Financial Crisis: Review of Federal Reserve System Financial Assistance to American International Group, Inc.
Published: 2011-09-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In September 2008, the Board of Governors of the Federal Reserve System (Federal Reserve Board) approved emergency lending to American International Group, Inc. (AIG)--the first in a series of actions that, together with the Department of the Treasury, authorized $182.3 billion in federal aid to assist the company. Federal Reserve System officials said that their goal was to avert a disorderly failure of AIG, which they believed would have posed systemic risk to the financial system. But these actions were controversial, raising questions about government intervention in the private marketplace. This report discusses (1) key decisions to provide aid to AIG; (2) decisions involving the Maiden Lane III (ML III) special purpose vehicle (SPV), which was a central part of providing assistance to the company; (3) the extent to which actions were consistent with relevant law or policy; and (4) lessons learned from the AIG assistance. To address these issues, GAO focused on the initial assistance to AIG and subsequent creation of ML III. GAO examined a large volume of AIG-related documents, primarily from the Federal Reserve System--the Federal Reserve Board and the Federal Reserve Bank of New York (FRBNY)--and conducted a wide range of interviews, including with Federal Reserve System staff, FRBNY advisors, former and current AIG executives, AIG business counterparties, credit rating agencies, potential private financiers, academics, finance experts, state insurance officials, and Securities and Exchange Commission (SEC) officials. Although GAO makes no new recommendations in this report, it reiterates previous recommendations aimed at improving the Federal Reserve System's documentation standards and conflict-of-interest policies.
section_title: What GAO Found
paragraphs: While warning signs of the company's difficulties had begun to appear a year before the Federal Reserve System provided assistance, Federal Reserve System officials said they became acutely aware of AIG's deteriorating condition in September 2008. The Federal Reserve System received information through its financial markets monitoring and ultimately intervened as the possibility of bankruptcy became imminent. Efforts by AIG and the Federal Reserve System to secure private financing failed after the extent of AIG's liquidity needs became clearer. Both the Federal Reserve System and AIG considered bankruptcy issues, although no bankruptcy filing was made. Due to AIG's deteriorating condition in September 2008, the Federal Reserve System said it had little opportunity to consider alternatives before its initial assistance. As AIG's troubles persisted, the company and the Federal Reserve System considered a range of options, including guarantees, accelerated asset sales, and nationalization. According to Federal Reserve System officials, AIG's credit ratings were a critical consideration in the assistance, as downgrades would have further strained AIG's liquidity position. After the initial federal assistance, ML III became a key part of the Federal Reserve System's continuing efforts to stabilize AIG. With ML III, FRBNY loaned funds to an SPV established to buy collateralized debt obligations (CDO) from AIG counterparties that had purchased credit default swaps from AIG to protect the value of those assets. In exchange, the counterparties agreed to terminate the credit default swaps, which were a significant source of AIG's liquidity problems. As the value of the CDO assets, or the condition of AIG itself, declined, AIG was required to provide additional collateral to its counterparties. In designing ML III, FRBNY said that it chose the only option available given constraints at the time, deciding against plans that could have reduced the size of its lending or increased the loan's security. Although the Federal Reserve Board approved ML III with an expectation that concessions would be negotiated with AIG's counterparties, FRBNY made varying attempts to obtain these discounts. FRBNY officials said that they had little bargaining power in seeking concessions and would have faced difficulty in getting all counterparties to agree to a discount. While FRBNY took actions to treat the counterparties alike, the perceived value of ML III participation likely varied by the size of a counterparty's exposure to AIG or its method of managing risk. While the Federal Reserve Board exercised broad emergency lending authority to assist AIG, it was not required to, nor did it, fully document its interpretation of its authority or the basis of its decisions. For federal securities filings AIG was required to make, FRBNY influenced the company's filings about federal aid but did not direct AIG on what information to disclose. In providing aid to AIG, FRBNY implemented conflict-of-interest procedures, and granted a number of waivers, many of which were conditioned on the separation of employees and information. A series of complex relationships grew out of the government's intervention, involving FRBNY advisors, AIG counterparties, and others, which could expose FRBNY to greater risk that it would not fully identify and appropriately manage conflict issues and relationships.

section_title: Letter
paragraphs: The financial crisis that reached a peak in 2008 was far-reaching,  threatening the stability of the U.S. banking system as well as the U.S.  and global economies. As the federal government responded to the crisis,  one of its most significant actions was providing extraordinary assistance  to American International Group, Inc. (AIG), the multinational insurer that  was also a significant participant in the financial derivatives market. AIG  was one of the largest recipients of government aid. The Board of  Governors of the Federal Reserve System, through its emergency  powers under section 13(3) of the Federal Reserve Act, and the  Department of the Treasury (Treasury), through the Emergency  Economic Stabilization Act of 2008, which authorized the Troubled Asset  Relief Program, collaborated to make available up to $182.3 billion in  assistance to AIG. The assistance, which was made available in several  stages beginning in September 2008, addressed large losses that  threatened to bankrupt the company. These losses stemmed from two  AIG businesses that involved the lending of securities and the provision of  insurance-like guarantees on the value of bond instruments known as  collateralized debt obligations (CDO). Largely due to the federal  government’s assistance, AIG’s financial health has improved over time.
The government’s unprecedented actions to save AIG from failure were  controversial, raising questions in Congress and among the public about  the federal government’s intervention into the private marketplace. Federal  Reserve System officials initially rejected offering assistance to the  company. However, when the financial markets experienced extreme  disruptions during the first 2 weeks of September 2008, and as AIG faced  the prospect of even greater financial difficulty, the Federal Reserve  System decided that providing assistance could avert a disorderly failure of  the company, which officials believed would pose systemic risk to the  financial system. Nonetheless, questions later arose about, for example,  whether AIG should have instead filed for bankruptcy, whether the  government assumed too much risk in rescuing the company, how the  government arrived at its decisions in providing assistance, and how the  government structured particular features of its assistance to the company.
Reflecting your interest in the nature and execution of government  assistance to AIG, this report provides a detailed review of assistance  extended by the Federal Reserve System, which was the first and largest  provider of assistance to the company. In particular, this report examines  (1) the sequence of events and key participants as critical decisions were  made to provide the various elements of federal assistance to AIG;   (2) decisions involving the Maiden Lane III (ML III) vehicle, which was a  key part of AIG assistance that followed the government’s initial aid to the  company; (3) the extent to which key actions taken were consistent with  relevant law or policy; (4) criteria that were used to determine the  treatment of, or the terms of key assistance extended to, AIG, its various  creditors and counterparties, and other significant parties; and (5) lessons  learned from the AIG assistance.
To address our reporting objectives, we obtained and reviewed a wide  range of AIG-related documents, primarily from the Federal Reserve  System, including records provided by the Federal Reserve System to  Congress. We also reviewed documents from the Securities and  Exchange Commission (SEC). The documents we reviewed included e- mails, proposals and analyses of options for aid to AIG, research,  memorandums, and other items. We conducted a wide range of  interviews, including with Federal Reserve System staff, advisors to the  Federal Reserve Bank of New York (FRBNY), current and former AIG  executives, advisors to AIG, AIG counterparties, credit rating agencies,  potential private-sector financiers, state insurance regulators, federal  banking regulators, SEC staff, academic and finance experts, and others.  We also reviewed our past work and the work of others who have  examined the government’s response to the financial crisis, including the  Congressional Oversight Panel, the Special Inspector General for the  Troubled Asset Relief Program, and the Financial Crisis Inquiry  Commission. As agreed with your staff, our scope is generally limited to  the Federal Reserve System’s initial decision to provide assistance to AIG  in September 2008 and the subsequent creation of ML III, because these  two instances of aid involved the largest amount of funds and were of  considerable interest. Our scope and methodology are detailed in  appendix I.
We undertook this performance audit from March 2010 to September  2011 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: AIG is an international insurance organization serving customers in more  than 130 countries. As of June 30, 2011, AIG reported assets of $616.8  billion and revenues of $34.1 billion for the preceding 6 months. AIG  companies serve commercial, institutional, and individual customers  through worldwide property/casualty networks. In addition, AIG  companies provide life insurance and retirement services in the United  States.
subsections: section_title: Regulation of the Company
paragraphs: Federal, state, and international authorities regulate AIG and its  subsidiaries. Until March 2010, the Office of Thrift Supervision (OTS) was  the consolidated supervisor of AIG, which was a thrift holding company by  virtue of its ownership of the AIG Federal Savings Bank. As the  consolidated supervisor, OTS was charged with identifying systemic  issues or weaknesses and helping ensure compliance with regulations  that govern permissible activities and transactions. The Federal Reserve  System was not a direct supervisor of AIG. Its involvement with the  company was through its responsibilities to maintain financial system  stability and contain systemic risk that may arise in financial markets.
AIG’s domestic life and property/casualty insurance companies are  regulated by the state insurance regulators in the state in which these  companies are domiciled. The primary state insurance regulators include  New York, Pennsylvania, and Texas. These state agencies regulate the  financial solvency and market conduct of these companies, and they have  the authority to approve or disapprove certain transactions between an  insurance company and its parent or its parent’s subsidiaries. These  agencies also coordinate the monitoring of companies’ insurance lines  among multiple state insurance regulators. For AIG in particular, these  regulators have reviewed reports on liquidity, investment income, and  surrender and renewal statistics; evaluated potential sales of AIG’s  domestic insurance companies; and investigated allegations of pricing  disparities. Finally, AIG’s general insurance business and life insurance  business that are conducted in foreign countries are regulated by the  supervisors in those jurisdictions.
section_title: AIG’s Financial Difficulties
paragraphs: AIG’s financial difficulties stemmed primarily from two sources:    Securities lending. Until 2008, AIG had maintained a large securities  lending program operated by its insurance subsidiaries. The securities  lending program allowed insurance companies, primarily AIG’s life  insurance companies, to lend securities in return for cash collateral,  which was then invested in investments such as residential mortgage- backed securities (RMBS).    Credit default swaps. AIG had been active, through its AIG Financial  Products Corporation (AIGFP) unit, in writing insurance-like protection  called credit default swaps (CDS) that guaranteed the value of  CDOs.
In September 2008, the Board of Governors of the Federal Reserve  System (Federal Reserve Board), FRBNY, and Treasury determined that  market events could cause AIG to fail. According to officials from these  entities, AIG’s failure would have posed systemic risk to financial  markets. Consequently, the Federal Reserve System and Treasury took  steps to help ensure that AIG obtained sufficient funds to continue to  meet its obligations and could complete an orderly sale of operating  assets and close its investment positions in its securities lending program  and AIGFP.
From July through early September in 2008, AIG faced increasing liquidity  pressure following a downgrade in its credit ratings in May 2008, which  was due in part to losses from its RMBS investments. The company was  experiencing declines in the value and market liquidity of the RMBS  assets that served as collateral for its securities lending operation, as well  as declining values of CDOs against which AIGFP had written CDS  protection. These losses in value forced AIG to use an estimated $9.3  billion of its cash reserves in July and August 2008 to provide capital to its  domestic life insurers following losses in their RMBS portfolios and to post  additional collateral required by the trading counterparties of AIGFP.
AIG attempted to secure private financing in September 2008 but was  unsuccessful. On September 15, 2008, credit rating agencies  downgraded AIG’s debt rating, which resulted in the need for an  additional $20 billion to fund its added collateral demands and transaction  termination payments. Following the credit rating downgrade, an  increasing number of counterparties refused to transact with AIG for fear  that it would fail. Also around this time, the insurance regulators decided  they would no longer allow AIG’s insurance subsidiaries to lend funds to  the parent company under a credit facility that AIG maintained, and they  demanded that any outstanding loans be repaid and that the facility be  terminated.
In September 2008, another large financial services firm—Lehman  Brothers Holdings, Inc. (Lehman)—was on the brink of bankruptcy. As  events surrounding AIG were developing over the weekend of September  13–14, 2008, Federal Reserve System officials were also addressing  Lehman’s problems. On September 15—the day before the Federal  Reserve Board voted to authorize FRBNY to make an emergency loan to  AIG—Lehman filed for bankruptcy. Stock prices fell sharply, with the  Dow Jones Industrial Average and the Nasdaq market losing 504 points  and 81 points, respectively.
section_title: Federal Assistance to AIG
paragraphs: Because of concerns about the effect of an AIG failure, in 2008 and 2009,  the Federal Reserve System and Treasury agreed to make $182.3 billion  available to assist AIG. First, on September 16, 2008, the Federal  Reserve Board, with the support of Treasury, authorized FRBNY to lend  AIG up to $85 billion through a secured revolving credit facility that AIG  could use as a reserve to meet its obligations. This debt was  subsequently restructured in November 2008 and March 2009 to  decrease the amount available under the facility, reduce the interest  charged, and extend the maturity date from 2 to 5 years, to September  2013. By January 2011, AIG had fully repaid the facility and it was closed.
In October 2008, the Federal Reserve Board approved further assistance  to AIG, authorizing FRBNY to borrow securities from certain AIG  domestic insurance subsidiaries. Under the program, FRBNY was  authorized to borrow up to $37.8 billion in investment-grade, fixed-income  securities from AIG in return for cash collateral. These securities were  previously lent by AIG’s insurance company subsidiaries to third parties.  This assistance was designed to allow AIG to replenish liquidity used to  settle securities lending transactions, while providing enhanced credit  protection to FRBNY in the form of a security interest in the securities.  This program was authorized for up to nearly 2 years but was terminated  in December 2008.
