regulators would
likely act to liquidate or rehabilitate the company's regulated
insurance subsidiaries in financial distress. The former President
said in written testimony January 27, 2010, for the House Committee on
Government Oversight and Reform that an AIG bankruptcy filing would
have led insurance regulators worldwide to seize the company's
insurance subsidiaries. In another written testimony, for the
Congressional Oversight Panel on May 26, 2010, a Treasury official
highlighted that an AIG bankruptcy filing would have resulted in
seizure of AIG's insurance subsidiaries, with severe effects.
[54] Conseco, Inc., was a holding company for a group of insurance
companies operating throughout the United States, which developed,
marketed, and administered supplemental health insurance, annuities,
individual life insurance, and other insurance products. On December
17, 2002, the company and certain of its noninsurance subsidiaries
filed for voluntary bankruptcy under Chapter 11 of the U.S. Bankruptcy
Code. The company emerged from bankruptcy protection on September 9,
2003, as CNO Financial Group, Inc. For the year ended December 31,
2002, Conseco reported a net loss of $7.8 billion on revenues of $4.5
billion.
[55] Records we reviewed indicate the call spanned 10 minutes. During
the call, FRBNY officials told AIG that it must decide before 8 p.m.
that day whether to accept the offer, so that funds could be advanced
immediately to avoid defaults the following day.
[56] According to the American Bankers Association, debtor-in-
possession financing in bankruptcy proceedings is new debt issued for
operating purposes that is senior to all other debt issued before the
firm entered Chapter 11.
[57] There would have been losses on the Revolving Credit Facility to
the extent collateral FRBNY had taken was insufficient to cover any
amounts AIG had borrowed but not repaid, officials told us.
[58] As to whether there was any actual consideration or analysis of
which AIG entities might have filed for bankruptcy, FRBNY's bankruptcy
advisor told us that in a corporate family filing, each eligible
entity files unless there is a strong reason not to. In AIG's case,
this would have included both the parent company and AIGFP. However, a
debtor-in-possession lender as well as a Chapter 11 budget are needed
before determining which entities would file. According to the
bankruptcy advisor, this is because solvent subsidiaries ideally would
not file.
[59] "Automatic stay" prohibits a creditor from acting to collect a
debt, repossess collateral, or perfect its security interest (protect
against competing claims) after a borrower has filed a bankruptcy
petition. See GAO, Bankruptcy: Complex Financial Institutions and
International Coordination Pose Challenges, [hyperlink,
http://www.gao.gov/products/GAO-11-707] (Washington, D.C.: July 19,
2011).
[60] According to FRBNY's bankruptcy advisor, any early termination of
AIGFP's CDS contracts following bankruptcy of AIGFP or the AIG parent
company were subject to the terms of the International Swap Dealers
Association (ISDA) Master Agreements. ISDA is the trade association
for the swap industry, which among other things, promotes the
standardization of terminology, contracts, and practices. An event of
default, like bankruptcy, would have given each counterparty the
right, but not the obligation, to terminate early. In the event of
early termination, the ISDA Master Agreement provides guidance on
determining an early termination amount.
[61] Commercial paper refers to short-term obligations, with
maturities ranging from 2 to 270 days, that corporations or other
institutional borrowers issue to investors. Commercial paper is
generally paid by rolling-over into new short-term paper.
[62] We found inconsistent accounts on the FHLB matter. The e-mail
also notes that AIG had a longstanding application for three insurance
subsidiaries to become members of the FHLB of Dallas. AIG executives
with whom we spoke said that they did not know if AIG ever formally
approached the FHLB system. An official of the FHLB of Dallas told us
there had been on-and-off discussions with the AIG parent company over
several years about membership. The contacts began before the crisis
and continued until early 2009, when both AIG and the bank agreed not
to pursue membership. In any case, FHLB was never a strong option,
FRBNY officials told us. In general, FHLB lending was meant to target
a particular subsidiary, and was not intended to assist something like
the entire AIG complex. In addition, in AIG's case, the base of
capital to support any loan was small. Thus, FHLB credit would not
have been an alternative solution to Federal Reserve System lending
but would have added complications, the officials said.
[63] For example, section 8.17 of the agreement, Alternative Financing
Structure, provides that "[i]f, following the Closing Date, the Lender
identifies to the Borrower an alternative financing structure which
provides benefits to the Borrower equivalent to those provided under
this Agreement without material detriment to the Borrower, and
complies in all material respects with applicable limitations imposed
by law or agreement, the Borrower will, and will cause its
Subsidiaries to, take such steps as the Lender may reasonably request
to implement such alternative structure."
[64] According to FRBNY officials, this approach followed a number of
requests for funds AIG made in the days following extension of the
Revolving Credit Facility.
[65] FRBNY officials told us that after the Revolving Credit Facility,
they neither considered private equity financing as an option to
assist AIG nor contacted any of the firms that participated in the
first phase of efforts to identify a private-sector solution for AIG.
They said FRBNY advisors reported it was unlikely a private-sector
entity would replace a portion of the FRBNY's commitment without
demanding that FRBNY release its liens on a substantial portion of
collateral held. Officials told us that this view was borne out when a
commercial bank offered a letter of credit conditioned on
unencumbering significant AIG assets.
[66] According to FRBNY officials, the rating agencies would not
maintain A-rated debt for a company planning to liquidate in 6 months.
As a result, they said, planning always contemplated there being a
surviving company that could be rated. This is what allowed the rating
agencies to maintain their ratings on a company that was substantially
over-leveraged, the officials said.
