Tuesday, October 05, 2010

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.



Cetamua said...

"The STO said he thought that the roots were in class warfare"

He really said THAT? This asshat thought that denouncing rewards for failure is tantamount to class warfare?

This ASOL (Administration Senior OfficiaL) may not be up to speed regarding the average American subculture: One of its tenets posit that no one can deserve anything more than a decreased salary (lucky fuck already very lucky to keep his/her job right?) and Hasta la Vista Baby for bonuses.

How hard can this be to understand?

Absolutely mind boggling!

Kid Dynamite said...

Cetamua - All I would say is that you took half of the sentence regarding class warfare, and that it wasn't a direct quote.

This WAS a direct quote: "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 agreed with that anger (I'll edit the post).

He added something about the sanctity of contracts which I thought would just be a distraction and divert the comments in the wrong way - since I've said from the start that the bailouts could have contained their own conditions regarding bonuses - NEW contracts...

EconomicDisconnect said...

Wow, all I get are calls from telemarketers!

Kid Dynamite said...

Interested readers should be sure to read Felix Salmon's piece today

it sounds like he had a very similar conversation to the one I did.

Zach said...

So, am I correct in reading your assessment as not perfect, not shady, not awful?

Mark said...

Kid, who in god's name is going to buy this stuff? What if it goes bad again? The public may not be so tolerant this time.

ndk said...

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?"

I agree and feel that the importance of the psychological changes they're causing is severely under-appreciated. The world ain't all contained in a TIPS-nominal spread, guys...

Kid Dynamite said...

mark - that depends on how much they earn. If you earn it, they will come!

Zach - well, kinda. I want to hate it. I really really do, but the logic was reasonable.

I guess it depends on how liquid you think debt would have been if they'd converted the Prefs into normal debt or other preferred debt instead - there are a huge amount of options there. I'm still mostly annoyed at the equity moral hazard.

D said...

You suggested that the government should play hard-ball with the debt holders (forcing them to swap to equity while the government would swap to debt). The problem with that is the treasury has lost all credibility as a deal-maker. Every single deal the government has been involved in has seen the treasury cry for mercy. Bear Stearns, AIG CDS payments, Citigroup, BAC, GM,... The only exceptions are when the government seems to (rather arbitrarily) decide not to help at all (Wamu, Lehman) and those haven't worked out that well for the government (JPM is now suing the FDIC over WAMU?!). If you were a debt holder the smart move would be to ignore the governments offer, and I suspect they realize they couldn't make any threats believable one month before the election.

Yangabanga said...

@cetamua ASOL! nice!

Well at least there is an explanation to why all equity holders weren't wiped out. I wonder if this is an ex-post explanation though because I cannot for a second imagine that the same treasury that heavy-handedly forced banks into shotgun marriages (after playing spin the bottle with various suitors) and into taking TARP funds godfather-style would give a crap about lawsuits when in their view they are saving the world...

Transor Z said...

To paraphrase: "Hey, if we lost $20B in the course of saving the world from a Depression, that's an acceptable loss."

Screw him and the smug self-congratulatory horse he rode in on. Does Treasury have a big "MISSION ACCOMPLISHED" sign draped across its facade?

Kid Dynamite said...

TZ - I'm kinda surprised to hear you say that. I thought you'd agree with your own paraphrase...

Anonymous said...

If I thought it were a true statement and not just a political talking point, I would... as if $20B is the total net loss on the gov't intervention! Fighting systemic risk becomes a convenient excuse to cover up a multitude of sins, like "national security."

BTW, I think it's awesome and completely well-deserved that Treasury showed you the respect of direct communication. But, you know, they lie and stuff.


Kid Dynamite said...

TZ - first off, I want to be clear that it's not my intention to defend Treasury here, although as one of their biggest critics, i have a duty to understand their logic.

Now, I don't think anything about TARP has gone well politically. I don't think saying "spending $20B to save the world" would be a good political talking point, and I don't think Treasury thinks that either. Here, what the guy was saying was that he thinks they'll do much better than that, even make money, but if they didn't it would still have been a good decision.

And yes, I'm very grateful that they gave me an hour of one on one time on this - what do you think they are lying about?

Kid Dynamite said...

TZ - i forgot to mention - never mind AIG - there's a HUGE problem with all of these "Cost" estimates to gov't intervention - they've devalued the dollar, bubbled up asset prices to the point where people don't feel comfortable buying stuff (for me: stocks especially) - since support must end at some point, and they've destroyed the value of savings.

I am guessing that's what you meant about the other costs of bailouts - and I agree COMPLETELY - but they can't be measured like "We put $XB into Citi and got (X+5B) back. PROFIT!"

Transor Z said...

Your 2:07 comment - Yes, exactly what I meant.

I'm skeptical about the alleged illiquidity of the block of non-cumulative prefs and I'm very troubled at the extent of a gov't agency's intervention in the capital restructuring of a private company. Turnaround artist is not in the Treasury job description. They don't have in-house expertise about that (unless by pure coincidence) and therefore some unknown private party is advising them and some other unknown private person is telling them to unload the shares in dark pool/algo transactions.

So, next time tell the STO you want to cut out the middleman and talk directly to the private third parties who are telling him what to do.


Kid Dynamite said...

TZ - I need to correct something you have wrong - another friend said something similar to me.

THe guy in charge of the AIG restructuring is an expert at this. It's what he was brought in to do - hired specifically for this.

It's not like Geithner trolled the Treasury halls yelling "hey - does anyone know how to recapitalize and restructure AIG?" - he went out and found The Guy who does know how to do it.

So I still very much agree with your "I'm very troubled at the extent of a gov't agency's intervention in the capital restructuring of a private company"

yet you're wrong on "turnaround artist is not in the Treasury job description" - for this job it is!

Anonymous said...

Even if Treasury hires Steven Spielberg, making movies still isn't in the agency's job description.


Kid Dynamite said...

TZ - right. but if they need to make a movie, aren't you glad they hired Spielberg? Point is, this isn't some MBA intern on this project.