In late 2008, AIG’s mounting debt—the result of borrowing from the  Revolving Credit Facility—led to concerns that the company’s credit  ratings would be lowered, which would have caused its condition to  deteriorate further. In response, the Federal Reserve Board and Treasury  in November 2008 announced the restructuring of AIG’s debt. Under the  restructured terms, Treasury purchased $40 billion in shares of AIG  preferred stock (Series D), and the cash from the sale was used to pay  down a portion of AIG’s outstanding balance from the Revolving Credit  Facility. The limit on the facility also was reduced to $60 billion, and other  changes were made to the terms of the facility. This restructuring was  critical to helping AIG maintain its credit ratings.
To provide further relief, FRBNY also announced in November 2008 the  creation of two new facilities to address some of AIG’s more pressing  liquidity issues. AIG’s securities lending program continued to be one of  the greatest ongoing demands on its working capital, and FRBNY  announced plans to create an RMBS facility—Maiden Lane II (ML II)  —to purchase RMBS assets from AIG’s U.S. securities lending portfolio.  The Federal Reserve Board authorized FRBNY to lend up to $22.5 billion  to ML II; AIG also acquired a subordinated $1 billion interest in the facility,  which would absorb the first $1 billion of any losses. In December 2008,  FRBNY extended a $19.5 billion loan to ML II to fund its portion of the  purchase price of the securities. The facility purchased $39.3 billion face  value of the RMBS directly from AIG subsidiaries (domestic life insurance  companies). As part of the ML II transaction, the $37.8 billion Securities  Borrowing Facility established in October before was repaid and  terminated. As of August 17, 2011, ML II owed $7.3 billion in principal and  interest to FRBNY.
In addition, FRBNY announced plans to create a second facility—ML III—to  purchase multisector CDOs on which AIGFP had written CDS contracts.  This facility was aimed at facilitating the restructuring of AIG by addressing  one of the greatest threats to AIG’s liquidity position. In connection with the  purchase of the CDOs, AIG’s CDS counterparties agreed to terminate the  CDS contracts, thereby eliminating the need for AIG to post additional  collateral as the value of the CDOs fell. The Federal Reserve Board  authorized FRBNY to lend up to $30 billion to ML III. In November and  December 2008, FRBNY extended a $24.3 billion loan to ML III. AIG also  paid $5 billion for an equity interest in ML III, which would absorb the first  $5 billion of any losses. As of August 17, 2011, ML III owed $11.2 billion in  principal and interest to FRBNY.
When the two AIG Maiden Lane facilities were created, FRBNY officials  said that the FRBNY loans to ML II and ML III were both expected to be  repaid with the proceeds from the interest and principal payments, or  liquidation, of the assets in the facilities. The repayment is to occur  through cash flows from the underlying securities as they are paid off.  Accordingly, FRBNY did not set a date for selling the assets; rather, it has  indicated that it is prepared to hold the assets to maturity if necessary. In  March 2011, FRBNY announced it declined an AIG offer to purchase all  ML II assets, and said that instead, it would sell the assets in segments  over an unspecified period, as market conditions warrant, through a  competitive sales process.
In March 2009, the Federal Reserve Board and Treasury announced  plans to further restructure AIG’s assistance. Among other items, debt  owed by AIG on the Revolving Credit Facility would be reduced by up to  about $26 billion in exchange for FRBNY’s receipt of preferred equity  interests in two special purpose vehicles (SPV) created to hold the  outstanding common stock of two AIG life insurance company  subsidiaries—American Life Insurance Company (ALICO) and AIA Group  Limited (AIA).
Also in March 2009, the Federal Reserve Board and Treasury announced  plans to assist AIG in the form of lending related to the company’s  domestic life insurance operations. FRBNY was authorized to extend  credit totaling up to approximately $8.5 billion to SPVs to be established  by certain AIG domestic life insurance subsidiaries. As announced, the  SPVs were to repay the loans from the net cash flows they were to  receive from designated blocks of existing life insurance policies held by  the insurance companies. The proceeds of the FRBNY loans were to pay  down an equivalent amount of outstanding debt under the Revolving  Credit Facility. However, in February 2010, AIG announced that it was no  longer pursuing this life insurance securitization transaction with FRBNY.
Treasury also has provided assistance to AIG. As noted, in November  2008, Treasury’s Office of Financial Stability announced plans under the  Troubled Asset Relief Program (TARP) to purchase $40 billion in AIG  preferred shares. AIG entered into an agreement with Treasury whereby  Treasury agreed to purchase $40 billion of fixed-rate cumulative preferred  stock of AIG (Series D) and received a warrant to purchase approximately  2 percent of the shares of AIG’s common stock. The proceeds of this  sale were used to pay down AIG’s outstanding balance on the Revolving  Credit Facility.
In April 2009, AIG and Treasury entered into an agreement in which  Treasury agreed to exchange its $40 billion of Series D cumulative  preferred stock for $41.6 billion of Series E fixed-rate noncumulative  preferred stock, allowing for a reduction in leverage and dividend  requirements. The $1.6 billion difference between the initial aggregate  liquidation preference of the Series E stock and the Series D stock  represents a compounding of accumulated but unpaid dividends owed by  AIG to Treasury on the Series D stock. Because the Series E preferred  stock more closely resembles common stock, principally because its  dividends were noncumulative, rating agencies viewed the stock more  positively when rating AIG’s financial condition.
Also in April 2009, Treasury made available a $29.835 billion equity  capital facility to AIG whereby AIG issued to Treasury 300,000 shares of  fixed-rate noncumulative perpetual preferred stock (Series F) and a  warrant to purchase up to 3,000 shares of AIG common stock. The facility  was intended to strengthen AIG’s capital levels and improve its leverage.
On January 14, 2011, with the closing of a recapitalization plan for AIG,  the company repaid $47 billion to FRBNY, including the outstanding  balance on the original $85 billion Revolving Credit Facility. With that, AIG  no longer had any outstanding obligations to FRBNY.
section_title: AIG’s Federal Securities Filings
paragraphs: As a publicly traded company, AIG makes regular filings with SEC. In  December 2008, AIG filed two Form 8-K statements related to ML III.  These filings included ML III contract information and did not initially  include a supporting record known as “Schedule A”—a listing of CDOs  sold to ML III, including names of the counterparties, valuations, collateral  posted, and other information. Questions arose about FRBNY’s role in  AIG’s filings and the degree to which the Reserve Bank may have  influenced the company’s filing decisions, as well as whether the  company’s filings satisfactorily disclosed the nature of payments to the  counterparties.
section_title: AIG’s Crisis Came Amid Overall Market Turmoil
paragraphs: AIG’s financial difficulties came as financial markets were experiencing  turmoil. A sharp decline in the U.S. housing market that began in 2006  precipitated a decline in the price of mortgage-related assets—particularly  mortgage assets based on subprime loans—in 2007. Some institutions  found themselves so exposed that they were threatened with failure, and  some failed because they were unable to raise capital or obtain liquidity  as the value of their portfolios declined. Other institutions, ranging from  government-sponsored enterprises such as Fannie Mae and Freddie Mac  to large securities firms, were left holding “toxic” mortgages or mortgage- related assets that became increasingly difficult to value, were illiquid,  and potentially had little worth. Moreover, investors not only stopped  buying private-label securities backed by mortgages but also became  reluctant to buy securities backed by other types of assets. Because of  uncertainty about the liquidity and solvency of financial entities, the prices  banks charged each other for funds rose dramatically, and interbank  lending conditions deteriorated sharply. The resulting liquidity and credit  crunch made the financing on which businesses and individuals depend  increasingly difficult to obtain. By late summer 2008, the effects of the  financial crisis ranged from the continued failure of financial institutions to  increased losses of individual savings and corporate investments to  further tightening of credit that would exacerbate an emerging global  economic slowdown.
section_title: The Possibility of AIG’s Failure Drove Federal Reserve Aid after Private Financing Failed
paragraphs: A year before the first federal assistance to AIG, warning signs of the  company’s financial difficulties began to appear. Over the following  months, the Federal Reserve System received information about AIG’s  deteriorating condition from a variety of sources and contacts, and it  stepped in to provide emergency assistance as possible bankruptcy  became imminent in mid-September 2008. Attempts to secure private  financing, which would have precluded or limited the need for government  intervention, failed as the extent of AIG’s liquidity needs became clearer.  Both the Federal Reserve System and AIG considered bankruptcy issues,  with AIG deciding independently to accept federal assistance in lieu of  bankruptcy. Because of urgency in financial markets by the time the  Federal Reserve System intervened, officials said there was little  opportunity to consider alternatives before extending the initial assistance  in the form of the Revolving Credit Facility. When AIG’s financial troubles  persisted after the Revolving Credit Facility was established, the company  and the Federal Reserve System considered a range of options for further  assistance. Throughout the course of AIG assistance, the company’s  credit ratings were a critical consideration, according to Federal Reserve  System officials, as downgrades would have triggered large new liquidity  demands on the company and could have jeopardized government  repayment. As a result, Federal Reserve System assistance reflected  rating agency concerns, although both FRBNY and the rating agencies  told us the rating agencies did not participate in the decision-making  process.
subsections: section_title: The Federal Reserve Monitored AIG’s Deteriorating Condition in 2008 and Took Action as Possible Bankruptcy Was Imminent
paragraphs: The difficulties that culminated in AIG’s crisis in September 2008 began to  draw financial regulators’ attention in 2007, when issues arose relating to  the company’s securities lending program and the CDS business of its  AIGFP subsidiary (see fig. 1). In December 2006, AIG’s lead state  insurance regulator for the company’s domestic life insurers (“lead life  insurance regulator”) began a routine examination of AIG in coordination  with several other state regulators. During the examination, the state  regulators identified issues related to the company’s securities lending  program. Prior to mid-2007, state regulators had not identified losses in  the securities lending program, and the lead life insurance regulator had  reviewed the program without major concerns. As the examination  continued into the fall of 2007, the program began to show losses  resulting from declines in the value of its RMBS portfolio. The lead life  insurance regulator told us the program had become riskier as a result of  how AIG had invested cash collateral it received from its lending  counterparties—in RMBS rather than in safer investments. The RMBS  investments were declining in value and had become less liquid, AIG told  us.
Regulators recognized that left unaddressed, AIG’s practices in the  securities lending program, including the losses they observed, could  create liquidity risks for AIG. In particular, these declines could lead AIG’s  securities lending counterparties to terminate their borrowing agreements,  thereby requiring AIG to return the cash collateral the counterparties had  posted, which AIG had invested in the RMBS. According to the lead life  insurance regulator, about 20 percent of the funds AIG had collected as  collateral remained in cash, indicating a potentially large liquidity shortfall  if the counterparties terminated their transactions. The lead life insurance  regulator also noted that AIG was disclosing relatively little information in  its regulatory filings about the program and its losses, which were off- balance sheet transactions. Another state insurance regulator told us  that as part of its review, it noted that AIG life insurance companies  engaging in securities lending were not correctly providing information in  annual statements or taking an appropriate charge against capital for the  securities lending activities. This regulator said it began discussions with  the company about securities lending in 2006. AIG told us it was unaware  of the regulator’s concerns.
The lead life insurance regulator met with AIG management in October  and November 2007 and presented the securities lending issues it had  noted at a “supervisory college” meeting held by AIG’s then-consolidated  regulator, OTS. The lead life insurance regulator told us it did not share  with all participants that it had identified off-balance-sheet losses but that  it privately advised OTS that it saw unrealized losses building in AIG’s  securities lending portfolio, with the total reaching an estimated $1 billion  by November 2007. It also told us this was the first time OTS learned  about issues in the company’s securities lending program.
At the time, OTS had concerns about a different matter at AIG. According  to OTS, in late 2007, it began to have concerns about AIGFP’s practices  for valuing the CDOs on which the company wrote CDS protection, in  particular whether the company’s valuations corresponded to market  values. Part of the concern was that AIGFP’s CDS counterparties were  seeking collateral from the company based on their own valuations. Thus,  in general, there were difficulties in assessing the value of the CDOs  behind the company’s CDS contracts. According to AIG’s lead life  insurance regulator, OTS did not communicate its concerns about AIGFP  to state insurance regulators at the supervisory college meeting in  November 2007. As a result, the lead life insurance regulator told us it  did not understand the extent of potential risks AIGFP posed to the AIG  parent company that in turn could have created risks for the regulated  insurance subsidiaries.
AIG executives and advisors told us that the company made thorough  disclosures about securities lending program issues, including losses and  the manner in which collateral was being invested, by the third quarter of  2007. They said that state regulators did not identify issues of which the  company was not aware and disclosing publicly.
AIG notified regulators in early 2008 that the securities lending program  had experienced significant losses as of December 2007, at which time  the lead life insurance regulator told us it began efforts to coordinate  regular communication among the states. Results of the examination of  the securities lending program provided greater disclosure of information  to regulators, such as credit ratings of underlying securities in the pool of  securities in which AIG had invested its counterparties’ collateral. By  February 2008, regular meetings were being held among AIG and state  insurance regulators.
As the monitoring continued into 2008, state insurance regulators held a  number of in-person and phone meetings with AIG executives, as the  company took steps to increase its liquidity and improve cash-flow  management within the securities lending program. The lead life  insurance regulator told us that prior to the stepped-up monitoring, the  company’s limited disclosure about the program did not allow the  regulators to understand the extent of the problem. Overall, the lead life  insurance regulator said, the consensus among the state regulators was  that securities lending issues, while of concern, did not present imminent  danger as long as AIG’s counterparties did not terminate their lending  transactions. Meanwhile, AIG management had already taken steps to  bolster liquidity and cash flow management—beginning in August 2007,  AIG told us—and the regulators hoped the company would recover  investment losses as market conditions improved. Moreover, the lead life  insurance regulator had a guarantee from the AIG parent company to  cover up to $5 billion in losses stemming from the program. The lead life  insurance regulator said this provided some comfort as a backstop, but it  was not certain that the company had the money to fulfill that agreement.