[67] According to one FRBNY advisor, the Revolving Credit Facility did
not provide enough liquidity to fully address AIG's needs, so the
choice presented was increasing the amount available under the
facility or considering other approaches.
[68] According to the document, in a keepwell agreement, the Federal
Reserve System would agree to maintain a minimum level of net worth,
risk-based capital or other appropriate measure, to ensure insurance
company credit ratings remained at their existing levels. An excess-of-
loss reinsurance agreement would provide coverage, subject to a
specified limit, if the insurance subsidiary failed to make a payment
on a claim.
[69] Ring-fencing is a strategy used to isolate specific assets, thus
creating a protective "ring" around them.
[70] FRBNY officials told us that there were mixed reactions from AIG
regarding ML II and ML III. Some at AIG did not want to lose the
profit-making potential of certain assets they viewed as valuable,
while others were relieved that the Federal Reserve System provided
the solutions.
[71] The advisor noted in briefing slides from February 23, 2009, that
although nationalization posed a number of risks and issues, it
simplified certain aspects of the AIG situation. For instance, it
would have provided a solution for AIGFP, prevented credit ratings
downgrades, and addressed complex restructuring issues that would no
longer have been relevant.
[72] Although the Federal Reserve Board authorized additional lending
for the March 2009 restructuring, the plan was not implemented. It
involved securitizing cash flows from certain AIG domestic life
insurance companies. According to FRBNY officials, the insurance
companies were valuable, but AIG had difficulties finding buyers amid
a volatile market. The plan contemplated long-term notes and partial
repayment of the Revolving Credit Facility from FRBNY's extension of
credit to the insurance companies. FRBNY officials told us they had
concerns about maturity of the notes, but as markets began recovering
by the summer of 2009, there was less of a need for this option.
[73] In the end, AIG was not successful in negotiating a resolution to
its CDS crisis with the counterparties. At the time, asset values were
falling, and in order to protect themselves from falling values and
general market turmoil, the counterparties did not terminate their CDS
contracts with AIG. We spoke with one large AIG counterparty about
attempts to cancel its CDS contracts. The counterparty said that
beginning in 2007 and continuing to before the time of ML III, it had
been exploring CDS terminations with AIG. The counterparty said it was
interested in unwinding the CDS contracts, but at market value, and
without any concessions. According to the counterparty, the
discussions were unsuccessful, and no terminations took place, because
when AIG produced asset valuations, they were still at initial par
value, or significantly above current market values. In the
counterparty's view, the valuations showed an unwillingness on AIG's
part to recognize economic realities.
[74] Rating agencies drew criticism for various reasons, including
complaints they assigned ratings to structured financial products,
RMBS in particular, based on flawed methodologies. As a result,
critics said, investors and financial institutions had a lower
perception of actual risks when making decisions on matters such as
investments or capital requirements.
[75] AIG's auditor, Pricewaterhouse Coopers LLC, concluded that, as of
December 31, 2007, AIG had "a material weakness in its internal
control over financial reporting and oversight relating to the fair
value valuation of the AIGFP super senior credit default swap
portfolio." AIG filed an 8-K report with SEC on February 11, 2008,
making this announcement and clarifying its procedures for valuing the
portfolio.
[76] FRBNY officials told us that had there not been dates for
expected ratings actions, they might not have announced the
restructuring plan by November 10. Nonetheless, government action
would still have been necessary, because markets would have punished
AIG when it released its earnings report, the officials said. In
effect, that would have accomplished what a downgrade would have done.
[77] There were government-rating agency contacts on September 15,
according to a former senior AIG executive, when the executive and a
Treasury official called several rating agencies in unsuccessful
attempts to delay decisions on rating downgrades.
[78] Three rating agencies told us they each met with FRBNY and AIG
approximately six times after establishment of the Revolving Credit
Facility.
[79] According to AIG, most of AIGFP's CDS contracts were subject to
collateral posting provisions, but specific provisions differed among
counterparties and asset classes. Collateral calls happen when the
value of assets being protected declines, and under terms of a "credit
support annex" accompanying the CDS contract, a party makes a call for
payments--collateral--to reflect the decline. In AIG's case, the
company's posting of collateral with its CDS counterparties reduced
the counterparties' exposure to AIG, mitigating the impact if AIG
could not honor its CDS contracts.
[80] See GAO, Federal Reserve System: Opportunities Exist to
Strengthen Policies and Processes for Managing Emergency Assistance,
[hyperlink, http://www.gao.gov/products/GAO-11-696] (Washington, D.C.:
July 21, 2011).
[81] FRBNY officials told us the goal was that when the company
announced its earnings, they could say that although AIG's performance
was weak, the government had solved the main problems that drove the
company to the brink of failure.
[82] According to FRBNY, the total amount received was somewhat less
than par value, as the counterparties paid financing charges and had
to forego some interest earnings. In this report, we generally use
"par" or "par value" to refer to this near-par value, except as
otherwise indicated.
[83] A senior note is a loan that has first priority for repayment
before other debt.
[84] A mezzanine note has an intermediate priority for repayment after
senior financing; here, the counterparties' mezzanine loans would have
been second in priority to FRBNY's senior note.
[85] CDS premiums, or spreads, are the periodic fees that
counterparties pay in return for CDS protection.
