Treasury's Response On AIG

I received a surprise follow-up from Treasury today regarding the questions I had posed them last week which went unanswered:

"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?"

I had an hour long conversation with a Senior Treasury Official (STO for short) in which he explained his thinking and rationale on the matter.  I'm going to keep him anonymous because the conversation was "off the record," although he gave me permission to detail aspects of the conversation, with the obvious caveat that I was accurate in my representations.  I've chosen to include a few direct quotes I found especially juicy, which I might not be able to include if I attributed them to a specific individual.

The STO delved right into my first question - that of the exchange of senior preferred stock for junior common equity.  First of all, the Fed's loans had senior claims on company assets attached to them, so they had to be paid back first, which is why the Treasury is essentially assuming the Fed's AIA/ALICO SPV preferred interests (Andrew Ross Sorkin got this part wrong - this "debt" is still outstanding, but will be paid back with the proceeds of planned asset sales)  He re-explained the life cycle of the support AIG had received:  Initially Treasury owned 10% coupon cumulative preferred stock that was, basically,  pretty sweet.  Cumulative means that if they miss a dividend, it accrues - it's owed to the holders of the preferred.  After reporting a $60B loss in early 2009, AIG had to massively restructure its capital, as the ratings agencies had determined that it was a perpetual loss making entity:  the profits generated by the business wouldn't cover the coupon payments on outstanding debt.  Thus, they restructured a lot of debt at this time - converting Fed loans into the SPV's holding the AIA/ALICO preferred stock positions, adding $30B in Series F Preferred available from Treasury (to increase liquidity, but only $7.5B of that was used), and converting the juicy Series D 10% Cumulative Preferred into the craptastic Series E non-cumulative preferred. 

Herein lies the rub: non-cumulative preferred is senior to common equity - common equity holders cannot be paid a dividend if the preferred holders haven't been paid - but that only applies to the most recent preferred dividend!  Missed dividend do not accrue.  In other words, if AIG didn't pay a dividend on the non-cumulative preferred for 2 years, they didn't have to make up all the missed dividends before they paid equity holders - they only had to make up ONE dividend to be current under the dividend "block."  In a way, it was reverse alchemy for Treasury - they turned gold into lead.

So, WHY did Treasury do this?  Who gives a crap about AIG's rating?  Did we want to bail out AIG's bondholders?  Well, no -  Treasury has a dual mandate here - they wanted to avoid bringing down the financial system while maximizing returns on the Taxpayers'  investment.    There were two basic options right away:  1) wind down the businesses over time while minimizing AIG's threat to the global financial system, or 2) shrink the bad businesses (AIGFP) while selling off the good assets to pay back the debts.   Initially, the plan was perhaps weighted more toward the former - Ed Liddy was brought in to try to wind down the mess, but a problem was that they were trying to sell at the bottom - they couldn't get the prices they wanted for the assets they had.  So Treasury regrouped and leaned toward option 2, in an effort to avoid massive losses.

Since they were trying to sell off assets in order to repay the debts owed to Treasury, they needed AIG to maintain its investment grade rating - after all, an insurance company without an IG rating doesn't stand much of a chance of maintaining the capital it needs.

There were two pressing questions as to how to do this.  The first, as it was put to me by the STO: "How do we terminate government support and leave it investment grade?"  Since ratings agencies' models give roughly 75% equity value to preferred stock, if they converted the $49B in preferred to common, that's a quick $12B in equity credit.    The next key question was "I've got $49B of this stuff, how do I monetize the value of it?"  I already explained the logic of the craptastic-ness of the non-cumulative preferred.  It has value, but the bottom line was that Treasury didn't think it was worth par (100c on the dollar).  How much was it worth?  "It's worth what we just turned it into,"  I was told - in essence, he was trying to say that something is only worth what someone will pay for it.  While it's conceivable that there might be buyers for a $10B chunk of cumulative preferred, the insinuation was that the non-cumulative preferred owned by Treasury didn't have a real liquid value.  That doesn't mean it was worthless, or even not worth par over the long term to Treasury, but Treasury didn't want to be in the business of owning AIG's preferred stock for the next 15+ years.

