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Of the three firms, AIG represents their best hope, even though its
credit spreads are still at levels that suggest a real risk of default.
The government fired a blunderbuss of money at it, with six
different categories of intervention (see table). Safest are probably
the direct loans from the Federal Reserve, the commercial paper
that the Fed has guaranteed and the loans that it is likely to make
that are secured by life-insurance policies. These instruments are
fairly high up the pecking order if the firm goes bust. The $25
billion preferred-equity stake that the Fed owns in two of AIG’s
insurance subsidiaries is also pretty safe: they may be worth as
much as double that sum.
The danger to taxpayers comes in two forms. First, the Fed has
lent $44 billion to two special-purpose vehicles, into which many of
AIG’s flakiest securities have been dumped, including derivatives
written on structured-credit instruments. At the end of March
these vehicles were $5.4 billion in the red: unless prices recover
taxpayers will ultimately take the hit. Second, the Treasury has
$43 billion of preferred shares in AIG itself. So far the firm’s core
book value (the value of its assets) is about equal to that,
suggesting that the investment is covered.
The Fed has around 25 full-time staff sitting in AIG now, so its accounts should be more reliable. But even
though AIG made a small profit in the second quarter, more losses are possible. It still has a giant
portfolio of credit-default swaps that European banks use to game capital rules. These have not lost
money yet, but remain a black box. And the government’s long-term plan to raise cash by spinning off or
selling the traditional insurance businesses could crystallise losses. Several AIG assets sold so far have
ended up fetching less than book value.
These risks, though, pale into insignificance compared with Fannie and Freddie. The two have racked up
colossal losses. As Wall Street ate into their securitisation business, they branched into buying debt
securities worth some $1.6 trillion. Of this about $230 billion turned out to be toxic, with losses of almost
$90 billion at market prices. Future pain will come from the traditional guarantee business. The pair have
underwritten $4.8 trillion of mortgages between them and delinquency rates are rising along with
unemployment. Impairments are likely to be only 4-5% of the total but that would be more than enough
to sink the two agencies.
The government has agreed to fund these losses with equity injections of up to $400 billion. It has
invested $98 billion so far, and Rajiv Setia of Barclays Capital thinks the total cumulative capital required
will be $160 billion-200 billion. It could turn out worse. The book value of the two firms, using market
prices and excluding the existing equity from the state as well as tax assets, showed a capital shortfall of
$280 billion at the end of June. This sum is a proxy for how much taxpayers will lose unless prices
recover.
Such massive insolvency makes it hard to restructure the two agencies. Right now they are staggering on
in “conservatorship”, a form of direct state control. The Treasury is backstopping their capital and the Fed
is helping them refinance their debts by buying up to $200 billion of their bonds in the open market. Over
time their holdings of securities will probably be wound down. The guarantee business will be harder to
kill. The government plans to decide on Fannie’s and Freddie’s futures by February, but the agencies are
likely to survive under state control or as co-operatives with state guarantees.
This extraordinary resilience reflects the widespread political lust in America for subsidising housing.
Anyone who doubts this should look at Ginnie Mae, another fully state-owned agency which guarantees
and bundles mortgages, usually of below-average quality, that are insured by the government. Fannie and
Freddie are now being conservative about writing new business, but Ginnie is enjoying its own bull
market, issuing guarantees at a furious rate. It is expected to have a trillion dollars outstanding by next
year. “We are seeing a gravitation of the subprime universe from Fannie and Freddie to Ginnie”, says Mr
Setia. It will be a miracle if taxpayers get their money back from Fannie and Freddie. Worse, there is a
chance the disaster will be repeated.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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