[86] According to FRBNY officials, this funding likely would have been
necessary because the counterparties might reasonably have objected to
novation of the AIG CDS contracts to a vehicle that had insufficient
capital to cover collateral calls in the event of future rating agency
downgrades or CDO defaults. Thus, it might have been necessary to pre-
fund the vehicle with the difference between par value and the amount
of collateral already posted by AIG, in order to persuade
counterparties to participate. FRBNY was viewed as the only realistic
funding source to meet this need, the officials said.
[87] The as-adopted vehicle purchased the counterparties' CDOs at what
were determined to be then-current fair market values, using the FRBNY
funding and the AIG equity contribution, but FRBNY officials said
their analysis provided sufficient assurance of repayment.
[88] The concern about lending against value related to a novation
vehicle potentially guaranteeing CDO notional values, because the
Federal Reserve System does not have the authority to issue
guarantees, FRBNY officials told us. A form of guarantee, which would
be fully collateralized, could be possible, but there would be
practical problems in implementation, the officials said. Among the
problems would be that such a guarantee would need to be capped, which
could create market perception issues.
[89] Consolidation means combining all assets, liabilities, and
operating accounts of a parent company and its subsidiaries into a
single set of financial statements. In this case, consolidation of ML
III would have meant reflecting ML III's operations in AIG's financial
statements. Consolidation of ML III was a key concern, and FRBNY
officials sought to avoid it, because it could have injected
volatility into AIG's operations at a time when the Federal Reserve
System was trying to accomplish the opposite and stabilize the
company. According to our review, the main ML III design feature
influenced by the consolidation issue was the residual cash flow
allocation; see discussion in the following paragraphs. Ultimately, ML
III was consolidated into Federal Reserve System financial statements.
[90] The portfolio on which this analysis was based had about $4.8
billion, or about 8 percent, greater assets than what ultimately
became the ML III portfolio. The base case scenario assumed housing
prices would decline 36 percent nationally and 59 percent in
California from their peak. The stress case assumed declines of 48
percent and 68 percent nationally and in California, respectively. The
extreme case assumed 56 percent and 75 percent price declines
nationally and in California, respectively.
[91] This figure neglects transaction costs and assumes a functioning
marketplace for the assets.
[92] The London Interbank Offered Rate is a reference interest rate
published by the British Bankers' Association, based on a daily survey
of major banks, in which they are asked to provide the interest rate
at which they believe they could borrow funds unsecured for a
particular maturity in the wholesale London money market. Basis points
are the smallest measures commonly used in quoting interest rates. One
basis point is one-hundredth of a percentage point, so that 100 basis
points equals 1 percentage point.
[93] FRBNY officials' position was that after the initial government
assistance, such protection was no longer necessary.
[94] Initially, FRBNY officials told us they contacted all 16
counterparties. A script prepared for FRBNY calls to the
counterparties read in part:
"We have asked to meet with you in order to give you an opportunity to
substantially reduce your counterparty exposure to AIG and assist in
promoting the long-term viability of the company....As evidenced by
recent government actions, the viability of AIG is an important policy
objective given the firm's systemic importance. As we are sure you can
appreciate, a collapse of AIG... would have jeopardized the financial
system in general, and your financial institution in particular....
[Market developments highlight] the significant economic costs that
would have been bourn by AIG's counterparties had the government not
intervened and the sizable counterparty exposure that your firm
continues to retain with AIG.
For these reasons, it is clear to us that we have a common objective
in ensuring the firm's long-term viability....We would propose that
you make us a compelling offer to unwind all your outstanding CDS
contracts with AIG [at a discount].... Of course, we are open to other
proposals you might have that would lead to a final resolution of this
complex portfolio and therefore satisfy our common objectives.
[Your] assessments should also reflect the cost of the considerable
direct and indirect benefits counterparties have derived from the
Federal Reserve's support of AIG and market stability more
broadly....Of course, participation is entirely voluntary...."
[95] We spoke with the remaining two counterparties--Bank of America
and Merrill Lynch--but they were unable to provide information on
whether FRBNY sought concessions. At the time of ML III, these
companies were independent, but Bank of America has acquired Merrill
Lynch in the interim.
[96] On numerous occasions in 2008 and 2009, the Federal Reserve Board
invoked emergency authority under the Federal Reserve Act of 1913 to
authorize new programs and financial assistance to individual
institutions to stabilize financial markets. Loans outstanding for the
emergency programs peaked at more than $1 trillion in late 2008. The
Federal Reserve Board directed FRBNY to implement most of these
emergency actions. See [hyperlink,
http://www.gao.gov/products/GAO-11-696].
[97] As noted earlier, however, FRBNY and its advisor had developed
three approaches to calculating concessions. Also, two counterparties
we spoke with had a rationale for evaluating concessions, which
included considering the removal of hedging costs and details
associated with collateral postings by AIG.
[98] Testimonies of Thomas C. Baxter, Jr., Executive Vice President
and General Counsel, FRBNY, and Treasury Secretary Timothy F.
Geithner, before the House Committee on Government Oversight and
Reform, January 27, 2010.
[99] See Questions for the Record, submitted in conjunction with
testimony of Timothy F. Geithner, before the House Committee on
Oversight and Government Reform, January 27, 2010.
[100] According to the French banking official, liability would arise
under civil law through claims by shareholders, and generally would
not involve an administrative action by regulators themselves. This is
because typically, banks would not act if they believed the regulator
would take subsequent action, the official said. If there was to be
liability, it could be governed by statutory provisions applicable to
specific legal forms of organization, such as joint stock company, or
cooperative or mutual banks. Liability could also arise generally
under the French civil code. Article 1382 of the French civil code,
cited by the French official, states: "Any act whatever of man, which
causes damage to another, obliges the one by whose fault it occurred,
to compensate it."