Our review indicated that neither OTS nor state insurance regulators  communicated with the Federal Reserve System about AIG’s problems  before the summer of 2008. FRBNY officials told us they monitored  financial institutions not regulated by the Federal Reserve System,  including AIG, based on publicly available information, as part of  monitoring overall financial market stability. In particular, FRBNY e-mails  from late 2007 and January 2008 indicated that staff were monitoring  AIG’s exposure and potential losses related to the subprime mortgage  market. For instance, market updates were circulated to FRBNY officials  in October and November 2007 highlighting multibillion dollar write-downs  in AIG’s subprime mortgage portfolio. Additionally, in January 2008, an  FRBNY staffer sent a market report of a private research firm to the then- FRBNY President that included analyses and estimates of AIG’s losses  for its RMBS, CDO, and CDS activities. In February 2008, FRBNY staff  wrote a memorandum on AIGFP’s CDS portfolio, which FRBNY officials  said was prepared as part of FRBNY’s regular monitoring of market  events. The report, circulated to some FRBNY staff, noted unrealized  losses related to the CDS portfolio and AIG’s exposure to the subprime  mortgage market. During the spring and summer of 2008, internal FRBNY  e-mails show that FRBNY officials circulated information on a range of  AIG issues, including reports about the company’s earnings losses,  widening CDS spreads, potential credit rating downgrades, and  worsening liquidity and capital positions. FRBNY officials told us that the  level of monitoring and internal reporting conducted for AIG was  consistent with that of other institutions not regulated directly by the  Federal Reserve System.
Under financial pressure, AIG raised $20 billion in new capital in May  2008 and also considered additional private financing options. AIG raised  the capital through three sources: common stock, hybrid securities, and  debt financing. The purpose, according to communication between  FRBNY staff and the then-FRBNY President, was to address liquidity  demands stemming from AIGFP’s requirements to post cash collateral to  its CDS counterparties. In addition, FRBNY intended to have  discussions with OTS to further understand the liquidity impact of  AIGFP’s CDS portfolio. This meeting occurred 3 months later in August  2008. Also during the summer of 2008, AIG considered joining the  Federal Home Loan Bank System (FHLB) via the company’s insurance  subsidiaries. Such membership could have allowed AIG’s insurance  operations to pledge some of their qualified assets against an extension  of credit. AIG executives told us the company discarded the idea after  learning that funds its subsidiaries might have received would not have  been accessible to the parent company.
By July 2008, AIG’s then-chief executive officer had concerns that the  company’s securities lending program could generate a liquidity crisis,  according to interviews we conducted. He shared these concerns with  AIG’s Board of Directors, telling them the only source from which the  company could secure enough liquidity if such a crisis occurred was the  government. He thought it was unlikely the company could approach the  capital markets again after raising $20 billion only 2 months before. On  July 29, the chief executive officer approached the then-FRBNY President  seeking government assistance. During the meeting, the chief executive  officer said he explained AIG’s liquidity situation and requested access to  the Federal Reserve System discount window. According to the chief  executive officer, the President did not think Federal Reserve System  officials could or would do that because if the discount window was made  available to AIG, it would likely precipitate the liquidity crisis the company  wanted to avoid. The chief executive officer noted that the Federal  Reserve System had allowed other nondepository institutions to borrow  from the discount window after the failure of Bear Stearns Companies,  Inc. (Bear Stearns), but said the argument failed to alter the FRBNY  President’s position.
In the weeks following this meeting, FRBNY officials and staff continued  to gather information on AIG’s condition and liquidity issues and to  circulate publicly available information. For instance, an e-mail sent in the  first week of August 2008 to FRBNY officials highlighted the concerns of  one rating agency about AIG’s deteriorating liquidity situation due to  strains from its securities lending program and CDS portfolio. The  message concluded that AIG needed to raise a large amount of additional  capital. On August 11, 2008, FRBNY officials held their first meeting with  OTS staff regarding AIG. According to a subsequent FRBNY e-mail, the  meeting was an introductory discussion about AIG’s situation and other  issues that could affect companies like AIG, such as problems facing  monoline insurance companies. Topics discussed relating to AIG  included the company’s raising of capital in May 2008, its liquidity and  capital positions, liquidity management, rating agency concerns, and  problems associated with AIGFP and the securities lending program. In  addition, a report on August 14 from an FRBNY staff member who  attended the meeting warned staff about AIG’s increasing capital and  liquidity pressures, asset and liability mismatches, and the potential for  credit rating downgrades, saying AIG needed to take action on these  issues. FRBNY officials told us that previously, OTS staff had not  communicated information about AIG that FRBNY staff would have  flagged as issues to raise with FRBNY management.
While FRBNY continued monitoring AIG’s situation into September 2008,  FRBNY staff also raised concerns internally about the company’s ability  to manage its liquidity problems. On August 18, 2008, FRBNY staff  circulated a new research report on AIG by a large investment bank,  which highlighted concern that AIG management may be unable to  accurately assess its exposures or losses given the complexity of the  company’s businesses. In its own memorandum on September 2, FRBNY  noted that AIG’s liquidity position was precarious and that the company’s  asset and liability management was inadequate given its substantial  liquidity needs. Further, a memorandum circulated among FRBNY  officials on September 14, which discussed possible lending to AIG,  stated that one rating agency’s rationale for potentially downgrading the  company stemmed from concerns about AIG’s risk management, not its  capital situation. A private research report, also circulated that day, further  detailed the view of the rating agency that even if AIG were to raise  capital, it might not offset risk management concerns. FRBNY officials  told us AIG had fragmented and decentralized liquidity management  before the government intervention. Liquidity management became the  responsibility of the AIG holding company in early 2008. As one official  stated, AIG understood corporate-level liquidity needs but not the needs  of subsidiaries, including AIGFP.
Leading up to the weekend of September 13–14, 2008, AIG made  renewed attempts to obtain discount window access while also initiating  efforts to identify a private-sector solution. On September 9, AIG’s then- chief executive officer met again with the then-FRBNY President in  another attempt to obtain relief, this time by means of becoming a primary  dealer. According to the AIG chief executive, the President said he had  not considered this option and would need to respond later. The chief  executive told us that he did not receive a response and that he made  another effort to contact the FRBNY President on September 11 but was  unsuccessful. Meanwhile, AIG also made an inquiry about federal aid to  Federal Reserve Board staff, according to a former member of the  Federal Reserve Board. According to the former FRBNY President, at the  time, a variety of firms, including AIG, were inquiring about discount  window access, and he did not recall in his meetings with the AIG chief  executive that the AIG chief executive conveyed any evidence or concern  about an acute, impending liquidity crisis at the company.
On Friday, September 12, 2008, AIG began assembling private equity  investors, strategic buyers, and sovereign wealth funds to discuss funding  and investment options. Also, AIG’s then-chief executive officer said he  spoke with the then-FRBNY President again about the company’s liquidity  problems, saying that although the company was pursuing private  financing, any solution would require assistance from the Federal  Reserve System. Federal Reserve System officials and AIG executives  held a meeting, during which the company provided details about its  liquidity problems and actions it was considering to address them.  According to the FRBNY President, September 12 was the first time the  Federal Reserve System received nonpublic information regarding AIG,  which indicated AIG was facing “potentially fatal” liquidity problems.
One option discussed at that meeting was whether AIG could borrow from  the discount window through its thrift subsidiary. FRBNY officials told us,  however, that the thrift only had $2 billion in total assets and only millions  of dollars in assets that could be used to collateralize a loan, which would  have been small relative to AIG’s overall liquidity needs. According to an  FRBNY summary of the meeting, AIG mentioned its plan to become a  primary dealer over a 6- to 12-month period, but FRBNY officials  determined this was not viable because its liquidity needs were  immediate. On the morning of September 13, according to an internal  communication, AIG executives asked Federal Reserve System officials  about how to obtain an emergency loan under the authority provided in  section 13(3) of the Federal Reserve Act. Officials responded that the  company should not to be optimistic about such assistance.
Over the September 13–14, 2008, weekend, FRBNY officials conducted  various analyses related to AIG, including an evaluation of the company’s  systemic importance, before the Federal Reserve Board ultimately  decided to authorize government assistance on September 16. We  found at least one instance of quantitative analysis of the systemic risk  AIG posed to the financial system. In this analysis, historical equity  returns of AIG were assessed, with a conclusion that the company was  not systemically important. However, FRBNY officials told us that this  analysis was conducted prior to the September 15 bankruptcy of Lehman  and did not take into account market conditions that followed that event.  Beyond this example, officials could not say whether any other  quantitative analyses were conducted regarding systemic risk posed by  AIG. Internal correspondence and documents indicate that officials’  assessment of AIG’s systemic risk relied primarily on qualitative factors.  For instance, documents show that officials assessed the potential impact  on subsidiaries of the AIG parent company filing for bankruptcy, the  potential response of state insurance regulators in that situation, and  differences between a failure of AIG and Lehman.
Officials told us the Lehman bankruptcy was a key factor in how they  assessed the systemic risk of an AIG failure, given what they believed  would be the strain AIG’s bankruptcy would place on financial markets.  Officials told us that had the Federal Reserve System prevented failure of  Lehman Brothers, they would have reassessed the potential systemic  impact of an AIG bankruptcy. A former senior AIG executive expressed a  similar idea to us, saying that had AIG’s crisis occurred before that of  Lehman Brothers, the Federal Reserve System would have not provided  any assistance to AIG, which would have led to its failure. On September  16, a day after Lehman filed for bankruptcy, an FRBNY official sent a  memorandum to the then-FRBNY President and other officials assessing  the expected systemic impacts of an AIG failure, including an analysis of  the qualitative factors previously discussed. Officials decided that a  disorderly failure of AIG posed systemic risk to the financial system, and  on that basis, the Federal Reserve Board approved the $85 billion  Revolving Credit Facility. They said the only other viable outcome  besides the assistance package would have been bankruptcy.
Although the Federal Reserve System had various contacts and  communications about AIG’s difficulties in the months preceding aid to  the company, officials appear to have not acted sooner for various  reasons. FRBNY’s then-President has said that because the Federal  Reserve System was not AIG’s regulator, it could not have known the full  depth of the company’s problems prior to AIG’s September 12 warning. In  addition, FRBNY officials told us that from March to September 2008,  following the collapse of Bear Stearns, they were intensively involved in  monitoring the remaining four large investment banks (Merrill Lynch,  Lehman, Goldman Sachs, and Morgan Stanley) not then supervised by  the Federal Reserve System. They said the concern was the possibility of  another collapse like that of Bear Stearns, and this unusual effort  consumed a significant amount of management attention.
section_title: As AIG’s Needs Became Clearer, Private Financing Failed, Prompting the Federal Reserve to Become More Involved
paragraphs: Following AIG’s unsuccessful requests for discount window access, the  company and the Federal Reserve System pursued what became a two- phase private-financing effort in advance of the ultimate government  intervention. In the week beginning September 15, 2008, AIG faced  pressing liquidity needs, and expected to receive rating agency  downgrades. The company anticipated this would result in $13 billion to  $18 billion in new liquidity demands, primarily stemming from collateral  postings on AIGFP CDS contracts. The ability to raise private financing  was a key issue for AIG because private funding could have reduced or  eliminated the company’s need for government assistance. Further, as  discussed later, the inability to obtain private financing was a condition for  Federal Reserve System emergency lending. For the first phase of  attempts to secure private financing, which AIG led, the company had  developed a three-part plan that envisioned raising equity capital, making  an asset swap among its insurance subsidiaries, and selling businesses.  In the second phase of attempts to secure private financing, which began  on September 15, 2008, FRBNY assembled a team of bankers from two  large financial institutions to pursue a syndicated bank loan.
For the first phase, AIG assembled private equity investors, strategic  buyers, and sovereign wealth funds over the weekend of September 13– 14. These parties considered scenarios ranging from equity investments in  AIG life insurance subsidiaries to purchases of AIG assets. In all, we  identified at least 14 entities as participating in the first phase (see table 1).  This effort identified at least $30 billion in potential financing—well short of  estimated needs that ran as high as $124 billion.
Throughout the September 13–14, 2008, weekend, private equity firms  and strategic buyers weighed investments in AIG’s life insurance  subsidiaries, although they had concerns about the parent company’s  solvency and liquidity needs. On September 12, AIG asked an investment  bank advisor to assist in contacting potential investors and to provide  financial information to these entities to assist in their assessments of  whether and under what terms they could invest in AIG. Also on  September 12, AIG engaged two investment banks and an advisor to  research and identify options to raise $20 billion in private financing.  According to the advisor, it was not certain at the time whether AIG was  facing a problem of insolvency or liquidity.
According to participants with whom we spoke, the process at AIG over  the weekend consisted of a series of formal and informal meetings, during  which they discussed potential investments and received briefings from  AIG about its financial condition and estimates of its liquidity shortfall.  Participants in the process told us there was uncertainty whether any  private investment could satisfy AIG’s liquidity needs and what those  specific needs were. One private equity firm told us that AIG did not  provide an agenda for the weekend, and although it said the process  became more organized on September 14, the firm did not receive data it  ordinarily obtains when considering an investment. According to another  private equity firm, AIG did not provide clear direction amid what the  private equity firm described as a chaotic environment. This private equity  firm added that some bankers expressed frustration that the process  could have been less hurried had AIG started it earlier.
