Thomas C Baxter, Jr and Sarah J Dahlgren: The Federal Reserve Bank of
New York's involvement with the American International Group (AIG)
Joint written testimony before the Congressional Oversight Panel by Mr Thomas
C Baxter, Jr, Executive Vice President and General Counsel, and Sarah J Dahlgren,
Executive Vice President, of the Federal Reserve Bank of New York, Washington DC,
26 May 2010.
* * *
Chair Warren and Members of the Panel, thank you for giving us the opportunity to testify
here today regarding the Federal Reserve Bank of New York's (New York Fed) involvement
with AIG.
I. The decision to lend to AIG
On the morning of September 16, 2008, it became clear to Federal Reserve and Treasury
policymakers that AIG, then one of the world's largest insurance and financial firms, was
facing a potentially fatal liquidity crisis. AIG's crisis was coming amidst the collapse of the
housing market, within weeks of the receiverships of Fannie Mae and Freddie Mac, and
within 24 hours of the bankruptcy of Lehman Brothers. Confidence in the financial system
was exceptionally fragile, and financial firms were taking dramatic and unusual measures to
protect their balance sheets. Money market funds, long viewed as a safe investment by
millions of Americans, were experiencing massive withdrawals. The run on these funds, in
turn, severely disrupted the commercial paper market, a vital source of funding for American
businesses. Securitization markets started to seize up, especially those that relied upon
instruments backed by consumer loans. Banks sharply curtailed their lending.
A full fledged panic had started and was spreading rapidly; the financial system was facing
the threat of collapse.
In light of the circumstances at the time, a bankruptcy filing by AIG would have had
disastrous consequences. Federal Reserve Chairman Bernanke has stated that it could well
have "resulted in a 1930's-style global financial and economic meltdown, with catastrophic
implications for production, income, and jobs." Because of the decisions made that morning,
we can never really know.
Let us be clear, though, about the risks that the policymakers did know. Policymakers knew
that AIG's largest creditors were other financial firms and that those firms clearly would have
been directly impacted by an AIG bankruptcy filing. But the gravest risks were not the direct
exposure of other financial firms to AIG. The gravest risks related to the indirect
consequences of a bankruptcy of AIG, indirect consequences that would impact millions of
Americans.
AIG's role as one of the world's largest and storied insurance companies meant that its
failure likely would have had a contagion effect, causing damage as it spread throughout the
insurance industry. Policy holders would be hurt. Municipalities, who were already reeling
from a lack of financing options for their building projects, would have seen their financial
protection disappear. Workers whose 401(k) plans had purchased $40 billion of insurance
from AIG against the risk that their stable value funds would decline in value would see that
insurance disappear. Pension plans that had placed funds in AIG guaranteed investment
contracts, or GICs, which function much like deposits in a bank, would have experienced
significant losses, losses that would be passed along to retirees or to others whose
aspirations to be retirees would surely have been changed.
And these indirect consequences of an AIG bankruptcy would not have stopped at the U.S.
border. AIG was global in scope. It conducted its operations in more than 130 countries, and
across various parts of the financial industry, insurance as well as banking. The damage
from an AIG filing would have been felt from the farms of Iowa to the streets of San
Francisco to the far off corners of the world. The unplanned and chaotic bankruptcy of this
trillion dollar financial conglomerate (especially a day after Lehman's filing) would have been
a global catastrophe.
That catastrophe did not happen.
More than a year and a half later, it is easy to forget the level of panic and fear that gripped
the world during the week of September 16, 2008. A bankruptcy of AIG would have fueled
the fear, much as gasoline fuels a fire. And let us not forget what Federal Reserve and
Treasury officials have said many times in testimony - we did not have the necessary tools,
such as legal authority for a special resolution regime, with which to limit the damage of an
AIG collapse.