[101] Once FRBNY and AIG counterparties agreed on the CDOs to be
acquired, the ML III transaction closed, with ML III paying the
counterparties for the CDOs it acquired. The ML III transaction had
three separate closings in two rounds, on November 25, 2008, and on
December 18 and 22, 2008. The two rounds settled $46.1 billion and $16
billion in CDO notional values, respectively. On the closing dates,
the counterparties delivered the CDOs into an escrow account. ML III
funded the escrow account with $29.3 billion. The escrow agent
released $26.9 billion to the counterparties and delivered the CDOs to
ML III.
[102] Synthetic CDOs are backed by credit derivatives such as CDS or
options contracts, not assets such as bonds or mortgage-backed
securities.
[103] Our review showed that ML III acquired CDOs from two
counterparties that had no collateral-posting provisions. The notional
value of these positions was about $487.5 million. FRBNY officials
told us they acquired these CDOs because posting of collateral (via a
credit support annex) was just one way that liquidity pressure, which
ML III was designed to relieve, could be created. Also, another ML III
objective was to assure a reasonably diverse portfolio for the
vehicle, with rights aimed at maximizing return on disposition,
officials said. They said CDOs from these two counterparties were
included for these reasons.
[104] FRBNY officials also told us that having CDOs in ML III that
were denominated in a foreign currency would have introduced foreign
exchange risk into management of the ML III portfolio, which they
wanted to avoid.
[105] As noted earlier, counterparties cited similar logic to us in
explaining their opposition to concessions for ML III participation--
namely, that because the CDS contracts protected par value, they were
entitled to par value for selling their CDOs and terminating their CDS
protection.
[106] On January 1, 2008, the cost of CDS protection on AIG was 79.7
basis points for 3-year coverage and 68.9 basis points for 5-year
coverage. On September 16, prior to the initial government
intervention, the premium cost had risen to 3,921.8 and 3,500.3 basis
points, respectively. On November 7, after having fallen by about 72
percent following establishment of the Revolving Credit Facility, the
cost had risen again, to 3,358.9 and 3,016.9 basis points,
respectively.
[107] To the extent there was uncollateralized exposure, actual losses
could vary, such as if the counterparties could sell their CDOs on the
open market and obtain enough value to cover any uncollateralized
amounts. Also, we examined counterparty exposure as a percentage of
CDO value lost, and high or low percentage figures, as shown in figure
4, do not necessarily correlate with size, in dollars, of fair market
values of CDO holdings or payments counterparties received from ML III.
[108] As of October 24, the total amount of collateral requested
ranged from about 44 percent of the loss in value of CDO holdings to
more about 235 percent.
[109] In particular, FRBNY officials noted that market valuations at
the time were uncertain, as there was little or no trading in the
relevant securities. The amount of collateral requested should not be
seen as a proxy for the amount entitled, they said. Also, market
conditions may have changed in the week between October 24 (the date
for which collateral posting data was available) and October 31 (the
date fair market values were established).
[110] Any such negotiations would have been like those required for
the three-tiered ML III option, the officials said, which, as
discussed earlier, they rejected as unworkable.
[111] The documents were a term sheet and two agreements--one to sell
their CDOs to ML III and another to terminate AIGFP's CDS contracts on
the CDOs.
[112] Section 13(3) was subsequently amended by the Dodd-Frank Act. As
a result of the amendments, as further discussed in this section, the
Federal Reserve System can now make section 13(3) loans only through
programs or facilities with broad-based eligibility. The language of
section 13(3) in effect at the time the Federal Reserve System
provided assistance to AIG was:
"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. All such
discounts for individuals, partnerships, or corporations shall be
subject to such limitations, restrictions, and regulations as the
Board of Governors of the Federal Reserve System may prescribe."
[113] Section 14(d) of the Federal Reserve Act authorizes each Reserve
Bank to set rates as follows:
"(d) To establish from time to time, subject to review and
determination of the Board of Governors of the Federal Reserve System,
rates of discount to be charged by the Federal reserve bank for each
class of paper, which shall be fixed with a view of accommodating
commerce and business; but each such bank shall establish such rates
every fourteen days, or oftener if deemed necessary by the Board[.]"
[114] We did not conduct any independent legal analysis of section
13(3) lending authority.
[115] See 12 C.F.R. § 201.4(d).
[116] Discount window lending is when financial institutions borrow
money from the Federal Reserve at the "discount rate," which is the
interest rate charged member banks for loans backed by collateral,
such as government securities or eligible notes. The discount rate
provides a floor on interest rates, as banks set their loan rates
above the discount rate.
[117] This explanation is inconsistent with another rationale provided
by a Federal Reserve Board official, who said the rates for these
vehicles were set according to what a private-sector borrower likely
would have obtained.
[118] Records we reviewed discussing the interest rates on these
facilities were prepared by FRBNY officials after Federal Reserve
Board approval of the lending.
[119] Section 1101(a)(6) of the Dodd-Frank Act amends section 13(3) of
the Federal Reserve Act to provide, among other things, that "[a]
program or facility that is structured to remove assets from the
balance sheet of a single and specific company, or that is established
for the purpose of assisting a single and specific company avoid
bankruptcy, resolution under title II of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, or any other Federal or State
insolvency proceeding, shall not be considered a program or facility
with broad-based eligibility."