As noted, one element of AIG’s three-part plan during the first phase  contemplated raising equity capital from commercial sources. We  identified two proposals the company received. First, on September 14, a  private equity firm, a sovereign wealth fund, and an insurance company  together made a $30 billion proposal to AIG. The offer included a private  equity investment totaling $10 billion in exchange for a 52 percent stake  in two life insurance subsidiaries. In addition, according to our review, the  potential investors included four other elements in their plan.  1.  The proposal would have created $20 billion in liquidity from an  exchange of assets between AIG’s property/casualty and life  insurance subsidiaries. This swap required approval of the New York  State Insurance Department (NYSID).  2.  The proposal relied on the Federal Reserve System granting AIG  access to its discount window for a $20 billion line of credit, to be  secured by bonds from the asset swap.  3.  The proposal required that rating agencies commit to maintaining the  company’s credit rating at AA-.  4.  The proposal required replacement of AIG senior management,  including the chief executive officer.
A former senior AIG executive said AIG’s Board of Directors rejected the  proposal because it was an inadequate bid with insufficient private equity  contribution and many conditions.
Another private equity firm told us that it also made an offer to AIG,  proposing to buy an AIG insurance subsidiary at a discounted price of  $20 billion. Like other firms participating in the first phase, the private  equity firm determined that investing in one of AIG’s life insurance  subsidiaries, rather than the parent company, posed less financial risk.  AIG rejected the proposal, according to the private equity firm. Our  review showed that other private equity firms present over the weekend  considered investing in AIG, but no formal proposals resulted. For  instance, one private equity firm contemplated a $10 billion investment in  AIG life insurance subsidiaries in exchange for a 30 percent ownership  interest, contingent upon additional financing from commercial banks or  the Federal Reserve System. Another private equity firm said it  considered an investment in AIG but was unable to make an offer given  time pressure and its available investment capacity.
The second part of AIG’s three-part plan during the first phase was an  asset swap. In addition to being incorporated into one of the plans  discussed earlier, the asset swap was also a standalone option. The  company contemplated an exchange of assets between AIG  property/casualty and life insurance subsidiaries to make available $20  billion in securities to pledge for cash, but this plan was contingent upon  approval from NYSID. AIG executives told us they first contacted the  then-Superintendent of NYSID late on September 12, 2008, in an effort to  assess whether such a swap was feasible. According to our review,  NYSID assisted AIG in developing the idea, although it never reached  final approval. A condition for approval was that the swap would be part of  a comprehensive solution that would include raising equity capital and  selling assets—conditions that ultimately were not met. Additionally, state  insurance regulators wanted to ensure that the property/casualty  companies that would be involved in the plan would still have sufficient  capital to protect policyholders after the asset swap occurred. According  to a former senior AIG executive, the asset swap would have generated  $20 billion in securities for AIG to use as security for borrowing, yielding  the company $16 billion to $18 billion in cash proceeds. Toward that end,  the company explored repurchase agreements, secured by assets from  the swap, with two investment banks. One of the investment banks  committed to $10 billion in such repurchase financing, and it noted that  another investment bank was contemplating an additional $10 billion in  repurchase financing. This second investment bank told us, however, that  it considered providing the full $20 billion in repurchase financing to the  company. According to executives of the bank, the deal never  materialized because certain assets they thought AIG would post as  collateral for the financing were unavailable.
For the third part of its plan, AIG or its advisor contacted strategic buyers  in an effort to generate cash from asset sales. On September 12, AIG  offered to sell its property/casualty business for $25 billion to another  insurance company. However, according to the potential buyer, the deal  proved to be too expensive given time pressure. In another potential deal  with the same company, AIG revived previous discussions regarding a  guarantee of $5.5 billion of guaranteed investment contracts that AIGFP  had written. The guarantee would have allowed AIG to avoid posting  $5.5 billion in collateral in the event of a credit rating downgrade in  exchange for a one-time fee. The fee contemplated was in the form of a  transfer of life settlement polices from AIG to the insurance company.  According to an executive of the insurance company, negotiations  surrounding the fee continued until September 15, but the parties could  not reach an agreement.
An FRBNY e-mail also showed internal discussions about two other asset  sales to other insurance companies—potential purchase of AIG’s Variable  Annuity Life Insurance Company for $8 billion and potential purchase of  another AIG subsidiary for $5 billion. In addition to these possible sales,  an AIG advisor told us about a potential $20 billion deal with a sovereign  wealth fund that was considering asset purchases. According to the  advisor, the fund’s primary interest was in purchasing tangible assets,  such as real estate.
By late in the day on September 14, the first phase of efforts to identify  private financing had failed, for reasons including financing terms, time  constraints, and uncertain AIG liquidity needs, according to those  involved. Two private equity firms indicated that a private solution was not  possible without assistance from the Federal Reserve System to assure  AIG’s solvency. Similarly, according to a former senior AIG executive,  potential investors wanted assurances of solvency before making any  investments, and the Federal Reserve System was the only entity in a  position at the time to provide such assurances. AIG executives with  whom we spoke acknowledged that any investments in the parent  company would have been risky. In addition, two would-be investors also  told us that a weekend was too little time to construct a deal that would  usually take at least 4 weeks. As these participants and AIG executives  noted, there was not enough time or money to assist the company.  Moreover, participants said the company lacked an understanding of its  own liquidity needs, and there was insufficient data to support would-be  investors’ decision making. As table 2 shows, AIG’s liquidity needs grew  as analysis of the company’s financial situation progressed over the  weekend.
Over the weekend of September 13–14, 2008, as AIG attempted to  secure private financing, the Federal Reserve System avoided actions  that could have signaled to companies or other regulators that it would  assist AIG. Officials received AIG requests for Federal Reserve System  assistance on at least five occasions during approximately the week  leading up to September 14. As noted, one of these instances occurred  during a meeting between Federal Reserve System officials and AIG  executives on the morning of September 13. A Federal Reserve System  internal communication documenting the meeting shows that during a  discussion about emergency lending under section 13(3) of the Federal  Reserve Act, officials indicated to AIG that an emergency loan would  send negative signals to the market. Officials told us that during the  meeting, they discouraged AIG from relying on a section 13(3) loan.
Meanwhile, an e-mail from an FRBNY official communicated to staff that  they should avoid conveying to firms or other regulators that the Federal  Reserve System was taking responsibility for AIG.
Although Federal Reserve System officials were downplaying assistance  to AIG, records we reviewed show they began considering the merits of  lending to AIG as early as September 2 and continuing through the  September 13–14 weekend. One communication we reviewed noted that  allowing AIG to borrow through the Federal Reserve System’s Primary  Dealer Credit Facility could support an orderly unwinding of the  company’s positions but questioned whether such assistance was  necessary for AIG’s survival. In addition, e-mails on September 13 show  officials considering the operational aspects of lending to AIG through the  Primary Dealer Credit Facility, including an evaluation of the collateral  available for AIG to post against a loan. Reflecting other concerns, a  September 14 communication discussed the merits and drawbacks of  lending to AIG. The merits included the possibility that Federal Reserve  System lending could prevent an AIG bankruptcy and the potential  impacts on global markets that could follow. The drawbacks included that  such a loan could diminish AIG’s incentives to pursue private financing to  solve its problems. Similarly, some staff preliminarily discussed reasons  why the Federal Reserve System should not lend to AIG. These staff  were concerned that although there could be short-term benefits, such as  helping to stabilize the financial system, the potential moral hazard costs  would be too great, according to information we reviewed. Federal  Reserve Board officials told us that, given insufficient information and the  speed at which events unfolded, no written staff recommendation on  whether to lend to AIG was ever finalized or circulated to the Federal  Reserve Board.
While Federal Reserve System officials considered implications of lending  to AIG, they also analyzed the company’s financial condition, including its  liquidity position and risk exposures. FRBNY officials told us that staff  were instructed to “understand” the nature and size of AIG’s exposures.  According to internal correspondence, officials established a team to  develop a risk profile of the AIG parent company and its subsidiaries and  to gather information, such as financial data. They also worked on a  series of memorandums over the weekend highlighting issues at AIG.  Much of the analysis focused on the exposures of AIGFP. In addition,  records from the weekend show that officials evaluated AIG’s asset- backed securities and CDS portfolio, the company’s systemic importance,  and bankruptcy-related issues. According to FRBNY officials, a team from  FRBNY’s Bank Supervision Group looked at public information to assess  AIG’s condition and, in particular, whether the company’s insurance  subsidiaries were a source of financial strength for the company. Officials  also met with AIG executives to discuss the company’s liquidity risks. The  company provided information detailing the financial institutions with the  largest exposures to the company, including credit, funding, derivatives  and CDS exposures.
The Federal Reserve System also monitored AIG’s discussions with  potential investors and NYSID on September 13–14. As noted, Federal  Reserve System officials met with AIG executives on September 13.  According to minutes from the meeting, although the company needed  financing immediately, asset sales could require 6–12 months to  complete. For that reason, as noted in the summary of the meeting, AIG  expressed interest in Federal Reserve System lending facilities to support  its liquidity needs as it sold assets.
Federal Reserve System records also indicate uncertainty among officials  about whether a private-sector solution would be forthcoming over the  weekend. For example, on the morning of September 13, Federal  Reserve Board and FRBNY officials discussed telling AIG that it could not  rely on the Federal Reserve System for financing, so that the company  would focus on its own actions to solve its problems. On the night of  September 14, a Federal Reserve Board official described two private  equity plans under consideration, both of which were conditioned on  Federal Reserve System assistance. After AIG had rejected one plan, a  question was raised on what would prompt AIG to consider restructuring  or a strategic partnership. Further, an e-mail from September 14 shows  the view of one official that AIG was unwilling to sell assets it thought  would offer profit-making potential in the future, while at the same time  attempting to use the situation to its advantage to convince the Federal  Reserve System to offer discount window access. According to the official  who wrote the e-mail, AIG was avoiding difficult but viable options to  secure private financing.
As part of its weekend monitoring of private-sector efforts, officials also had  discussions with NYSID and AIG about the status of plans being  considered. In addition, one FRBNY official told us of a meeting with a  private equity firm over the weekend in order to assess whether its plans to  finance AIG were genuine. Overall, FRBNY officials told us that they acted  as observers to the events unfolding at AIG over September 13–14 and did  not participate in any negotiations on private financing. Rather, they told us  their primary focus was addressing the Lehman crisis occurring that same  weekend. Officials had meetings throughout the weekend with senior  executives of various financial institutions about the Lehman situation.  During these meetings, the issue of AIG arose. FRBNY officials told us they  received assurances from chief executive officers of three financial  institutions present that they were working on AIG’s problems and would  address the company’s liquidity needs. Although the Federal Reserve  System’s own monitoring of the situation that weekend showed AIG was  unable to arrange private financing, an FRBNY official told us there was no  information calling into question the financial institutions’ assurances that  they would handle the AIG situation. Rather, the Lehman bankruptcy on  September 15 and its effect on financial markets eventually called the  assurances into question, the official told us.
A related issue arose regarding assurances and AIG’s regulators. FRBNY  officials said in Congressional testimony that state insurance regulators  and OTS had assured them over the September 13–14 weekend that a  private-sector solution was available for AIG, and that officials had no  basis to question those assurances. State insurance regulators,  however, told us no such assurances were given. According to Federal  Reserve System officials, they did not consult OTS about AIG’s condition,  given the time pressure of events. Further, records we examined indicate  that AIG and Federal Reserve System officials themselves communicated  the difficulties the company encountered in attempting to obtain private  financing over the weekend.
Following the failure of the AIG-led weekend efforts, FRBNY began what  became the second phase of the private-financing effort on Monday,  September 15, 2008. This attempt moved away from equity investments  or asset sales and instead focused on syndicating a loan. FRBNY records  we reviewed show that some officials continued to believe on September  15 that AIG had options to solve its problems on its own. Nonetheless,  FRBNY called together a number of parties and urged them to come up  with a private loan solution. According to our review, participants in the  meeting included AIG, Treasury, three investment banks, an AIG advisor,  an FRBNY advisor, and NYSID. The then-FRBNY President initiated this  effort late in the morning of September 15 and requested that the two  investment banks identify a commercial bank loan solution for AIG.  According to investment banks we interviewed, the FRBNY President did  not specify any deadlines or provide special instructions to the financial  institutions but asserted that government assistance was not an option.
One of the investment banks told us that participants focused on four  areas during the second phase—assessing liquidity needs, valuing  assets, creating loan terms, and identifying potential lenders. Participants  contemplated a $75 billion syndicated loan, consisting of $5 billion  contributions from 15 financial institutions. According to FRBNY, the  banks envisioned that AIG would need 6 months to sell assets and repay  the loan. While the banks worked to create a loan package, FRBNY  focused on assessing the exposures to AIG of regulated financial entities,  nonbank institutions, and others. Late on September 15, according to our  review, the participants reported to the then-FRBNY President about  difficulties in securing a loan, to which the President responded with a  request that they continue—but this time, also considering a potential  government role. According to a former Treasury official, the then-FRBNY  President said the Federal Reserve System would provide $40 billion in  financing for AIG, but the participants would have to find the remainder.  This was the first instance we identified in which officials indicated  externally that they would consider government assistance. According to  an investment bank, the participants then continued discussions.  Nonetheless, the loan effort failed. By the night of September 15, officials  concluded private firms could not find the resources to solve the problem,  the former FRBNY President told us. The next day, the then-FRBNY  President ended the second phase of attempts to find private financing for  AIG. The former President told us he could not recall the first mention of  government intervention, but that he believed the possibility of  government assistance was discussed with the Federal Reserve Board  and Treasury on the night of September 15.
