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Friday, October 01, 2010

AIG Preferred Conversion Math - Something Is Rotten in the State of America

EDIT:  after you read this post, please be sure to read my follow up post for some clarifications and corrections.  Bottom line: Treasury didn't screw itself out of $6B by using a $45 conversion price instead of a $39 conversion price.

This AIG story has been bugging me for the past few days.  The government has already restruck the terms of its AIG loans multiple times to make them more favorable for AIG, so I'm wary of us (the government) getting screwed one way or another in this whole conversion process.  It's quite possible that I'm missing something in this math, and if I am, I'd love for a reader to correct me.  I hope I'm wrong.

Here's what we need to know:  First, AIG has a page on their website detailing the status of their obligations to the Fed and Treasury. There are different series of preferred stock outstanding.  Series E is worth $41.6B.  Series F is worth $7.5B.   Next, we look at the 8k filed yesterday for the conversion details:

"At the Closing, (i) the shares of AIG’s Series C Perpetual, Convertible, Participating Preferred Stock (the “Series C Preferred Stock”) held by the Trust will be exchanged for approximately 562.9 million shares of AIG common stock, which will ultimately be held by the Treasury Department; (ii) the shares of AIG’s Series E Fixed Rate Non-Cumulative Preferred Stock (the “Series E Preferred Stock”) held by the Treasury Department will be exchanged for approximately 924.5 million shares of AIG common stock; and (iii) the shares of the Series F Preferred Stock held by the Treasury Department will be exchanged for (a) the Transferred SPV Preferred Interests (as described above), (b) newly issued shares of Series G Preferred Stock (reflecting an initial liquidation preference if and to the extent that AIG has drawn down available funds under the SPA between the date hereof and the Closing) and (c) approximately 167.6 million shares of AIG common stock. The Treasury Department will then hold approximately 1.655 billion shares of AIG common stock, representing pro forma ownership of approximately 92.1 percent of the AIG common stock that will be outstanding as of the Closing."

That sounds complicated, but what it's saying is that the warrants to buy 80% of AIG's common stock (the Series C preferred) will convert into 562.9MM shares of stock.  The Series E preferred (which we just said was worth 41.6B) will convert to 924.5MM shares of stock, and the series F preferred (worth 7.5B) will convert to 167.6MM shares of stock.  Those numbers sum to the 1.655B shares of stock that the Treasury will own in total.

Now, is Treasury getting screwed?  Let's look at some math.

For $41.6B of Series E Preferred, we got 924.5MM shares of stock.  That implies a conversion price of $45 per share (41.6B / 924.5MM) !  Huh?  Current AIG price is $39.  Why are we exchanging senior, dividend paying preferred stock worth $41.6B for junior common stock worth $36B at current prices??!?! (by the way, I believe that AIG neglected to pay the dividend  on the preferred stock!)

The $7.5B of Series F Preferred was exchanged for 167.6MM shares of common stock, implying a conversion price of $44.75 per share.  Why did we exchange Series F Preferred stock worth $7.5B for common stock worth $6.5B?  Anyone? Anyone?  Beuller?  Maybe we'll make up for it in volume? (sarcasm!)

The Series C Preferred, which are the 80% warrants, are being converted into 562.9MM shares of stock, worth $21.9B at current prices.  Since there are roughly 135MM shares of AIG currently held by the government, converting the Series C Preferred into 562.9MM common shares is a fair deal for Treasury.   On the other hand, these Preferreds had a balance sheet value of $23B, and the converted shares are currently worth less than that, so it could be looked at as a loss.  In my opinion, that's the least of the problems.

Then there's the matter of the 75mm $45 strike warrants being given to current AIG holders.  This serves to dilute the government's value further.  Why do we continue to subsidize shareholders of failed institutions?  Any money/equity that the government is giving up here is a direct subsidy to existing shareholders of AIG.

So talk to me, people - why shouldn't we be outraged that AIG managed to swindle the Government once again, getting us to convert our senior (preferred) holdings into junior (common) holdings worth roughly $6B less?

A side issue is that the post-conversion shares outstanding of AIG (1.655B owned by the government, and roughly 135MM owned by the public) imply a post-conversion market cap of nearly $70B at current share prices!


I posed the following questions to a contact at Treasury - I will update readers if I get a response from them on the record:  "Why is the treasury converting senior obligations into junior obligations at a discount?  How does Treasury justify the roughly $45 conversion price?  Why are we giving non-government AIG common shareholders another subsidy?"