We also did not have the luxury of time. AIG needed liquidity and it needed it that day. In the
early days of the intervention, when we knew precious little about AIG, but knew that it
needed billions of dollars, we were truly facing a binary choice to either let AIG file for
bankruptcy or to provide it with liquidity. It is worth noting that this choice fell to the Federal
Reserve because Congress had equipped it with an ability to lend to a non bank like AIG in
extraordinary and exigent circumstances. Given AIG's situation on September 16, 2008, and
given what had transpired over the preceding days and months, how could we responsibly
not have lent pursuant to our statutory authority?
With authorization from the Board of Governors under Section 13(3) of the Federal Reserve
Act, the Federal Reserve Bank of New York had the ability to provide liquidity to AIG by
making a fully secured loan. The decision to activate the authority and lend was clearly
justified on the merits but was difficult because of the collateral consequence, the moral
hazard resulting from AIG's rescue. Within hours of the policy determination, the Federal
Reserve took over the term sheet originally created by a private sector consortium of
commercial banks. In the aftermath of Lehman's bankruptcy, the consortium was no longer
prepared to lend to AIG. On the evening of September 16th, we advanced $14 billion in
credit to AIG through a fully collateralized lending, and announced the term sheet for what
would become an $85 billion revolving credit facility with AIG (Fed Facility).1
Some have asked why the Federal Reserve did not see the threat that AIG posed to the
financial system before September 16th. The short answer is that AIG had hundreds of
regulators, none of which was the Federal Reserve. The Federal Reserve had no regulatory
authority over the firm - no authority over its capital, no authority over its liquidity, and no
oversight over its control functions. The Federal Reserve was not engaged in supervision of
AIG. It did not have the legal authority to do so. These roles and responsibilities remained
with state insurance regulators, and with the comprehensive consolidated supervisor, the
Office of Thrift Supervision. Throughout the weekend of September 13th and 14th we were
assured by those regulators that a private sector consortium of commercial banks had a
solution to AIG's liquidity problems, and we had no basis to question those assurances. But
then Lehman filed for bankruptcy protection and the private sector consortium unequivocally
stated that they were no longer prepared to lend to AIG.
The AIG situation is both different and similar to that of Long-Term Capital Management
(LTCM), a hedge fund that nearly collapsed in the fall of 1998. In the LTCM situation, the
Federal Reserve called together a private sector consortium made up of LTCM's major
counterparties, who agreed to rescue LTCM by investing about $3.6 billion in new equity, in
return for a 90 percent equity stake in LTCM's portfolio along with operational control. The
counterparties made this decision after the Federal Reserve encouraged them to recognize
their self-interest in saving LTCM. The consortium invested in LTCM because its members
came to believe that the Federal Reserve staff was right. Several years later, when the
investors received back all of their capital with interest, they came to see that the Federal
Reserve was right. The market conditions in September 2008 presented a very different
situation to AIG's counterparties who, in the aftermath of Lehman's failure, found themselves
facing liquidity concerns that compelled them to maintain cash on their balance sheets rather
than lend to AIG. Moreover, the unprecedented size of AIG's liquidity need - ultimately more
than $150 billion - could not have been met by the private sector. There is, however, one
very important similarity. We believe that we will receive full payment of principal and interest
from AIG, much like the consortium did in LTCM.
Still others have wondered why Lehman went bankrupt, while the Federal Reserve extended
credit to AIG that prevented its default. The answer is that AIG presented a very different
case. AIG had enough high-quality collateral to permit the Federal Reserve to extend a
secured loan to provide liquidity to the firm. On September 16th, our focus was on providing
liquidity so that AIG could meet its obligations and avoid default. To be clear, we were not
making an investment in AIG; we were making a fully secured loan. We were not assuming
management responsibility for the company; we were a lender to the company. The recently
released Volukas Report shows in a thorough, exhaustive manner that an effective solution
to Lehman required a strong merger partner that could provide much needed capital to
ensure a going concern. While Federal Reserve and Treasury officials tried very hard to find
that merger partner for Lehman, in the end we did not succeed as we had succeeded in
March of 2008, when we brought in JPMorgan Chase to acquire Bear Stearns.