[120] See [hyperlink, http://www.gao.gov/products/GAO-11-696].
[121] Federal Reserve Board officials have said the agency should be
more open about its actions to promote financial stability. In
exchange for the ability to make independent monetary policy, the
Federal Reserve System must be transparent, the Federal Reserve Board
Chairman has said. Transparency about actions to promote financial
stability assures Congress and the public that the Federal Reserve
System is using its resources and authority well, its General Counsel
has said. According to the Chairman, the Federal Reserve System will
look for opportunities to broaden the scope of information and
analysis it provides on its efforts to ensure financial system
soundness.
[122] SEC Form 8-K is a report companies must file with SEC to
announce major events that shareholders should know about. AIG filed
two 8-K statements because the company amended an original filing, SEC
officials told us. AIG's first 8-K statement was filed on December 2,
2008, and is available at (last accessed, Sept. 21, 2011) [hyperlink,
http://www.sec.gov/Archives/edgar/data/5272/000095012308016800/y72879e8v
k.htm]. It reported the company's November 25, 2008, agreement with
FRBNY on ML III. The second 8-K statement, available at (last
accessed, Sept. 21, 2011) [hyperlink,
http://www.sec.gov/Archives/edgar/data/5272/000095012308018339/y73482e8v
k.htm], was filed December 24, 2008, and reported purchases of
additional CDOs for ML III on December 18 and 22, 2008.
[123] SEC officials told us this discussion prompted AIG to consider
seeking confidential treatment of the information. According to the
officials, AIG responded that given the two choices, the company would
likely seek confidential treatment.
[124] AIG filed two distinct CTRs--because there initially were two 8-
K filings--but the material under consideration was the same, SEC
officials told us. In this report, we use the singular "CTR" to refer
to both. According to information from SEC, CTRs are not unusual. From
2001 to 2009, the agency received from 1,200 to 1,700 CTRs annually.
Most requests involve competitively sensitive information. According
to SEC officials, when evaluating a CTR, SEC's goal is to balance
investors' need for information with the impact of disclosure on a
company. A key determining factor is whether the information is
material to investors for making an investment decision. If so,
confidential treatment will not be granted. According to SEC, a matter
is "material" if there is a substantial likelihood that a reasonable
person would consider it important in making an investment decision.
Procedures for requesting confidential treatment of information that
otherwise must be disclosed in reports to SEC are contained in Rule
406 under the Securities Act of 1933 and Rule 24b-2 under the
Securities Exchange Act of 1934, as well as in SEC Staff Legal
Bulletin No. 1, dated February 28, 1997, as amended.
[125] FRBNY officials never considered that ML III deal information
would be made public and had told the AIG counterparties their
identities would not be disclosed.
[126] The goal of Maiden Lane goal was to prevent contagion effects on
the economy from a disorderly collapse of Bear Stearns, according to
FRBNY. Maiden Lane borrowed $28.8 billion from FRBNY. This loan,
together with $1.15 billion in funding from JPMorgan Chase, was used
to purchase a portfolio of mortgage-related securities, residential
and commercial mortgage loans, and associated derivatives from Bear
Stearns.
[127] AIG executives said the company's disclosure counsel circulated
for comment the idea of withdrawing the CTR but that, upon reflection,
the company realized a complete withdrawal was inappropriate, and the
idea was dropped.
[128] Although companies grant the consent, release of information is
not automatic, SEC officials told us. In general, no SEC staff may
release confidential information to an agency or Congress without
formal Commission approval. In the specific case of releasing CTR
information to Congress, officials said the Commission would consider
such approval on a case-by-case basis.
[129] SEC rules require CTR filings to be made in paper format only.
The drop-off procedure involved hand delivery of the CTR to an agency
official, bypassing normal routing procedures within SEC that involve
delivery of the CTR by mail or courier. SEC officials said that if
requested, they would consider this procedure in other instances as
well.
[130] In March 2009, AIG began disclosing Schedule A information,
following SEC review. On January 27, 2010, the ranking member of the
House Committee on Oversight and Government Reform released the full
Schedule A after a committee hearing on AIG. On January 29, 2010, AIG
amended its 8-K filings to fully disclose Schedule A.
[131] CUSIP, a commonly used acronym for Committee on Uniform
Securities Identification Procedures, provides a unique identifying
number for most securities. The CUSIP system facilitates clearing and
settlement of securities trades. In the case of information previously
made public, AIG had made a disclosure on 4 of the 10 CDOs, and FRBNY
had released information on the remaining 6. "Tranche" refers to a
particular class within a multi-class security.
[132] FRBNY officials told us it is difficult to gauge any effect of
the disclosure yet, for two reasons. First, there has not been a CDO
liquidation since the CUSIPs were made public, partly because the
market has performed better. Second, any impact will not be felt until
wholesale disposition of portfolio assets begins, when FRBNY will
negotiate with investors. But even then, it will be difficult to draw
cause-and-effect relationships, they said. In the meantime, there has
been considerable interest in the information, officials told us.
After the CUSIPs were released, for example, FRBNY got a number of
calls from market participants who were pleased to learn the positions
held by ML III, officials told us, because the market typically is
opaque and a private investor would not release such information.
