Tuesday, February 23, 2010

AIG, FRBNY, Maiden Lane III, and Goldman Sachs

The attempt to figure out what happened in the AIG bailout continues.  Bloomberg News has posted an article today on the subject -- "Secret AIG Document Shows Goldman Sachs Minted Most Toxic CDOs."  This article is based on a document that the Federal Reserve Bank of New York ("FRBNY") did  not want made public in unredacted form but was inserted into the record by Representative Darrell Issa (R, CA.), the ranking member of the U.S. House Committee on Oversight and Government Reform.  The document, called "Schedule A," lists the credit default swaps ("CDS's") on collateralized debt obligations ("CDOs") that were put into an investment vehicle created by the FRBNY called Maiden Lane III (named after one of the streets bordering the FRBNY building in the Wall Street area).

Schedule A lists each underlying CDO by CUSIP number along with the tranche name, the associated AIG counterparty for the CDS on each CDO, the notional value (principle value of each CDO), the amount of collateral AIG had posted  for each CDS, and the negative mark to market (difference between the market and notional value).

As explained in the written statement of Tom Baxter, the FRBNY's General Counsel, for a January 27 hearing of the House Oversight Committee, Maiden Lane III was funded by a $24.3 billion loan from the FRBNY, which is secured by CDOs AIG had insured with CDS contracts and a $5 billion equity investment from AIG.  The purpose of Maiden Lane III was to terminate, or tear up, the CDS's sold to 16 AIG counterparties.  In return for agreeing to tear up the contracts, the AIG counterparties were allowed to retain $35 billion in collateral which AIG had posted with them and to sell the underlying CDOs to Maiden Lane III.  The $29.3 billion of funding was used to purchase the CDOs, which had a principal value of $62 billion.  Mr. Baxter states that the fair market value of the CDOs was approximately $29.6 billion, and that therefore the counterparties essentially received "par" for the securities in return for tearing up the contracts.

Baxter's statement is somewhat vague about the exact amount the counterparties received from Maiden Lane III for the CDOs.  According to a November 2009 report of the Special Inspector General for the Troubled Asset Relief Program ("SIGTARP"), Maiden Lane III paid the counterparties $27.1 billion and AIG Financial Products $2.5 billion as "an adjustment payment to reflect overcollateralization."  (Page 5 of the report.)  This adds up to $29.6 billion, the deemed fair value of the CDOs.  Left unexplained is how Maiden Lane III was able to make payments of $29.6 billion, when its initial funding amounted to $29.3 billion.

Baxter also states that AIG's $5 billion equity investment is subordinated to the FRBNY's $24.3 billion loan and that the FRBNY, in addition to this downside protection, will get two-thirds of any profits Maiden Lane III makes.  Maiden Lane III can hold the CDOs to maturity.

This seems like a pretty sweet deal for the counterparties for getting out of their exposures to both the CDOs they held and  to AIG if the CDOs were to suffer a credit event that triggered a payment on the CDS (which I am distinguishing from collateral posting).  In defense of the arrangement, Baxter states "...if AIG defaulted, and even filed for bankruptcy protection, the counterparties would have kept both the collateral and the underlying CDOs (and would have been made whole if they had sold the CDOs for fair value." [Emphasis in original.]  However, this particular argument does not square with some of the Fed's justification for this transaction.  If AIG had filed for bankruptcy, the "fair value" of the underlying CDOs would have  gone down, perhaps substantially.

There will likely be more revelations about this matter as the press and official groups, such as the Financial Crisis Inquiry Commission and various Congressional committees, continue to investigate.  In addition, as mentioned in a previous post, Goldman is a focus.  This additional evidence that it was such a large counterparty to AIG, backed by some hard numbers, guarantees additional public scrutiny of the firm.

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