As a liquidity provider, we did not consider conditioning our lending to AIG on a requirement
that the company obtain concessions from some of its major creditors. Conditioning our
lending on AIG coercing certain creditors to agree to reduce the amounts due and owing
from AIG would have been to ensure failure. The tactic would have undercut our primary goal
in providing AIG with necessary liquidity - enabling AIG to pay creditors, maintain consumer,
regulator, and counterparty confidence, and avoid default. A default would have triggered
AIG's bankruptcy, with all of the systemic risk that bankruptcy would have entailed. While
these tactics have been used in certain sovereign debt restructurings, they can be used there
only because sovereigns cannot go bankrupt, and only with months of pre-planning.
Any attempt to condition our lending would have created further uncertainty in a time of panic
as to which of AIG's counterparties would get paid and which would be forced to take
substantial losses. One of our objectives was to calm market participants, and uncertainty
(and the allegations of favoritism that surely would have followed) does not do that - it fuels
fear. Would the conditions extend only to AIG's Credit Default Swap (CDS) counterparties, or
might the Federal government make value judgments as to other AIG contracts? Would
senior unsecured debt holders be forced to take concessions? And most importantly, would a
creditor who was pressed for a discount simply refuse and declare a default? Conditional
lending would have heightened the risk of an AIG default, which is what we were trying to
- and did - avoid.
The default risk would have been exacerbated by the credit rating downgrade that almost
certainly would have followed any effort by AIG to coerce creditor concessions. AIG's failure
to pay all of its contractual obligations in full would likely constitute a selective default
resulting in a downgrade. That downgrade not only would have triggered potential
terminations and collateral calls at AIG's Financial Products unit (AIG FP), but also would
have resulted in substantial value destruction at AIG's insurance companies. Large annuity
distributors likely would have stopped selling AIG products, replacing them with better-rated,
more stable competitors. High-end life insurance sales would have decreased significantly,
and remaining sales would have been vulnerable to adverse selection. Withdrawals and
surrenders among existing customers would have increased, depleting cash reserves and
creating pressure for asset sales at depressed levels. As a result of a downgrade, many of
AIG's insurance companies may have been unable to write new business, and state and
foreign insurance regulators may have begun seizing AIG insurance company assets in their
respective jurisdictions. Conditional lending would not have allowed AIG to remain a going
concern, but rather would have pushed it into bankruptcy.
II. Continuing pressures on AIG
By the end of September 2008, AIG had drawn $61 billion from the Fed Facility. While
successful in providing AIG with the liquidity it needed to avoid default and bankruptcy in the
short term, over the longer term AIG's borrowings from the Fed Facility were perceived by
some to be potentially unsustainable. The company continued to experience pressing
liquidity needs that necessitated rapid draws on the Fed Facility and concerns that AIG's
needs might well exceed the facility's capacity. Even greater concerns arose out of the
continued downgrade risk. The probability of a ratings downgrade was considered high
unless the Federal Reserve took further action because the aggregate size of AIG's draws
on the Fed Facility was greater than rating agency expectations - the rating agencies felt that
AIG had too much debt - and AIG's expected third quarter losses, which were to be
announced on November 10, 2008, far exceeded analyst estimates.
As discussed in Vice Chairman Kohn's testimony of March 5, 2009, in early October 2008,
the Board of Governors approved an additional credit facility (the Securities Borrowing
Facility) that permitted the New York Fed to lend to certain AIG domestic insurance
subsidiaries up to $37.8 billion in order to allow them to return the cash collateral they
received from their securities borrowing counterparties. Additionally, toward the end of
October, four AIG affiliates began participating in the Federal Reserve's Commercial Paper
Funding Facility (CPFF) on the same terms and conditions as other participants. The CPFF
is a generally available program that involves the purchase, through a special purpose
vehicle with financing from the Federal Reserve, of three-month unsecured and
assetbacked commercial paper directly from eligible issuers.