[133] See AIG correspondence to SEC, August 12, 2008, available at
(last accessed, Sept. 21, 2011) [hyperlink,
http://www.sec.gov/Archives/edgar/data/5272/000095012308009400/filename1
.htm]. SEC officials told us the correspondence was in response to
agency comments in connection with review of an AIG quarterly Form 10-
Q filing. According to the officials, a table in the AIG response
letter included names of the company's largest CDO counterparties,
including a summary of aggregate notional values. AIG, in its
correspondence, said the material was confidential business and
financial information relating to a "breakdown of the super senior
multi-sector CDO credit default swap portfolio." SEC officials noted
differences between this matter and the company's later CTR. The
earlier request was not a CTR, and it did not involve information
required to be disclosed under SEC disclosure requirements. The
information was provided pursuant to SEC Rule 83, which provides a
different standard of review than a CTR and does not require SEC to
make a determination on the request until it receives a request for
the information under the Freedom of Information Act. AIG provided the
information in response to SEC staff comments, to assist the staff in
understanding information AIG had disclosed in the 10-Q report.
Although a different matter than the CTR AIG later filed, we note
nonetheless that it was an effort, in advance of government aid, to
protect CDO information similar in nature to Schedule A data. Other
than to note the earlier filing and the nature of the content, review
of this matter was beyond the scope of this report.
[134] As noted earlier, AIG filed two 8-K statements initially. The
first, as originally prepared, did not contain the language directly
stating that the counterparties would receive par value, AIG
executives told us. It was in the initial draft of the second 8-K
filing that this language appeared, they said.
[135] See, for example, Public Disclosure As a Last Resort: How the
Federal Reserve Fought to Cover Up the Details of the AIG
Counterparties Bailout From the American People, House Committee on
Oversight and Government Reform, report by the ranking member, January
25, 2010.
[136] Neither the Federal Reserve Board nor FRBNY owned AIG stock.
Instead, as a condition of extending the Revolving Credit Facility to
AIG, FRBNY required that AIG agree to transfer a 79.9 percent
controlling interest in the company to a trust for the benefit of the
U.S. Treasury, which officials noted is distinct from the Department
of the Treasury.
[137] Overall, the federal government's involvement in the corporate
governance of companies receiving exceptional amounts of assistance--
including AIG--has varied according to the nature of the assistance.
In the case of Bank of America, Citigroup, and GMAC, for example, the
government's role was as an investor, but its activities were
initially limited because the government received preferred shares
with limited voting rights. In the case of General Motors and
Chrysler, the government was an investor and creditor, and it has been
more involved in some aspects of the companies' operations than it has
been with other companies. This has included monitoring financial
strength through regular reports and meetings with senior management,
plus requiring certain actions, such as maintaining the level of
domestic production. See GAO, Financial Assistance: Ongoing Challenges
and Guiding Principles Related to Government Assistance for Private
Sector Companies, [hyperlink, http://www.gao.gov/products/GAO-10-719]
(Washington, D.C.: Aug. 3, 2010).
[138] FRBNY contracted with a number of vendors for AIG assistance,
including those for the Revolving Credit Facility and ML III. For
details, see [hyperlink, http://www.gao.gov/products/GAO-11-696],
appendix III.
[139] FRBNY's Operating Bulletin 10 sets forth FRBNY's acquisition
policy. Exigency is defined as occurring when "[t]he Bank's need for
the property or services is of such unusual and compelling urgency
that it would be demonstrably and significantly injured unless it can
limit the number of suppliers from which it solicits responses or take
other steps to shorten the time needed to acquire the property or
services." See [hyperlink, http://www.gao.gov/products/GAO-11-696] for
a more detailed discussion on FRBNY's use of noncompetitive bidding to
award contracts to vendors for Federal Reserve System emergency
lending programs.
[140] In the case of ML III portfolio management, the advisor directs
the investment and manages the assets of ML III, according to the
direction and authority granted to it by FRBNY.
[141] Operating Bulletin 10 is labeled as an "acquisition policy" and
describes, for example, a FRBNY contract representative's
responsibility to avoid "conduct which gives rise to an actual or
apparent conflict of interest, or which might result in a question
being raised regarding the independence of the Contract
Representative's judgment or the Contract Representative's ability to
perform the duties of his or her position satisfactorily." Overall, an
evaluation of FRBNY's implementation of conflict procedures was beyond
the scope of this report. See [hyperlink,
http://www.gao.gov/products/GAO-11-696] for a review of Federal
Reserve System emergency lending facilities created during the
financial crisis, which includes a review of FRBNY's conflict policies
and procedures. FRBNY also has an employee Code of Conduct, which
generally addresses conflict issues for employees, such as avoiding
preferential treatment, conduct that places private gain above duties
to the bank, or situations that might result in questions about
employee independence. The code also incorporates the provisions of a
federal criminal conflict of interest statute and its regulations. See
(last accessed, Sept. 21, 2011) [hyperlink,
http://www.newyorkfed.org/aboutthefed/ob43.pdf].
[142] The Treasury regulations, at 31 C.F.R. Part 31, define an
organizational conflict of interest as a situation in which the
retained entity has an interest or relationship that could cause a
reasonable person with knowledge of the relevant facts to question the
retained entity's objectivity or judgment to perform under the
contract, or its ability to represent Treasury. The regulations
provide that, as early as possible before entering into a contract to
perform services for Treasury, a retained entity shall provide
Treasury with sufficient information to evaluate any organizational
conflict of interest. Steps necessary to mitigate a conflict may
depend on a variety of factors, including the type of conflict, the
scope of work, and the organizational structure of the retained
entity. Some conflicts may be so substantial and pervasive that they
cannot be mitigated. 31 C.F.R. § 31.211.