-KD

disclosure - no positions in AIG

18 comments:

Ritholtz said...

Exactly.

Its a bad deal, and its likely to get worse, as we dumb down the rescue to "save face."

Anonymous said...

I'm no financial analyst but you need to come up with a core earnings estimate for a company that has sold off its most profitable divisions (to pay down fed/treasury debt) and will likely move forward with an impaired credit rating in an industry where that is currency and brand. P/E's in this industry are tightly bunched (and low) so I wouldn't put much weight on the implied value of the company based on the 135m shares held by a cabal of hf yahoos. How much can this company earn, multiply it by 8 and then calculate how much we lost. The price of the conversion only nominally impacts the total value of the loss as we are going to own 92% of the company.

Kid Dynamite said...

anon - I deliberately avoided that entire subject because it's not really relevant. Unless Treasury's goal is to become a long term value investor in AIG, which I'm fairly certain is NOT the case.

In other words, the market has assigned AIG a value already. It's not Treasury's position to say "omg - AIG common equity is a STEAL here! It would still be cheap even if we converted our senior obligations at a discount!"

In any case, no matter how you look at it, no matter what the value of AIG is, this conversion subsidized non-gov't equity holders.

Anonymous said...

I agree the conversion ratio is material to the folks who hold the soon-to-be 8% stake, but the ultimate cost to this thing will be the price at which the Treasury can sell it's 92% stake. The fact that there is ANY residual value to common is ridiculous in my opinion, but we are arguing about 8% of the pie. What needs to be calculated--and I am not FA and that's why I posted, hoping to get an informed estimate--is the going forward earnings power of a company that has been partially dismantled, has permanent brand damage, and will have a comparatively poor credit rating. At that point, we can make an estimate of how much money the T will ultimately recoup from their equity stake.

Kid Dynamite said...

Yes - the outcome of this "Trade" is absolutely still up in the air. again, just to clarify, the implied conversion price in this announcement could have been the current market price, and the Treasury could certainly still lose money.

I just want to be clear that that's another issue. Because the conversion was done with disadvantageous prices, we'll make less than we would have otherwise made, or lose more than we would have otherwise lost. How much that is definitely remains to be seen.

I also want to see someone's AIG equity valuation model (remember, they're selling off tons of core businesses), but I want to make sure everyone realizes that it's a separate issue.

David Merkel said...

The government assumed that the market price was wrong, and said AIG is worth $45/share.

Personally, if I had been in the government's shoes, I would have said that the market price was wrong, and priced it around $36, with no warrants for outside investors. Liquidity deserves to be paid, and the government provided the liquidity.

jck said...

Treasury is not getting screwed, it paid nothing for the Series C Perpetual. AIG was obligated to issue that stock to access the loan facilities. Given away 80% of the company the price to pay to be "saved" (usually ignored by the media).

Anonymous said...

I guess I should have posted this under the FT headline "AIG Exit Plan Set To Deliver A Profit" which was the top stories in today's paper. Agreed that the conversion price and the addition of warrants (wtf?) for common is a terd, but the fact that common EXISTS should have long ago suspended your disbelief. What sticks in my craw is the assumption of a "profit" that is based off a 92% equity stake that has to be sold at some point in the future. Let me go out on a limb here and say that the Treasury is not going to be able to sell it's equity stake in AIG for $50b unless the sale comes will a whole lot of expensive subsidies on the back end.

Kid Dynamite said...

JCK - that logic is clearly flawed. Why don't we just throw the warrants away then? After all, we didn't buy them...

The initial terms of AIG's bailout were reasonable - they were offered liquidity and a backstop, with a steep price. Those terms were quickly adjusted lower, and then adjusted lower again. Now, we're not even getting full value from the doubly adjusted terms.

As the other anon noted, the "price" should have been 100% of the common equity - that's why there's a capital structure in the first place.

In any case, I already noted that the series C was the least of the problems - they were for 80% of the common equity, and that's what they were translated into. Seems reasonable.

getyourselfconnected said...

Great discussion. Seems like a bad deal for the US but it is not like anything can be done about it.

jck said...

If you got these warrants for free and you sell them for $21.9 bln, it's not trivial and it is a profit of $21.9 bln.

Kid Dynamite said...

jck - I don't think that's what this post is about at all though. This isn't the Treasury's AIG Profit/Loss report (that will come later)

this post points out that the Treasury exchanged some assets (preferred stock) worth $49B for some assets further down the cap structure with a lower value ($42.5B).. I don't think those facts are debatable. And I don't think it's debatable that this exchange was better for the non-gov't common stock holders than an exchange with a lower conversion price would have been.

jck said...