Notwithstanding AIG's access to these additional Federal Reserve credit facilities, AIG
remained extremely vulnerable to the ongoing and intensifying financial crisis. Falling asset
values generated both substantial losses on its balance sheet and increases in required
payments to AIG's counterparties under the terms of its credit protection contracts. The
liquidity crisis was not driven solely by AIG's need to meet collateral calls on its CDS; AIG
also faced severe liquidity pressures arising out of its losses on residential mortgage backed
securities (RMBS) in which its domestic life insurance companies had invested as part of its
securities lending program. These factors undermined market confidence in AIG and again
put its investment-grade credit rating at risk.
To address AIG's untenable debt burden, the Federal Reserve decided to reduce AIG's debt
by transferring RMBS and CDO exposures from AIG's balance sheet to the balance sheets
of the two Federal Reserve Limited Liability Companies (LLCs), Maiden Lane II and Maiden
Lane III. The LLCs acquired these assets by paying to AIG the cash proceeds of certain
loans and capital contributions made to the LLCs by the Federal Reserve and AIG
respectively. On November 10, 2008, the Federal Reserve Board and the Treasury
announced this restructuring of the government's financial support to establish a more
durable capital structure, resolve liquidity issues, facilitate AIG's execution of its plan to sell
certain of its businesses in an orderly manner, promote market stability, and protect the
interests of the U.S. government and taxpayers. The details of this restructuring have already
been the focus of an examination by the Treasury Special Inspector General for the Troubled
Asset Relief Program. They have also been the focus of testimony before a number of
committees in Congress, including Secretary Geithner and Thomas Baxter's January 27,
2010 testimony before the House Oversight and Government Reform Committees. A
summary of the salient facts, however, follows.
As part of the November 2008 restructuring, Treasury invested $40 billion in newly issued
Senior Preferred Stock of AIG under its TARP authority.2 In connection with that investment,
the Federal Reserve modified the terms of the Fed Facility to be more sustainable: The
maturity of the Fed Facility was extended to five years (due 2013), the maximum amount
available was reduced from $85 billion to $60 billion, and the interest rate and commitment
fees were reduced. The Fed Facility remained secured by substantially all of AIG's assets,
and the company continued to be required to apply proceeds of asset sales to permanently
repay any outstanding balances under the facility.
At the same time, the Board approved the establishment of an additional lending facility that
would provide a permanent solution to the AIG securities lending program's losses and
liquidity drains, thus eliminating the need for the Securities Borrowing Facility. Under the new
facility, the New York Fed extended approximately $19.5 billion in secured, non-recourse
credit to a special purpose limited liability company, Maiden Lane II, in which AIG would hold
a $1 billion first-loss position. Maiden Lane II then purchased, at market prices, RMBS with a
par value of $39.3 billion from certain AIG domestic insurance company subsidiaries. This
facility allowed AIG to terminate its domestic securities lending program and to repay fully all
outstanding amounts under the Securities Borrowing Facility, which was then terminated.
The Federal Reserve also took steps to help address the drain of liquidity on AIG arising
from potential collateral calls associated with credit default swap contracts written by AIG FP
on multi-sector CDOs. The New York Fed made a secured, non-recourse loan in the amount
of $24.3 billion to another special purpose limited liability company, Maiden Lane III. Maiden
Lane III then purchased, at market prices, multi-sector collateralized debt obligations with a
par value of approximately $62 billion from credit default swap counterparties of AIG FP in
return for the agreement of the counterparties to terminate the credit default swaps. AIG
provided $5 billion in equity to Maiden Lane III to absorb any potential future losses on the
CDOs held by Maiden Lane III. The Federal Reserve loans to Maiden Lane II and III have a
term of six years and are secured by the entire portfolio of each LLC.