[143] The reviews were of Morgan Stanley, Ernst & Young, BlackRock,
and Bank of New York Mellon.
[144] Collateral managers perform duties including managing portfolio
risks, such as credit and interest rates; purchasing and managing
collateral assets; executing trades and hedges; and working closely
with trustees.
[145] "Aggregating" orders is when a firm combines different orders
together, involving its own account, customer account(s), or both.
[146] See [hyperlink, http://www.gao.gov/products/GAO-11-696] for a
description of such facilities.
[147] According to FRBNY officials, advisors generally prescreened
their conflict waiver requests internally, so that they only presented
those likely to be approved.
[148] According to FRBNY officials, the decision in this matter took
into account that certain trigger events had already occurred, which
resulted in a restriction on any trading by the CDO collateral
manager. In addition, FRBNY staff took on sole responsibility for
monitoring the assets.
[149] Although FRBNY did not begin tracking waiver requests until
January 2010, we obtained records for such requests from FRBNY
advisors.
[150] Voting rights allow the holder to direct, or consent to, certain
significant actions, such as replacing managers or amending contracts.
[151] Hedge counterparties, through derivative contracts with CDOs,
hedge various CDO risks, including interest rate, foreign exchange,
and cash flow timing.
[152] Interest rate swaps are financial products that provide swap
buyers with hedging protection against the risk that interest rates
will increase in the future. Because AIG's credit rating had been
downgraded below a specified level, the collateral managers of these
CDOs had the right to direct the termination of AIGFP as an interest
rate swap counterparty. At issue were timing of a potential CDO
liquidation and the effect that would have had on AIGFP's ability to
receive a swap termination payment. In deciding whether to direct
liquidation, FRBNY did not discuss these matters with AIGFP. As of
February 5, 2009, AIGFP was an interest rate swap counterparty to 72
CDOs in which ML III was an investor, with a net exposure of about $12
billion.
[153] Trustee duties generally include distributing payments to CDO
investors according to their payment seniority, performing compliance
tests on the composition and quality of CDO assets, and producing and
distributing investor reports.
[154] The collateral manager is Trust Company of the West, which is a
Societe Generale subsidiary.
[155] Tranches can vary in risk profile and yield. Junior tranches
will bear the initial risk of loss, followed by more senior tranches.
The CDOs in the ML III portfolio are largely senior tranches. Because
senior tranches are shielded from defaults by the subordinated
tranches, they typically have lower yields and higher credit ratings--
often investment grade.
[156] ML III had unilateral liquidation rights upon events of defaults
in 26 of 89 CDO deals (39 percent by principal balance). Prior to
liquidation, discussions take place between the investor and the
trustee on liquidation matters.
[157] Liquidation involves selling a CDO's underlying securities
through an auction process. If a CDO experiences an event of default,
specified voting classes may have the right to either accelerate or
liquidate the CDO to recover any remaining value. Acceleration alters
the CDO cash flow payment priority to divert cash flows to the senior
tranches, which are generally the tranches ML III holds.
[158] Bank of New York Mellon's fee letter with FRBNY states that fees
are based on the average notional balance of ML III assets.
[159] According to officials, the Federal Reserve Board makes
supervisory rules and is responsible for supervision. To carry out
that responsibility, the Federal Reserve Board has delegated functions
to the Reserve Banks, including FRBNY.
[160] In addition to the advisor relationships described here, the
Federal Reserve System was also the regulator of some entities
involved in efforts to obtain private financing for AIG prior to
extension of the Revolving Credit Facility and of some AIG CDS
counterparties that were part of negotiations leading to ML III.
[161] Our review was based on information from data provider SNL
Financial and SEC Form 13F filings, the latter of which report
holdings of institutional investment managers. According to SEC, in
general, an institutional investment manager is (1) an entity that
invests in, or buys and sells, securities for its own account or (2) a
person or entity that exercises investment discretion over accounts of
others. Institutional investment managers can include investment
advisers, banks, insurance companies, broker-dealers, pension funds,
and corporations. There is a $100 million threshold for Form 13F
reporting. If cross-holding of the type we identified existed at a
level below the threshold, it would not be reportable.
[162] Our analysis focused on cross-ownership. Hence, we do not
discuss one-way ownership here--that is, where an advisor had holdings
in a counterparty but the counterparty did not have holdings in the
advisor, or vice-versa. Our analysis also excluded counterparties not
publicly traded.
[163] Bank of America later reduced its BlackRock holdings. According
to a BlackRock securities filing, as of December 31, 2010, Bank of
America did not hold any BlackRock voting common stock but still held
approximately 7.1 percent of BlackRock's capital stock.
[164] For example, FRBNY's employee Code of Conduct, in addressing
conflicts of interest, summarizes its general standard as "[a]n
employee should avoid any situation that might give rise to an actual
conflict of interest or even the appearance of a conflict of interest"
(emphasis added). As an illustration, it cites an employee working on
a contract award who has a sibling or close friend working for one of
the bidders.
[165] See [hyperlink, http://www.gao.gov/products/GAO-11-696].
[166] AIG signed a term sheet outlining the terms of the Revolving
Credit Facility on September 16, 2008. To meet AIG's funding needs
until a final agreement could be drafted, FRBNY made four loans to AIG
from September 16-19. In the following week, FRBNY and its advisors
drafted final documentation, which the parties signed on September 22.
FRBNY officials told us they did not communicate to AIG the terms of
the facility prior to the company's Board of Directors meeting on
September 16.