Participants and FRBNY officials provided varying explanations for why  the second phase failed. According to one of the investment banks, AIG’s  liquidity needs at the time exceeded the value of any security to back a  loan. Therefore, the participants on September 15 did not attempt to line  up syndication partners. In addition, one senior AIG executive expressed  the view that the Federal Reserve System waited too long to understand  and act on the company’s problems. FRBNY officials, however, cited a  desire by the banks to protect their finances amid general market turmoil  that was exacerbated by the Lehman bankruptcy. They added that  private-sector collateral concerns notwithstanding, the collateral AIG used  to back the $85 billion Revolving Credit Facility fully secured the Federal  Reserve System to its satisfaction, a condition of section 13(3)  emergency lending. On the morning of September 16, 2008, the then- Secretary of the Treasury, the Chairman of the Federal Reserve Board,  and the then-FRBNY President held a conference call regarding AIG.  According to an FRBNY official on the call, the three agreed that the  Federal Reserve Board should approve lending to the company. The  former FRBNY President told us nothing more could have been done to  secure private financing, as the extent and severity of AIG’s liquidity  needs, coupled with mounting panic in financial markets that was  accelerated by the failure of Lehman, meant private firms had no capacity  to satisfy AIG’s needs. Later that day, after the two failed efforts at private  financing, the Federal Reserve Board authorized FRBNY to enter into the  Revolving Credit Facility with AIG to avoid what officials judged to be  unacceptable systemic consequences if AIG filed for bankruptcy.
section_title: The Federal Reserve Offered AIG Help in Avoiding Bankruptcy, and AIG Made the Final Decision to Accept Government Assistance
paragraphs: By September 12, 2008, as AIG headed into the weekend meetings aimed  at identifying private financing, the company had also begun considering  bankruptcy issues, as it faced possible failure during the week of  September 15. According to a former senior AIG executive, around  September 12, the company engaged legal counsel to begin preparations  for a possible bankruptcy. As noted, AIG also gave a presentation to  FRBNY officials on September 12, which included information about  possible impacts of bankruptcy. After AIG’s presentation, FRBNY officials  began their own assessment of the prospect and possible effects of AIG’s  failure, focusing on the systemic consequences of bankruptcy and how the  legal process of filing might unfold. On September 14, FRBNY held a  discussion about AIG with risk managers of an investment bank as well as  the Office of the Comptroller of the Currency. According to a meeting  record, AIG would have been forced to file for bankruptcy on September  15, absent private financing to meet its liquidity demands.
Officials’ concern about the systemic effect of an AIG bankruptcy included  whether such a filing would have prompted state insurance  commissioners to seize AIG insurance subsidiaries. According to FRBNY  officials, regulatory seizures of AIG’s insurance subsidiaries following a  bankruptcy filing would have complicated any efforts to rescue the  company because AIG’s businesses were interconnected in areas such  as operations and funding. Therefore, according to the officials, discrete  seizures by individual state insurance regulators would have made  bankruptcy unworkable. In addition, foreign authorities were becoming  concerned, and bankruptcy could have resulted in insurance regulators  worldwide seizing hundreds of AIG entities. According to the officials, they  looked at the experience of previous insurance company failures, but  none were comparable to AIG’s situation.
According to our review, both AIG executives and a number of  government officials expressed concerns about possible seizures of AIG  assets shortly before the Federal Reserve Board authorized the  Revolving Credit Facility. For example, at an AIG Board meeting on  September 16, an AIG executive stated that NYSID would seize the  company’s New York insurance units if AIG went into bankruptcy. A  former senior AIG executive told us that on September 16, at least three  state insurance regulators said they would seize AIG insurance  subsidiaries in their states if the parent company filed for bankruptcy. In a  number of records we examined, government officials also stressed the  likelihood that insurance subsidiaries would be seized, particularly those  experiencing financial difficulties.
State insurance regulators were less certain of the likelihood of seizure,  according to our review. A former state insurance official told us that he  cautioned FRBNY officials that seizures were highly likely. AIG’s lead life  insurance regulator told us it considered the possibility of intervention, but  added that states generally have an incentive not to place insurance  companies into receivership, as that has negative connotations that could  diminish companies’ value. Several state insurance officials overseeing  AIG’s property/casualty and life insurance businesses told us that  bankruptcy of the AIG parent company would not have required them to  act as long as the insurance subsidiaries were solvent, and they did not  foresee insolvency. Two state insurance regulators also told us they did  not communicate to the Federal Reserve System or AIG that they would  intervene in the company’s subsidiaries. State insurance officials said that  in the past, their approach has been to monitor the situation when a  parent company filed for bankruptcy—for example, Conseco, Inc.— because statutory provisions protected insurance company assets.
In offering to assist AIG, the Federal Reserve Board sought specifically to  give the company the means to avoid a bankruptcy filing because of  concerns about systemic risk, officials told us. Our review showed that  beyond offering a way to avoid such a filing, the Federal Reserve Board  had no direct role in the AIG board’s consideration of bankruptcy on  September 16. On that day, an AIG board meeting had already been  scheduled at 5 p.m. to discuss the possibility of bankruptcy, according to  a former senior AIG executive. After the Federal Reserve Board offer  earlier in the day, the meeting became a discussion about government  assistance versus filing for bankruptcy, the former executive said, which  was described as the only available alternative. According to information  we reviewed, the AIG board’s view was that the terms of the  government’s offer were unacceptable, given a high interest rate and the  large stake in the company—79.9 percent—the government would take at  the expense of current shareholders. AIG executives telephoned FRBNY  officials during the AIG board meeting in an effort to negotiate terms of  the Revolving Credit Facility, but the FRBNY officials said the terms were  nonnegotiable and that the company had no obligation to accept the  offer.
During the AIG board meeting, AIG’s advisors also discussed implications  of a potential bankruptcy filing. This discussion included the value of  potential future asset sales and the value of the company’s subsidiaries  generally, as well as legal advice on what the company’s fiduciary duties  were in any such event. As part of its bankruptcy issues consideration,  AIG’s board also contemplated debtor-in-possession financing from an  investment bank. But AIG told us its financial adviser believed such  financing would have been difficult in light of then-current market  conditions, and a former senior AIG executive told us AIG would have  required debtor-in-possession funding of unprecedented size at a time  when markets were volatile.
The AIG board decided that government assistance was the best option  because that would best protect AIG’s value, according to records we  reviewed. Additionally, a former senior AIG executive told us that AIG  accepted the Federal Reserve System’s offer of assistance because of  uncertainty about how bankruptcy proceedings would unfold. Ultimately,  10 of the 11 directors voted to accept the federal loan offer.
AIG executives and advisors stressed to us that the only matter  presented for consideration that day was whether to accept the Federal  Reserve System’s loan offer. As part of that, however, directors  considered issues and implications that might arise from a bankruptcy  filing, they said. The executives said that at that point, the company was  not prepared to file for bankruptcy if it did not accept the loan, and no  bankruptcy petition had been prepared for filing or directed to be  prepared.
AIG executives told us that after accepting the Federal Reserve System  loan, they did not consider bankruptcy issues again but rather focused on  devising solutions to the company’s problems. FRBNY officials told us  that as a practical matter, AIG’s acceptance of the Revolving Credit  Facility had effectively precluded bankruptcy as an option, at least in the  short term, because it would have immediately put the funds that FRBNY  had loaned to AIG at risk. Nevertheless, FRBNY continued to examine  bankruptcy as an alternative to additional government assistance over the  next several months following the establishment of the Revolving Credit  Facility, according to records we examined. For instance, in briefing slides  circulated to FRBNY officials on October 7, one FRBNY staff member  argued that bankruptcy was the least-cost resolution for AIG, even though  the company continued to pose systemic risk. Also, Federal Reserve  Board staff began gathering data on the systemic implications of an AIG  bankruptcy and devising a contingency plan to protect the banking  system.
A bankruptcy advisor to FRBNY told us that officials continued to discuss  bankruptcy in lieu of federal assistance throughout the fourth quarter of  2008 and into early 2009. Internal FRBNY briefing slides from February  2009 show consideration of the consequences and costs of bankruptcy  versus further government assistance, including restructuring of the  government’s TARP investment in AIG and additional capital  commitments for AIG’s subsidiaries. The assessment concluded that  bankruptcy costs would reflect loss of the government’s TARP investment  in preferred stock, plus any additional losses from unpaid portions of the  Revolving Credit Facility. It further noted that AIG would be more likely  to repay the government if it received more assistance than if it filed for  bankruptcy. Moreover, due to AIG’s interconnections with other financial  institutions, bankruptcy had other potential costs to the government, such  as the possibility that other institutions with exposure to AIG would need  subsequent government support. There could also be a run on the life  insurance industry, the assessment noted. The Federal Reserve Board  also weighed effects of bankruptcy when considering additional  government assistance, according to minutes of a Federal Reserve Board  meeting on February 19, 2009. The minutes show that given the potential  costs of bankruptcy to AIG’s insured parties, the governors generally  agreed that stabilizing AIG with more government aid was the only option  at that point, notwithstanding concerns over potentially increased  taxpayer exposure.
In addition to these concerns, FRBNY, its bankruptcy advisor, and state  insurance regulators also cited other factors that complicated the viability  of bankruptcy for either the AIG parent company or its subsidiaries. First,  according to the advisor, AIG’s Delaware-based federal savings bank, as  well as the company’s foreign and domestic insurance subsidiaries, could  not file for bankruptcy protection because they were not eligible to be  Chapter 11 debtors. State insurance regulators told us that if AIG failed,  then the parent company, its AIGFP unit, and other entities would have  filed for bankruptcy, but that state insurance laws prevented the parent  company from accessing insurance subsidiary assets to satisfy claims of  any entities other than policyholders. FRBNY’s advisor told us that the  legal limitations on any partial bankruptcy were as important to assessing  whether to provide assistance to AIG as the issues concerning the  company’s close connections with other entities.
Second, AIG’s parent company had guaranteed many liabilities of its  subsidiaries. For example, AIGFP relied on the strength of the parent  company’s finances and credit ratings. As a result, according to FRBNY’s  bankruptcy advisor, a bankruptcy of either the parent or AIGFP would have  constituted a default under AIGFP’s CDS contracts, potentially leading to  termination of the contracts and additional demands for liquidity. As noted  in a document circulated among FRBNY officials on October 7, 2008, a  default on AIGFP’s CDS contracts could have involved a large number of  the company’s counterparties. Moreover, according to an advisor, the CDS  contracts were defined as agreements that would have been exempt from  automatic stay under the U.S. bankruptcy code. As a result, AIGFP’s  CDS counterparties could have terminated their contracts notwithstanding  an AIG bankruptcy filing, obligating AIG to pay the counterparties early  termination amounts on those transactions. FRBNY’s bankruptcy advisor  told us that neither AIGFP nor the parent company, as guarantor of  AIGFP’s obligations, would have had the funds to pay the cost of early  terminations of all such positions in AIGFP’s derivatives portfolio, including  CDS and other types of derivatives. As discussed earlier, FRBNY briefing  slides indicated that AIG’s bankruptcy at the time would have resulted in  $18–24 billion in funding needs. Also, because some of the company’s  CDS counterparties were European banks, the potential economic loss  from a default could have affected the global banking system.
Another concern underlying officials’ bankruptcy considerations was  whether refusing to provide additional support for AIG beyond the original  aid would have hurt the government’s reputation or market confidence,  according to records we reviewed. For instance, one memorandum notes  that allowing AIG to fail after providing the Revolving Credit Facility would  have caused loss of market confidence in government support, which could  have had systemic consequences. FRBNY officials told us that a similar  concern existed about preserving confidence in policymakers and that  withdrawing from the Federal Reserve System’s strategy only weeks after  the Revolving Credit Facility was extended would have been extraordinary.
There were similar confidence issues with respect to AIG that contributed  to decisions on assistance. An FRBNY advisor told us there were  questions of whether AIG could survive a bankruptcy proceeding because  the company had built its business model on long-term customer  confidence. For example, the advisor noted that during the fall of 2008,  customers were saying they would not renew their coverage without a  solution in place to address AIG’s problems. Another advisor opined that  if AIG filed for bankruptcy, officials could have avoided moral hazard and  criticism over use of additional public funds. However, bankruptcy also  could have led to further market deterioration at a time when there was  already uncertainty about Lehman and other financial issues, the advisor  said.
FRBNY officials told us they continued to consider contingency plans for  AIG, including the desirability of bankruptcy, until around August 2009, by  which time new board members and a new chief executive had been  named. According to officials, the contingency planning reflected overall  concerns about financial market stability that persisted beyond the  September 2008 weekend of the Lehman bankruptcy and AIG crisis. For  example, officials told us that between September 16, 2008, and January  2009, insurance companies other than AIG lost approximately $1 trillion in  market value, and many of them were on the verge of bankruptcy. By the  end of 2009, however, the company’s situation had improved to a point  that bankruptcy ceased to be a focus in consideration of options,  according to the officials.
section_title: Given the Crisis, There Was Little Time to Consider Alternatives for Initial Aid, but AIG and the Federal Reserve Considered a Range of Options for Later Assistance
paragraphs: FRBNY officials told us that overwhelming pressure to act quickly at the  time the Revolving Credit Facility was established prevented them from  thoroughly considering other options. They said this pressure was the  result of three factors:    They did not understand the size and nature of AIG’s liquidity needs  until AIG’s presentation on September 12, 2008.    AIG, as noted, faced a potential credit rating downgrade on  September 15 or 16 that would have generated large demands for  cash.    The company was unable to roll over commercial paper at maturity,  so large cash commitments would have been due on September 17.
Officials told us that given these constraints, there was no time to engage  advisors and fully explore options. Still, records we examined show that  some alternatives were considered. An FRBNY staff memorandum from  September 13, 2008, cited two alternatives to the Revolving Credit Facility.  One was to lend to AIG through an intermediary to which a Reserve Bank  had the authority to lend, such as a commercial bank or primary dealer.  Officials told us the problem with this idea was uncertainty whether an  intermediary would execute any plan and under what terms. The other idea  was to provide financing to AIG from Treasury or NYSID. Officials told us,  however, that at that time, Treasury had no authority to offer assistance  and NYSID did not have the necessary funds.