III. Ongoing investment management of the Maiden Lane II and Maiden Lane III
portfolios
The Panel has asked us to discuss the New York Fed's "strategy for divesting its AIG
holdings." We must emphasize that the New York Fed did not ever decide to invest in AIG.
We cannot make such an investment. Our role has always been that of lender, although we
are a lender that re-structured our original Fed Facility to accommodate AIG's changing
circumstances. The New York Fed is the managing member of Maiden Lane II and Maiden
Lane III, and, as set forth above, has control rights over the RMBS and CDOs that were
acquired by these LLCs. BlackRock Financial Management Inc., an investment manager,
has been retained to serve as the New York Fed's agent in managing the RMBS and the
CDOs. The management objective for both is maximization of long-term cash flows to pay
the New York Fed's Senior Loans to the LLCs (subject to certain fees, costs, and reserves
that are senior to the Senior Loans), and refraining from investment actions that would
disturb general financial market conditions. Distribution of all cash flows realized by the
Maiden Lane II and Maiden Lane III occurs on a monthly basis.
Cash proceeds from the assets may be invested solely in U.S. Treasury or agency securities
that have a remaining maturity of one year or less, U.S. 2a-7 government money market
funds, reverse repurchase agreements collateralized by U.S. Treasury and agency
securities, and dollar denominated deposits. However, in the case of Maiden Lane III, a
broader range of assets may be acquired as part of a portfolio liquidation of one or more
CDOs held in the Maiden Lane III portfolio.
The Maiden Lane II and Maiden Lane III assets continue to generate substantial proceeds,
which are distributed monthly to pay down the New York Fed's Senior Loans to the
respective Maiden Lane LLCs. While the New York Fed may direct its investment manager to
sell Maiden Lane II and Maiden Lane III assets into the market at any time, as a practical
matter, the value maximizing strategy has been largely to hold the assets to maturity while
collecting interest income, and principal repayments. Currently, the hold-to-maturity expected
proceeds of each LLC's portfolio are greater than the LLC's debt to the New York Fed. As of
May 20, 2010, the balance on the New York Fed's Senior Loan to Maiden Lane II was
$14.9 billion (inclusive of accrued interest), while the total asset value was $15.8 billion. The
balance on the New York Fed's Senior Loan to Maiden Lane III was $16.6 billion (inclusive of
accrued interest), while the total asset value was $23.4 billion. In sum, the LLCs have repaid
approximately $13.1 billion of the loans made to them by the Federal Reserve. Based on the
current performance of both portfolios, as well as our analysis of forecasts provided by our
investment advisor, it is anticipated that the proceeds from both portfolios will exceed the
principal and interest due on the New York Fed's Senior Loans to both Maiden Lane II and
Maiden Lane III.
We expect to recover our principal and interest on the loans to the LLCs, and on the Fed
Facility. The funds necessary to repay the balance of the Fed Facility will ultimately come
from the cash proceeds of the AIA and ALICO transactions, cash AIG generates as it
monetizes the non-cash sales proceeds of the AIA and ALICO transactions, the divestiture of
certain non-core assets, and profit derived from AIG's core operating businesses. That said,
our goal was never to make money - it was to avoid the systemic consequences that would
have resulted from an AIG default and bankruptcy and to foster financial stability.
IV. Conclusion
In all that the Federal Reserve has done, we have been motivated by two goals: to foster
financial stability and to protect the U.S. taxpayer. Had we not acted to prevent an AIG
failure, the financial crisis would have been substantially worse and even greater economic
damage and suffering would have occurred. The decision to lend to AIG was a difficult one
because addressing the systemic issues required us to provide liquidity to a non-banking
company we did not supervise whose management had made poor business decisions. Still,
our understanding of the consequences of an AIG failure left us no real choice.
Thank you again for giving us the opportunity to appear before you today. We look forward to
answering your questions.