[167] The official told us that FRBNY discount window staff found the
interest rate exceedingly high. Ordinarily, rates would be set low
enough that they would not be an additional burden in a crisis, but
high enough that they would not be attractive once conditions improve
and the market returns to normal. The rate imposed appeared to be
extremely high and a burden to AIG and thus seemed contrary to the
idea of trying to sustain the firm, the official told us.
[168] Objections notwithstanding, AIG executives told us they expected
the terms of any financing, whether from the private-sector or
government, to be punitive and expensive and that would-be private
lenders were initially enthusiastic about a potentially lucrative
opportunity when exploring the possibility of a private loan.
[169] A lien is a creditor's claim against property.
[170] After authorization of the Revolving Credit Facility, FRBNY drew
on two advisors to assist in valuing the assets that secured its loan
to AIG, according to FRBNY officials. The officials said there was a
considerable effort to calculate collateral value, with much of the
collateral in the form of equity in insurance subsidiaries that AIG
held. Officials said that because this type of collateral valuation
was new to FRBNY, they needed the assistance of the advisors. The
valuation of the collateral securing the loan was based on AIG as a
going concern, the officials told us.
[171] According to an internal FRBNY memorandum on August 26, 2009,
FRBNY viewed it as undesirable for AIG to have excess cash, out of the
concern the company might not use it effectively.
[172] Seller financing is when a seller receives a secured note from a
buyer in exchange for financing the purchase of the asset.
[173] Specifically, FRBNY officials cited section 6.04 of the credit
agreement, which states that AIG and its subsidiaries will not
"purchase, hold or acquire any Equity Interests, evidences of
indebtedness or other securities of, make or permit to exist any loans
or advances to, or make or permit to exist any investment or any other
interest in, any other Person," except in specified cases. Also,
notwithstanding specific instances listed in the agreement, "the
Borrower and its Subsidiaries shall not be permitted to make any
material investment in illiquid, complex structured products for which
no external market price, liquid market quotes or price based on
common agreed modeling is available except (i) pursuant to Investment
Commitments in effect on the Closing Date and entered into in the
ordinary course of business or (ii) with the prior written consent of
the Lender."
[174] The officials noted that these terminations ultimately led to
the establishment of the Securities Borrowing Facility authorized by
the Federal Reserve Board.
[175] The fact sheet also noted that the restructured loan would be
more durable in addressing AIG's problems because ML II and ML III
removed capital and liquidity drains stemming from AIG's exposure to
domestic mortgage markets.
[176] AIG retained control of the two limited liability companies, AIA
Aurora LLC and ALICO Holdings LLC, and FRBNY held rights with respect
to preferred interests it held in each vehicle.
[177] We did not seek to independently verify the company's
representations about fulfillment of its obligations.
[178] This discussion excludes employee compensation matters. Under
TARP, through which Treasury provided assistance to AIG, compensation
was limited for executives of companies receiving assistance.
[179] Notwithstanding the company's position, Federal Reserve
officials said the fact of government involvement, and need to repay
government lending, probably caused the company to behave differently
than it would have otherwise.
[180] Against the backdrop of time pressure, another factor at work,
according to one Reserve Bank official, was the unofficial practice of
"constructive ambiguity," in which regulators encourage financial
firms and their creditors to behave as if government support will not
be available while at the same time standing ready to act in a crisis.
Thus market participants must draw their own inferences about future
policy. The ambiguity, however, tends to force officials' decisions in
a crisis because deciding against providing aid would mean greater
turmoil, the official said. In effect, policymakers are forced to be
more generous than desired, the official said.
[181] Resolution Plans and Credit Exposure Reports Required, 76 Fed.
Reg. 22,648 (Apr. 22, 2011).
[182] See Regulatory Notice 10-57, November 2010.
[183] See GAO, Troubled Asset Relief Program: Bank Stress Test Offers
Lessons as Regulators Take Further Actions to Strengthen Supervisory
Oversight, [hyperlink, http://www.gao.gov/products/GAO-10-861]
(Washington, D.C.: Sept. 29, 2010).
[184] In congressional testimony, the former Treasury Secretary summed
up AIG's interconnections: "AIG was incredibly large and
interconnected. It had a $1 trillion dollar (sic) balance sheet; a
massive derivatives business that connected it to hundreds of
financial institutions, businesses, and governments; tens of millions
of life insurance customers; and tens of billions of dollars of
contracts guaranteeing the retirement savings of individuals. If AIG
collapsed, it would have buckled our financial system and wrought
economic havoc on the lives of millions of our citizens." See
testimony of Henry M. Paulson before the House Committee on Oversight
and Government Reform, January 27, 2010.
[185] The Federal Reserve Board is a federal agency. A network of 12
Reserve Banks and their branches carries out a variety of functions,
including operating a nationwide payments system, distributing the
nation's currency and coin, and, under delegated authority from the
Federal Reserve Board, supervising and regulating member banks and
bank holding companies. The Federal Reserve Board oversees the
operations and activities of the Reserve Banks and their branches. The
Reserve Banks, which combine features of public and private
institutions, are federally chartered corporations with boards of
directors. As part of the Federal Reserve System, the Reserve Banks
are subject to oversight by Congress. In this report, we distinguish
among the Federal Reserve Board, meaning the Board of Governors of the
Federal Reserve System; the Federal Reserve System, meaning the
Federal Reserve Board and at least one of its regional Reserve Banks;
and the Federal Reserve Bank of New York, which is the regional
Reserve Bank for the Second Federal Reserve District.
[End of section]
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