There was also discussion before the Revolving Credit Facility of potential  financing through the FHLB system. FRBNY e-mails on September 15,  2008, show consideration of whether AIG could secure FHLB financing  through its insurance subsidiaries, which as noted earlier, AIG itself had  contemplated over the summer of 2008. The e-mails note that AIG’s  federal savings bank was a member of the FHLB of Pittsburgh and  indicate that the FHLB of Dallas was willing to lend to AIG against high- quality collateral. Nevertheless, FRBNY officials said the time  constraints prevented meaningful exploration of solutions other than to  either let AIG fail or to provide the emergency loan.
In the week following establishment of the Revolving Credit Facility,  officials began their own assessment of AIG’s condition before  considering options for additional assistance. Previously they had relied  on information from AIG and those involved in private financing efforts.  Records we reviewed show that on September 17, 2008, the day after  AIG accepted the Revolving Credit Facility, FRBNY had a team at AIG to  monitor collateral valuation practices, risk management, and exposures of  various subsidiaries. According to FRBNY officials, there were two main  objectives during that first week: (1) to forecast AIG’s liquidity situation to  better understand the company’s needs moving forward and (2) to verify  that the Revolving Credit Facility was secured and that AIG’s draws  against it did not exceed the value of posted collateral. FRBNY officials  said that they wanted to develop their own views on these matters and  engaged three advisors for assistance during that week.
Following initial assessments, FRBNY and its advisors shifted attention to  considering additional options for AIG. According to FRBNY officials, they  already had begun to think about other ways to provide aid they believed  AIG would need while still in the process of drafting documents for the  Revolving Credit Facility. For that reason, officials said, they drafted a  credit agreement for the facility that would allow them to make changes in  government support for AIG without the company’s consent. FRBNY  officials said their general approach in considering options was to have  AIG bear a cost for any benefit received, so that the company had a  strong economic incentive to repay assistance. According to these  officials, FRBNY had no interest in providing funds beyond the initial  Revolving Credit Facility unless the clear purpose was to stabilize the  company. Also, the officials said they did not want aid to create negative  incentives in the company that could create reliance on government  protection, and they were mindful of rating agencies’ concerns. Further,  avoiding arrangements that created a continuing relationship with AIG  was important.
An FRBNY advisor told us that this approach also included trying to  contain the problems at AIGFP. FRBNY officials told us that in general,  the process for developing options, given the objectives cited previously,  was to brainstorm ideas while taking note of applicable constraints or  barriers. In the end, the available options narrowed to essentially the  plans that were implemented.
FRBNY officials said that in developing options, one element remained  constant—the expectation that AIG’s source of repayment for its  emergency lending would be through liquidation or sale of whole  subsidiaries, rather than through company earnings. Officials did not  consider company earnings alone to be sufficient in light of AIG’s needs  to reduce its size and stabilize itself through recapitalization. Further, the  officials told us that while the private-sector lending plan of September 15,  2008, contemplated liquidating the company in 6 months, they were  doubtful that could be achieved. According to these officials, liquidation  over a short period would have led to additional credit rating downgrades,  furthering concerns about AIG’s rating-sensitive business model.
After the initial provision of aid, AIG’s liquidity problems remained and the  original terms of the Revolving Credit Facility contributed to higher debt  costs. Officials were concerned the company’s credit ratings would be  lowered, which would have caused its condition to deteriorate further.  There were also continuing concerns about AIG’s solvency. As discussed  in October 2008, market doubts about solvency stemmed from concerns  about liquidity, the company’s exposure to RMBS and asset-backed  securities (via its CDS transactions), and the impact of AIG’s difficulties  on the business prospects of its insurance subsidiaries. FRBNY officials  noted that in addition to its own particular problems, AIG also was facing  the same difficulties as other financial institutions at the time, such as the  loss of access to the commercial paper market.
In the weeks following the announcement of the Revolving Credit Facility,  AIG’s actual and projected draws on the facility grew steadily (see fig. 2).  AIG used almost half the facility by September 25 and was projected to  begin approaching the $85 billion limit by early October. Ultimately, AIG’s  actual use of the facility peaked at $72.3 billion on October 22, 2008.
In response to AIG’s continuing difficulties, FRBNY officials told us that  they considered a range of options leading up to the November 2008  restructuring of government assistance. However, our review identified  that the first possibility for modifying assistance to AIG came from the  private-sector. We found that on September 17, 2008, a consultant  contacted the Chairman of the Federal Reserve Board and the then- FRBNY President to raise an idea, suggested by a client, to form an  investor group that was willing to purchase about $40 billion of the $85  billion Revolving Credit Facility. The client said such a purchase would be  advantageous to the Federal Reserve System because it would provide a  positive signal to financial markets and could transfer some of the risk of  the loan to the private parties, whose involvement would also  demonstrate that the Revolving Credit Facility had commercial appeal.  Federal Reserve Board officials told us that this idea, which came only  days after the failure to obtain private financing for AIG, did not develop  further. Earlier, as AIG’s board contemplated government assistance on  September 16, the former FRBNY President told the company he was  willing to consider an offer for private parties to take over the credit  facility. The President characterized the idea as a preliminary offer and  told us he understood one feature was to make the investors’ $40 billion  investment senior to the government’s interest. That would have  significantly increased the risk of the FRBNY loan, making the Reserve  Bank more vulnerable to a loss, the former President said. He said  allowing FRBNY’s interest to become subordinate to that of private  investors would not have been in the best interest of taxpayers.
During October 2008, the Federal Reserve System considered options  that included what became ML II and ML III, as well as an accelerated  asset sales process and government purchases of AIG’s life insurance  subsidiaries. As discussed earlier, officials expected that AIG would have  to divest assets to generate cash to repay the government’s loan. Toward  that end, the Federal Reserve Board asked staff to encourage AIG to sell  assets with greater urgency, according to information we reviewed from  October 2008. In addition, as FRBNY briefing slides from October 2,  2008, show, officials contemplated other options, including financial  guarantees on the obligations of AIGFP and its CDS portfolio, increasing  the $85 billion available under the Revolving Credit Facility, and  becoming the counterparty to the company’s securities lending portfolio  (the latter of which was acted upon, with the Securities Borrowing  Facility). FRBNY officials also considered a proposal to directly support  AIG’s insurance subsidiaries, to preserve their value, according to the  October 2 slides. The presentation notes that these potential support  actions would include “keepwell” agreements and excess-of-loss  reinsurance agreements, which would ultimately terminate upon sale of  the subsidiary. It further noted that this approach would have allowed  officials to address credit rating concerns by severing the link between the  ratings of AIG’s parent and its subsidiaries.
When considering options for AIG, FRBNY officials said they also took  into account legal barriers, which eliminated some of the alternatives  contemplated, such as guarantees, keepwell agreements, and ring- fencing of AIG’s subsidiaries. Under section 13(3) of the Federal  Reserve Act, a Reserve Bank’s authority did not extend beyond making  loans authorized by the Federal Reserve Board that were secured to the  Reserve Bank’s satisfaction. Moreover, officials told us they had no  authority to issue a guarantee. In mid-October, Federal Reserve Board  and FRBNY staff discussed options, such as a guarantee or keepwell  agreement, with Federal Reserve Board staff being opposed to these  options. The staffs also discussed the possibility of Treasury providing  such arrangements and whether these options were important in case of  a credit rating downgrade. The issues were whether the government  could protect the value of the AIG insurance subsidiaries that  collateralized the FRBNY credit facility and prevent the abrupt seizure of  those companies by state insurance regulators. As for ring-fencing,  officials told us it was not viable due to time constraints and the lack of a  legal structure to facilitate it. An FRBNY advisor told us that Treasury may  have been able to provide a guarantee to AIG but that the amount of any  guarantee would have been subject to limitations. The advisor added that  the guarantee also raised moral hazard issues.
As Federal Reserve System officials continued to consider the best  approach for AIG, other relief became available. In late October 2008,  some AIG affiliates began to access the Federal Reserve System’s newly  created Commercial Paper Funding Facility. The Emergency Economic  Stabilization Act of 2008, enacted the same month, gave Treasury the  authority to make equity investments, which it used to make its $40 billion  investment in AIG in November 2008. Meanwhile, according to records  and interviews with FRBNY officials, AIG proposed plans—including the  provision of additional government funds to purchase CDOs that were the  subject of the company’s CDS contracts and a repurchase facility with the  government—in which AIG would purchase assets in a transaction similar  to what ML III did. The officials told us that while they aimed to stem AIG’s  liquidity drains, they also wanted to limit erosion of the company’s capital,  and a repurchase facility would have jeopardized that objective. In  addition, the repurchase facility would have placed FRBNY in a  continuing relationship with AIG, which FRBNY officials told us was  generally an unwanted outcome for any option. Ultimately, the assistance  provided to AIG in the 2 months following the Revolving Credit Facility  included the Securities Borrowing Facility, ML II and ML III, restructuring  of the Revolving Credit Facility’s terms, the Commercial Paper Funding  Facility, and assistance from Treasury under TARP.
Before the March 2009 restructuring of government assistance, FRBNY  and its advisors continued to consider more possibilities for assisting AIG,  in particular, for helping it sell assets. According to one advisor, AIG faced  a number of challenges in the months leading up to this second  restructuring of government assistance. For example, AIG was expecting  a loss for the fourth quarter of 2008 of $40 billion, which was $15 billion  more than its loss in the previous quarter. (The actual loss AIG reported  was $61.7 billion, which was reported at the time as being the largest  quarterly loss in U.S. corporate history.) In addition, AIG’s asset-sale plan  was under pressure from low bids, delays, and limited interest from  buyers who lacked financing in a fragile credit market. As a result of these  and other issues, FRBNY officials expected AIG to receive a credit rating  downgrade. In response, both the company and FRBNY considered a  number of new options. According to company records, AIG considered a  package of options that included asset and funding guarantees, a debt  exchange to reduce the Revolving Credit Facility, and recapture of fees  the company paid on the Revolving Credit Facility worth $1.7 billion plus  interest. Ideas of FRBNY or its advisors included additional TARP  investments by Treasury, $5 billion in guaranteed financing for AIG’s  International Lease Finance Corporation, and nationalization of the  company. The latter, as noted in the records of an advisor, included  provisions for winding down AIGFP, converting Treasury’s preferred stock  investment under TARP into common stock, and providing government  guarantees of all AIG obligations.
FRBNY and its advisors continued to develop options after the  restructuring on March 29, 2009, but that was the last time the Federal  Reserve Board formally authorized assistance for AIG, as the company’s  prospects began to stabilize. According to records we reviewed, these  options included creation of a derivatives products company with a  government backstop to engage in transactions with AIGFP’s derivative  counterparties and separating AIGFP from the AIG parent company to  mitigate risks the subsidiary posed.
According to FRBNY officials, their general attitude toward AIG and  consideration of options in the months following the Revolving Credit  Facility was to listen and observe, trying to see how the firm was  attempting to solve its problems. This approach sometimes meant they  did not share information or plans with AIG—for example, when they were  considering details for ML III or expected contingencies if the government  decided not to provide additional support for the company. AIG  executives described their relationship with FRBNY as collaborative and  said that FRBNY officials did not deter the company from proposing  solutions. They also noted there was frequent contact between the  company and FRBNY.
Overall, FRBNY officials told us that they led the development of options,  while relying on three advisors for expertise in designing structures and  analyzing scenarios. FRBNY engaged advisors primarily for evaluation of  technical details, as staff did not have the expertise to conduct the depth  of analysis and modeling required, for example, in creating ML II and ML  III. FRBNY officials also told us they gave guidance to AIG while focusing  on options that would stabilize the company and provide repayment of the  government assistance—although those goals were not always aligned.  In mid-October 2008, for instance, AIG approached officials about the  company’s idea for the repurchase facility noted earlier. FRBNY officials  said they told the company not to pursue that course but to continue  attempts to negotiate terminations with its CDS counterparties. Officials  said that they were in a good position to assess ideas AIG proposed  because they had begun work related to ML II and ML III in the weeks  after the establishment of the Revolving Credit Facility.
section_title: Credit Ratings Were a Key Consideration in AIG Assistance
paragraphs: Although the performance of credit rating agencies during the financial  crisis has drawn criticism, Federal Reserve System officials said AIG’s  credit ratings were central to decisions about assistance because rating  downgrades could have triggered billions of dollars in additional liquidity  demands for the company. Downgrades could also have jeopardized  AIG’s asset sales plan and repayment of government aid, if a downgrade  led to events that significantly reduced the value of AIG assets. As a  result, FRBNY joined with AIG to address rating agency concerns  throughout the course of government assistance to the company.
Beginning in late 2007, AIG’s exposure to the subprime mortgage market  and its deteriorating derivatives portfolio raised concerns among rating  agencies, rating agency executives told us. In February 2008, AIG  announced a material weakness in the valuation of its CDS portfolio,  leading Moody’s Investors Service to lower its ratings outlook for AIG  senior debt from stable to negative. In the same month, other rating  agencies also placed AIG on negative outlook, suggesting the possibility  of a future downgrade. As 2008 progressed, AIG executives met with  rating agencies to discuss the company’s situation. Following reviews of  AIG’s deteriorating condition and the announcement of losses for the first  quarter of 2008, Moody’s Investors Service, Standard & Poor’s, Fitch  Ratings, and A.M. Best Company all downgraded AIG’s ratings in May  2008.