I am not debating your exchange calculations for the 2 other series of preferred, just that you are ignoring a material fact, that is the c preferred yield a profit of $21.9 bln vs your loss of around $6.5 bln for the other 2 series. net net, treasury is in the money. period. and you are implying it is not.

Kid Dynamite said...

JCK - in the money, eh? again - we will have that discussion when the Treasury finally liquidates its stake.

But the point is that even if Treasury is in the money, they should be MORE in the money - except that they keep improving the terms of the trade for AIG and AIG's non-govt equity holders. That's factual - it's not my opinion. And that's what this post was about.

Kid Dynamite said...

I really don't want to have the "we're going to turn a profit on AIG" "We're going to lose money on AIG" "Treasury is in the money on AIG" discussion right now. Although it's an important one, there are too many unknowns still.

It's essential for readers to understand that the topic of this post is giving up value that we (the gov't) should not be giving up.

for those interested, the Congressional Oversight Panel wrote a report on AIG.

http://cop.senate.gov/documents/cop-061010-report-execsummary.pdf

from page 4:

"Even at this late stage, it remains unclear whether taxpayers will ever be repaid in full. AIG and Treasury have provided optimistic assessments of AIG‟s value. As current AIG CEO Robert Benmosche told the Panel, “I‟m confident you‟ll get your money, plus a profit.”

The Congressional Budget Office (CBO), however, currently estimates that taxpayers will lose $36 billion. A large portion of the funds needed to repay taxpayers will be generated through the sale of assets bought by the government to assist AIG, assets still held by AIG, and units of AIG
sold to third parties or to the public through initial public offerings. The uncertainty lies in whether AIG‟s remaining business units will generate sufficient new business to create the
necessary shareholder value to repay taxpayers in full. AIG‟s management is unsurprisingly bullish on that prospect, where the CBO does not attempt to forecast such expansion in revenues and instead relies on a baseline estimate. For now, the ultimate cost or profit to taxpayers is
unknowable, but it is clear that taxpayers remain at risk for severe losses."

Anonymous said...

KD -

As a former employee of Citigroup, I'd like to jump in on JCK's side (although the big C and AIG have some material differences obviously). Whether or not the Treasury makes money on the whole AIG "experience" is a very relevant discussion. Unless the point of the government's involvement was to get a raider/distressed capital like return. I'm of the opinion that if the government gets involved like it did in AIG it is trying to pick the best of 2 awful options and get out fast, not trying to double its money. The alternative of the UST using it preferred stake to squeeze out the common as much as its could is silly.
Here is one way to think of this. Think of this as pre-packed bankruptcy. The government has the preferred stake in AIG via the three preferred classes, including the warrants. Let's say that the preferred equity is worth Y (there are no observable prices). Mr. Market has determined the the COMMON equity is worth X. In order to get liquidity (since AIG does not have cash), the preferred class must convert to common and sell. Let's assume that preferred + common = Z = X +Y. That sale will be the ultimate realization for the Y holder. In the process of the exchange we are now just arguing how much of Z does Y get. In this case, they got 92%. This is pretty consistent with most preferred exchanges that I've seen. Perhaps even generous. The most the government could have gotten was approaching 100%. Let's aggressively assume the ultimate value of Z is $70b. So the government is, at most, out $5.6B on this negotiation. Given where we are coming from with AIG, really does not seem so bad.
When the Treasury exchanged the TARP preferred in C for common it did so at a big discount. It used $3.25 (as did other private shareholders) as the stock valuation for a company that the market was valuing at $2.4 (when pro-forma TBV post-exchange was $5). After the announcement of the exchange the C stock traded sub $1. Now the government is selling for $4. Point being the fact of an exchange and a bit of clarity in where a company is headed can result in a HIGHER price for the common than our brilliant Mr. Market might suggest. I've always thought AIG was a black hole, but I'd like to believe that 2 years of intense government oversight/ownership should give the government clarity as to what they think they are actually getting.

Kid Dynamite said...

anon -

don't lose sight of this fact: using a higher or lower price doesn't change the value of the company at all. All it does is change the balance of ownership. Using a higher conversion price shifts more equity to the current non-gov't owners.

That may be alright with you - it's certainly not alright with me.

Ritholtz said...

JCK -- imagine that, for only $182.3 billion dollars, you get free warrants.

Sounds like a surefire investment