So how much is the common stock worth?  AIG had its bankers run their own fairness opinions, Treasury had its bankers run THEIR fairness opinions, but the bottom line is that they took an estimated $8B net income number for the residual insurance businesses, slapped an 8 multiple on it (low end of their valuation range) and came up with $64B as a starting point.  The next question is what capital structure to use - who should get that equity?   The fact that the government already had rights to 80% of it complicates things, as I discussed in my previous pieces on the subject, because conversions of preferred into common dilute our own stake.

The STO acknowledged that there were a lot of possible ways to recreate the new capital structure, but that in the end they chose conversion into common equity as the way to go.

As one of my friends put it to me, "Common shares should have been offered to debt holders, and for every $1 of debt exchanged into equity, the Government should have converted $1 of preferred into debt," thus owning a senior, liquid, money good, coupon paying instrument.    Again, talking with Treasury, I think that Treasury thought their best chance for a profitable, speedy exit from this "mess" would be to convert to equity.  They could have converted part of the preferred into a more liquid, more attractive cumulative preferred, and part into common equity, but the STO was bullish on the equity conversion as the best option incorporating all the factors (liquidity, leverage, and ability of Treasury to exit profitably)

Now, the big question - why are we giving existing non-government shareholders anything at all?  In my view, this is another unjustified bailout, and the moral hazard aspect of it infuriates me.  We had begun our discussion by talking about how the STO thought that the public didn't really understand TARP.  I admitted that this was certainly true, but that I thought the current rage against moral hazard, even if the ragers couldn't specifically tell you what "moral hazard" is, is very real and understandable:  hard working Americans don't like people getting paid for failure.  To some people that means that they don't like their neighbor getting subsidies to stay in his house if he can't pay his mortgage,  to others that means they hate the Wall Street bailouts.  The STO said he thought that the roots were that the public didn't understand how we could put billions of dollars into these companies and the companies still pay millions of dollars of bonuses - and that he understood the public's angst on that topic, and I countered that it had started that way, but has morphed into much more than that - it's metastasized into a disgust that is essentially summed up by "Hey - why should I work hard if the Government will bail me out if I don't?"

So back to the topic of non-government equity holders getting any stake in the new company:  he explained that this was a public company, with a new board instituted post-blowup that had duties under Delaware Corporate law.  In short, Treasury wanted to avoid lawsuits from the equity holders if they were to get wiped out.   By giving them a token (8%) piece of the company, the Board could satisfy its duties and placate the shareholders.  Maybe this was a flaw back in the original assistance - that the terms were 80%, not 100% of the common stock - that the Government should have wiped out the common equity while they had the chance, and to do so now would be too messy.  I don't know - it bothers me greatly to see shareholders "rewarded" with any value whatsoever, but the STO kinda shrugged it off as not the biggest issue on the table.  Someone left a comment on one of my earlier AIG posts that since the company never went through bankruptcy, we can't prove that the equity would have been worthless.  Even $180Billion dollars in government assistance doesn't prove that the equity would have been a zero, and we never gave the shareholders their due process in that regard through bankruptcy - so we can't wipe them out.

We briefly discussed how long it would take the Government to liquidate its common equity position.  The cabal of big market makers had given guidance of how long it would take, ranging from 6-9 months to 1 1/2 - 2 years.  The brokers cited "dark pools" and "algorithms" as ways for Treasury to bleed their position into the market slowly and with limited effect, and the STO mentioned that there is virtually no institutional ownership of AIG currently.  I explained that "dark pools" and "algos" were my background, and that if you're trying to sell $65Billion of AIG stock, especially to big natural holders, you don't do it through dark pools and algos - you go to them directly and put up large secondary offerings.  He agreed on this note, and I'm guessing that they will try to expand the public float first via a large secondary offering, and then go for the periodic sale route, like Citigroup is doing.

I thought the call was a great experience in trying to get inside Treasury's head, and to get the logic behind Treasury's answers to my questions.  Summing up,  the STO mentioned that someone had told him "If you prevented the next great depression and it cost you $20B on your AIG investment, it was a good trade," while at the same time explaining that he actually expects Treasury to come out ahead.  They received 1.66B shares for their $47.5B in cash out the door, for a breakeven basis around $29.

-KD