Over the summer of 2008, AIG communicated with rating agencies about  its development of a strategic plan to address its problems. The company  expected to announce the plan at the end of September, a former AIG  executive told us. On August 6, AIG announced a second quarter loss of  $5.36 billion. Rating agencies initially said they would hold off action until  the company’s chief executive officer presented the new strategic plan,  the former executive told us. By late August, however, rating agencies  had indicated to AIG that they would review the company and probably  downgrade its rating, the executive said. This development, the senior  executive added, was ultimately responsible for the company’s liquidity  crisis in September 2008.
In the weeks leading up to AIG’s crisis weekend of September 13–14,  rating agencies cited concerns about mounting problems in AIG’s CDS  portfolio and indicated they would lower AIG’s credit ratings unless the  company took actions to prevent the move. Other rating agency concerns  included AIG’s declining stock price, its liquidity position in general, and its  risk management practices above and beyond capital needs. One rating  agency said that during the second week of September, concerns about  AIG’s financial condition increased greatly over a short period of time.
Immediately after the Federal Reserve Board authorized the Revolving  Credit Facility, the potential for downgrades following the announcement  of an expected quarterly loss effectively established a deadline for the  Federal Reserve System as it worked to restructure its assistance to the  company. FRBNY officials told us they timed restructuring plans to  coincide with AIG’s release of its third quarter results on November 10,  2008, because they expected that an announcement of a quarterly loss  would result in a downgrade without a strategy to further stabilize the  company. By early October, Federal Reserve Board staff identified  forestalling a ratings downgrade as the priority because a downgrade  would hurt AIG subsidiaries’ business, among other problems. Although  the Federal Reserve System’s Securities Borrowing Facility implemented  earlier had helped to prevent downgrades, rating agencies wanted to see  additional measures taken. FRBNY also considered asking rating  agencies to take a “ratings holiday,” whereby the rating agencies would  agree not to downgrade AIG.
Information we reviewed further indicates that leading up to the  announcement of restructuring of government assistance in November  2008, FRBNY and Federal Reserve Board officials were concerned about  ratings and whether options they were considering would prevent a  downgrade. October 26 briefing slides from an FRBNY advisor detailed  various rating agency concerns, including ongoing liquidity and capital  problems at AIGFP, the parent company’s debt levels following the  Revolving Credit Facility, and risks associated with executing AIG’s asset  sales plan. When the Federal Reserve Board considered authorization of  the restructuring package, a key factor was rating agency concerns.
Ratings implications continued to factor into officials’ decisions leading up  to the second restructuring of government assistance in March 2009 but  with a greater focus on AIG’s asset sale plans and the performance of its  insurance subsidiaries. According to an FRBNY advisor, potential losses,  combined with AIG’s deteriorating business performance, difficulties  selling assets, and a volatile market environment, meant that a ratings  downgrade was likely unless the government took additional steps to  assist the company. FRBNY officials told us a main rating agency  concern was whether AIG could successfully execute its restructuring  plan over the multiyear period envisioned.
Both rating agency executives and FRBNY officials told us they had no  contact with one another concerning AIG before September 16. After  the establishment of the Revolving Credit Facility, FRBNY officials began  to develop a strategy for communicating with the rating agencies to  address their concerns. They told us that they implemented this approach  after the rating agencies contacted them in the week following September  16, 2008, seeking to understand what the government had planned.  FRBNY officials also said there was a rating agency concern that the  FRBNY loan was senior to AIG’s existing debt. As a result, according to  the officials, it became clear early that the rating agencies would play a  key role, because further downgrades would have a serious impact on  AIG and cause further harm to financial markets. In response to rating  agency issues, officials said they provided information about the  Revolving Credit Facility in the 2 weeks following authorization of the  lending, but not about AIG or potential future government plans. FRBNY  engaged three advisors to develop its strategy for rating agency  communications. As part of the effort, FRBNY officials began participating  in discussions between AIG and the rating agencies about the  implications of government assistance on AIG’s ratings.
FRBNY officials told us they generally met with AIG and rating agencies  together, but that officials had some independent discussions with the  rating agencies, along with a Treasury official, to confirm details of federal  plans to assist the company. These separate sessions were not,  however, related to what AIG itself was doing or intended to do, the  officials said. In general, interacting with rating agencies in this way was  new for FRBNY officials, who told us they were concerned that talking to  the rating agencies without AIG present could influence the ratings  without allowing AIG to have any input. They also noted that the proper  relationship was between the rating agencies and the company, as  FRBNY was not managing AIG.
FRBNY officials said that they viewed the rating agencies as a limiting  factor in considering options but not necessarily a driving force, as  restructuring efforts focused on stabilizing AIG and not necessarily on  preventing a downgrade. AIG’s business partners, brokers, and bank  distribution channels had concerns about the company’s ratings, because  a specified credit rating can be required to transact business, the officials  said. But FRBNY’s policy objective was to prevent a disorderly failure of  AIG, and FRBNY officials said they did not believe that would have been  possible if AIG was downgraded to the levels rating agencies were  considering. The rating agencies, FRBNY officials said, were an indicator  of how the market would view AIG upon implementation of various  solutions. They added that the rating agencies wanted to hear solutions  and that the government was flexible and committed to helping AIG but  did not wish to participate in decision making.
Several rating agencies told us they did not see their role in discussions  with AIG executives and FRBNY officials as becoming involved in  decision making or management of AIG. Instead, meetings with AIG were  standard in nature, whereby the agencies would gather information, react  to plans, or share perspectives on potential ratings implications of  contemplated actions. Representatives from one rating agency  described, for example, meetings at which AIG presented its plans and  the agency commented about the potential implications on ratings in  general without mentioning a specific rating that would result. Similarly,  another agency told us that it would ask questions about options AIG  presented but did not offer input or recommendations regarding individual  plans. The agency added that legal barriers prevented it from suggesting  how to structure transactions so that a company could improve its rating.
FRBNY officials concurred with the rating agencies’ description of their  role. They said the agencies did not indicate what they considered  acceptable or provide detailed feedback on government plans. To the  contrary, FRBNY officials told us that they would have liked for the rating  agencies to provide instructions on minimum actions needed to maintain  AIG’s ratings. But the agencies frequently pointed out that they did not  want to be in the position of effectively running the company by passing  judgment on various plans. FRBNY officials said that they generally  understood the rating agencies’ concerns, but did not make specific  changes to the restructured Revolving Credit Facility, ML II, or ML III  based on rating agency feedback.
section_title: FRBNY’s Maiden Lane III Design Likely Required Greater Borrowing, and Accounts of Attempts to Gain Concessions From AIG Counterparties are Inconsistent
paragraphs: After the first extension of federal assistance to AIG—the Revolving  Credit Facility—ML III was a key part of the Federal Reserve System’s  continuing efforts to stabilize the company. We found that in designing ML  III, FRBNY decided against plans that could have reduced the size of its  lending or increased the loan’s security, as it opted against seeking  financial contributions from AIG’s financial counterparties. We also found  that the Federal Reserve Board approved ML III with an expectation that  concessions would be negotiated with the counterparties, but that FRBNY  made varying attempts to obtain these discounts, which could have been  another way to provide greater loan security or to lower the size of the  government’s lending commitment. FRBNY officials told us, however, that  the design they pursued was the only option available given constraints at  the time, and that insistence on discounts in the face of counterparty  opposition would have put their stabilization efforts at serious risk. In  creating ML III, FRBNY sought to treat the counterparties alike, with each  of them receiving full value on their CDO holdings. However, because the  circumstances of individual counterparties’ involvement with AIGFP  varied, the counterparties’ perception of the value of ML III participation  likely varied as well.
subsections: section_title: Need to Resolve Liquidity Issues Quickly Drove the Federal Reserve’s Decision Making on Maiden Lane III
paragraphs: The financial pressures on AIGFP arose primarily from collateral calls on  approximately 140 CDS contracts on 112 mortgage-related, multisector  CDOs with $71.5 billion in notional, or face, value for about 20 financial  institution counterparties. To address AIGFP’s difficulties, FRBNY had  three broad approaches it could take, according to the then-FRBNY  President: (1) let AIG default on the CDS contracts that were causing its  liquidity problems; (2) continue to lend to AIG, so it could meet its  obligations under those CDS contracts; or (3) restructure the CDS  contracts to stop the financial pressure. FRBNY chose the third approach,  and officials said that in the subsequent design of a specific structure for  ML III, time pressure was a key factor.
Collateral figured prominently in ML III assistance. Shortly prior to ML III’s  creation in November 2008, AIGFP had posted approximately $30.3  billion in collateral to its counterparties. AIG faced the prospect of being  required to post still more collateral if there were further declines in the  market value of the CDOs being covered, which could have created  significant additional liquidity demands for the company.
In addressing AIGFP’s liquidity risk from additional collateral calls,  FRBNY contracted with financial advisors in September and October  2008. These advisors, among other things, developed alternatives,  forecasted scenarios of macroeconomic stress to be used in decision  making, calculated the value of CDOs that would be included in ML III,  and helped develop messages to describe ML III to AIG’s rating agencies.  According to FRBNY and its advisors, the process of considering options  was collaborative, with FRBNY providing guiding principles and direction  and the advisors developing detailed designs.
FRBNY’s goal was to have a structure in place before AIG’s quarterly  earnings announcement on November 10, 2008, when AIG was expected  to report a large loss that likely would have resulted in a credit rating  agency downgrade, which in turn, would have caused additional CDS  collateral calls for AIGFP. FRBNY and its advisors considered three  alternatives designed to halt AIGFP’s liquidity drain, each of which  contemplated differing funding contributions and payments to AIGFP’s  CDS counterparties. As illustrated in figure 3, the alternatives were:  the as-adopted ML III structure, in which FRBNY loaned and AIG  contributed funds to the ML III vehicle;    a “three-tiered” structure, in which AIG and FRBNY, plus AIGFP’s  counterparties, would have contributed funds to the structure; and    a “novation” structure, in which AIGFP’s CDS contracts would have  been transferred to a new vehicle funded by FRBNY, AIG, and  collateral previously posted to AIGFP’s counterparties.
The as-adopted structure. Under the as-adopted ML III structure, AIG’s  counterparties received essentially par value—that is, the notional, or  face, value—for their CDOs (or close to par value after certain  expenses). They did so through a combination of receiving payments  from ML III plus retaining collateral AIG had posted to them under the  company’s CDS contracts. In return, the counterparties agreed to cancel  their CDS contracts with AIG. The as-adopted ML III structure was  financed with a $24.3 billion FRBNY loan in the form of a senior note and  a $5 billion AIG equity contribution, resulting in an 83/17 percent split in  total funding, respectively. ML III used these funds to purchase the  CDOs from AIG counterparties at what were determined to be then-fair  market values. The AIG equity contribution was designated to absorb the  first principal losses the ML III portfolio might incur.
The three-tiered structure. Under the three-tiered alternative, the  counterparties choosing to participate would have received less than par  value for their CDOs. This would have been through a combination of  retaining collateral AIG had posted and receiving payment from ML III for  the sale of their CDOs, but also making funding contributions to ML III. In  return, as in the as-adopted structure, the counterparties would have  canceled their CDS contracts with AIG and transferred the CDOs to the  structure. The three-tiered structure would have been financed with an  FRBNY loan in the form of a senior note and an AIG equity contribution, as  in the as-adopted structure, plus loans from AIGFP counterparties in the  form of “mezzanine” notes. As under the as-adopted structure, the AIG  equity contribution would have absorbed the first principal losses. In  contrast to the chosen model, however, the counterparties’ mezzanine  contribution would have covered losses exceeding the AIG equity amount.  Thus, under the three-tiered option, FRBNY’s loan would have been more  secure because it would have had both the AIG and the mezzanine  contributions to absorb principal losses. The mezzanine contribution could  have reduced the size of FRBNY’s loan to ML III. However, the potential  size of FRBNY’s loan under this plan was not known, FRBNY officials told  us. It would have depended on the size of the mezzanine contribution and  hence the counterparties’ willingness to participate, they said.
The novation structure. Under this structure, the counterparties choosing  to participate would have kept their CDOs, rather than selling them to the  ML III vehicle. The CDS protection on the CDOs would have remained,  except that losses protected by the CDS contracts would be paid by the ML  III vehicle and not AIG. Counterparties would have consented to AIGFP  novating, or transferring, their CDS contracts to the vehicle. In return, the  counterparties would have received par payment from ML III only if a CDO  credit event occurred, such as bankruptcy or failure to pay. The  counterparties would also have continued to pay CDS premiums, but to the  vehicle rather than to AIGFP, which had initially sold them the protection.  The novation structure would have been financed with an FRBNY  guarantee; the collateral AIG had previously posted to the counterparties,  which the counterparties would have remitted to the vehicle; and an AIG  equity contribution. Overall, novation would have meant that the  counterparties would not have initially received par value in return for  canceling their CDS contracts. Instead, the CDS coverage would have  continued. Even assuming that legal issues, discussed in the following  section, could have been resolved, FRBNY would have needed to fully  fund the vehicle, essentially lending an amount equal to the difference  between par value and collateral already posted by AIG to the  counterparties, FRBNY officials told us.
FRBNY and its advisors identified a number of merits and drawbacks for  each of the three ML III options. The as-adopted ML III structure had  lower execution risk than the other structures, FRBNY officials told us,  meaning there was lower risk that the vehicle would ultimately not be  implemented after the parties agreed to terms. It was also the simplest  structure. However, it could have required a greater FRBNY financial  commitment, and after the AIG equity contribution, there were no other  funds contributed to offset potential losses.
The three-tiered structure, with its counterparty contributions, could have  required a smaller FRBNY loan and provided FRBNY greater protection  because the counterparty funding would have absorbed any principal  losses that exceeded AIG’s equity contribution. This added protection  would have been a major benefit in providing more security for the  FRBNY loan, according to FRBNY officials, because at the time, financial  markets were in turmoil and it was difficult to know when declines would  end. However, according to FRBNY, the three-tiered structure would have  required complex, lengthy negotiations with the counterparties, including  pricing of individual securities in the portfolio. An FRBNY advisor told us  those negotiations could have taken a year or longer. The structure also  would have required discussion on how potential losses would be shared  among the counterparties. Under this option, credit rating agencies might  also have had to rate notes issued by ML III to the counterparties, which  would have required time. Further, the structure would have created  ongoing relationships between counterparties and FRBNY, which an  advisor said created the potential for conflicts due to the Federal Reserve  System’s supervisory relationships. In particular, FRBNY officials told us,  the key feature of the three-tiered structure was that it would have forced  the counterparties into a new position: being required to absorb losses on  their own assets and perhaps those of other counterparties participating  in the vehicle. It would have been a significant undertaking—lengthy  negotiations with no assurance of success—to persuade the  counterparties to take that risk, the officials said, although they did not  have any such discussions with counterparties before rejecting this  option. However, they told us that they were aware of difficulties in AIG’s  efforts to negotiate with its counterparties during this time, and that these  negotiations factored into their expectations about the three-tiered option.
The novation option could also have reduced the amount of ML III  payments made to the counterparties. However, according to FRBNY, the  chief factor against novation was that officials did not think they had the  legal authority to execute this kind of structure because it likely would not  have met the Federal Reserve System’s requirement to lend against  value. In addition, according to FRBNY and an advisor, any novation  structure would have been complex; would have required counterparty  consent, including agreement to give up the collateral if the structure was to  be fully funded; could have caused concern among credit rating agencies;  and would have required giving up the opportunity for potential future gains  in CDO value because the vehicle would not have owned the CDO assets.  An advisor also cited concern that a novation structure would drain liquidity  from the financial system during a time of market weakness because the  counterparties would give up collateral AIG had already provided to them to  the new vehicle, where it would no longer be available to the counterparties  for their own uses. In all, there would have been considerable execution  risk while under great time pressure, FRBNY officials said.
FRBNY and its advisors assessed the three structures against their goals  of both meeting policy objectives and stabilizing AIG. Policy objectives  included lending against assets of value; ensuring that FRBNY funding  would be repaid, even in a stressed economic environment; speed of  execution; and avoiding long-term relationships with counterparties. AIG  stabilization objectives included eliminating AIGFP’s liquidity drain  stemming from CDS collateral calls while limiting the burden on the  company through the contribution AIG would make to ML III. Other  stabilization objectives were avoiding accounting rules that would have  required AIG to consolidate any ML III structure onto its own books and  also enabling AIG to share in potential gains once the federal lending and  the company’s equity position were repaid.
FRBNY officials told us they ultimately chose the as-adopted ML III  structure because it was the only one that worked, given the constraints  at the time. According to FRBNY, time to execute was the most important  objective, and compared to the other alternatives, the as-adopted ML III  structure was simpler, could be executed more quickly, and had lower  execution risk.
As noted, the value the counterparties received under the as-adopted ML  III structure came from two sources—retaining the collateral AIGFP had  already posted to them, plus payments from ML III to purchase their  CDOs. By the time of ML III in November 2008, much of the collateral the  counterparties had received from AIG had been funded with proceeds  from FRBNY’s Revolving Credit Facility. Accounting for use of these loan  proceeds, of the $62.1 billion in value the counterparties received through  the process of establishing the ML III vehicle, about 76 percent came  from FRBNY, as shown in table 3.
FRBNY officials designed the as-adopted ML III with a focus on three  main features: (1) the debt and equity structure of the vehicle, (2) the  different interest rates to be used to calculate payments to FRBNY and  AIG on their respective contributions, and (3) a division of future earnings  between FRBNY and AIG.
The first key design feature involved establishing the debt and equity  structure of the total funding provided to ML III so that the FRBNY loan  would be repaid even under conditions of extreme economic stress and  so that AIG’s equity contribution would be sufficient to protect the FRBNY  loan. The Federal Reserve Board authorized FRBNY to extend a loan of  up to $30 billion to ML III, secured with the CDOs that ML III would be  purchasing. The actual amount of the loan was $24.3 billion, which,  coupled with a $5 billion AIG equity contribution, provided total funding of  $29.3 billion to ML III. The allocation between the FRBNY loan and the  AIG equity contribution was a balance between providing safety for the  loan and knowledge that FRBNY’s previously approved Revolving Credit  Facility would fund the AIG contribution, FRBNY officials said. As part of  its consideration, FRBNY took into account potentially extreme ML III  portfolio losses. During this process, FRBNY directed an advisor to  examine a larger AIG contribution than initially proposed, in the interest of  providing stronger protection for its loan, and that examination produced  the $5 billion figure eventually selected.
In November 2008, using three economic stress scenarios, an FRBNY  advisor estimated that CDO losses on a portfolio close to what became  the ML III portfolio could be 32 percent, 46 percent, and 54 percent of  notional, or face, value under a base case; a stress case; and an extreme  stress case, respectively. In particular, based on expected losses during  extreme stress, our analysis of FRBNY advisor information showed the  ML III portfolio was expected to lose 57 percent of its notional value of  $62.1 billion, leaving a value of about $27 billion. That amount, however,  was still expected to be $2.7 billion greater than FRBNY’s $24.3 billion  loan. Thus, the stress tests indicated that the CDO collateral held by ML  III would be sufficient to protect the FRBNY loan under the extreme stress  scenario indicated.
Likewise, AIG’s equity contribution of $5 billion to ML III was designed to  protect FRBNY’s loan during extreme economic stress. As noted, the  equity position absorbs first principal losses in the ML III portfolio. Under  the extreme stress case, ML III’s CDO recovery value would be $2.6  billion less than ML III’s total funding, according to our analysis. That is,  after the projected loss of 57 percent, as noted previously, the assets  would have a value of $26.7 billion. That would be less than the $29.3  billion in ML III funding provided by the combination of FRBNY’s $24.3  billion loan and AIG’s $5 billion in equity financing. However, if such a  $2.6 billion shortfall occurred, the loss would be applied first against AIG’s  $5 billion equity investment. Thus, the structure would allow AIG’s equity  position to provide protection for FRBNY’s loan.
Although AIG made an equity contribution to ML III, the company funded  its investment using proceeds from the Revolving Credit Facility. FRBNY  officials said they knew that AIG would need to borrow to fund its  contribution, but they preferred that the company borrow from the  Revolving Credit Facility as they did not want AIG to take on expensive  debt to make its contribution. Nevertheless, this situation presented  FRBNY with a trade-off when determining the size of AIG’s contribution to  ML III. On one hand, a higher contribution would have provided more  protection to FRBNY. On the other, a higher contribution would have  required AIG to borrow more under the Revolving Credit Facility, and  officials wanted to minimize use of that facility. FRBNY officials also said  they did not want the size of AIG’s contribution to undermine the company  if the contribution was entirely lost in a worst-case scenario. Our review  showed that FRBNY also considered other methods for AIG to fund its  contribution, such as a quarterly payments plan or financing the AIG  equity contribution with a secured loan from ML III.
The second key ML III design feature was the interest rate used to  calculate payment on FRBNY’s loan and AIG’s equity contribution. The  Federal Reserve Board approved an interest rate on FRBNY’s loan of 1- month London Interbank Offered Rate (LIBOR) plus 100 basis points, with  the rate paid on AIG’s equity position set at 1-month LIBOR plus 300 basis  points. Proceeds from the ML III CDO portfolio were to be applied first to  FRBNY’s senior note until the loan was paid in full and then to AIG’s equity  until it was also repaid in full. According to internal correspondence,  FRBNY chose LIBOR as the base rate because LIBOR was also the base  rate for a number of the assets in the ML III portfolio. As for the add-ons to  the base rate, an FRBNY advisor judged the 100 and 300 basis point  spreads to be normal market terms a year prior to the financial crisis. In  addition, FRBNY officials told us that they wanted to leave open the option  of selling the FRBNY loan in the future and thus wanted to include features  that might be appealing to a potential future investor. The spread might be  attractive to an investor as a form of profit-sharing.
The final design feature addressed allocation of residual cash flow—that  is, any income received by ML III from CDOs in its portfolio after  repayment of the FRBNY loan and the AIG equity contribution. The as- adopted structure split residual cash flows between FRBNY and AIG on a  67 percent and 33 percent (67/33) basis, respectively. As of November 5,  2008, just before ML III was announced, residual cash flows to FRBNY  and AIG were estimated to total $31.8 billion and $15.7 billion,  respectively, under the base economic scenario. The division of residual  cash flows was determined based on the proportion of funding  contributed to ML III and what FRBNY officials deemed would be a fair  return for its loan and AIG’s equity position. Table 4 shows the divisions  of residual cash flows that FRBNY and its advisors considered based on  variations in the size of AIG’s equity contribution, as of October 26, 2008.
Under these alternatives, as AIG’s equity position increased, its residual  cash flow allocation also increased, but at a disproportionately higher  rate. Conversely, as FRBNY’s contribution decreased because AIG would  be contributing more, FRBNY’s share of residual cash flow decreased at  a higher rate.
Another factor that influenced the choice of the residual split was the  issue of consolidation of ML III onto AIG’s books. FRBNY requested that  one of its advisors determine how much ML III could increase AIG’s  allocation of residual cash flows before consolidation became an issue.
FRBNY officials said they determined that FRBNY would need to take at  least a 55 percent share of the residual cash flows to avoid AIG having to  consolidate. That, however, would have provided a 45 percent share for  AIG, which in turn would have produced an extraordinarily high rate of  return on the company’s $5 billion contribution, FRBNY officials told us.  As a result, FRBNY chose the 67/33 division, which also had the  advantage of being a more conservative position for the FRBNY loan.
Rating agency concerns also played a role in the allocation of the residual  cash flows, according to FRBNY officials. The agencies told FRBNY that  in assessing AIG for rating purposes, they would have concerns if there  was no benefit for the company via the residual cash flow, because that  could leave the company in a weaker position. FRBNY officials told us  they viewed the rating agencies’ position as a constraint to be considered  in their design, along with such factors as tax considerations and market  perceptions. As a result, FRBNY included a residual share for AIG,  although officials said that was not necessarily for the sake of the rating  agencies alone. According to advisor estimates as of November 5, 2008,  FRBNY could have expected to receive an additional $15.7 billion in  residual cash flows had it decided not to provide AIG with a share.
In general, according to FRBNY officials, they were not looking to earn  large returns from the residual earnings. Instead, they said their primary  interest was ensuring FRBNY would be repaid even in a highly stressed  environment, while also seeking to stabilize AIG. The primary driver of  repayment was the size of the AIG first-loss contribution. FRBNY wanted  a bigger first-loss piece, to protect its loan, and in return, was willing to  provide AIG with a bigger share of the residual earnings. Although the  67/33 split favored FRBNY, its focus was not on the residual earnings per  se, officials told us.
As part of the ML III process, ML III and AIGFP also executed another  agreement, known as the Shortfall Agreement, under which ML III  transferred about $2.5 billion to AIGFP. This amount was based on what  FRBNY officials described as excess collateral that AIGFP had posted to  the counterparties, based on fair market values determined for the CDOs  in question. As described later, a portion of the Shortfall Agreement  became an issue with AIG securities filings and disclosure of information  about AIG counterparties participating in ML III.
section_title: While the Federal Reserve Expected Concessions Would Be Negotiated, Accounts of FRBNY’s Attempts to Obtain Them Are Inconsistent
paragraphs: The Federal Reserve Board authorized ML III with an expectation that  concessions, or discounts, would be obtained on the par value of AIGFP  counterparties’ CDOs. Our review found that FRBNY made varying  attempts to obtain concessions and halted efforts before some of the  counterparties responded to the Bank’s request for the discounts. The  counterparties opposed concessions, we found, and FRBNY officials told  us that insistence on discounts in the face of that opposition would have  put their stabilization efforts at serious risk.
The business rationale for seeking concessions from AIG’s CDS  counterparties was similar to the logic for the option—not adopted—of  having counterparties contribute to the three-tiered ML III structure—namely,  to provide an additional layer of loss protection for FRBNY’s ML III loan.  Some Federal Reserve Board governors also raised concerns that the  counterparties receiving par value on CDOs could appear too generous,  noting that the counterparties would receive accounting benefits from the  transaction and no longer be exposed to AIG credit risk. Concessions would  be a way for the Federal Reserve System to recover some of the benefits the  counterparties had obtained through its intervention in AIG.
According to FRBNY officials, discounts were justified because the  counterparties would benefit from participation in ML III, while at the same  time, such concessions would better protect FRBNY’s risk in lending to  the vehicle. Under ML III, the theory of concessions was that  counterparties would be relieved of a risk early, and be provided  additional funding they would not otherwise get. Because the  counterparties themselves were facing a risky partner in AIG, they should  have been willing to accept concessions, officials told us. In particular,  according to FRBNY and an advisor, ML III could have benefited AIG  CDS counterparties in several ways:    Liquidity benefits. The counterparties would receive ML III cash  payments immediately for purchase of their CDOs.    Financial statement benefits. Sale of CDOs would allow release of  any valuation reserves previously booked in connection with the CDS  transactions, which reflected potential exposure to AIG. Upon  cancellation of AIG’s CDS contracts, the counterparties would no  longer need to hold reserves against these exposures, and the  reserves could be released into earnings.    Capital benefits. The counterparties would receive a capital benefit, by  reducing risk-weighted assets on their balance sheets.    Risk of future declines in value. By participating in ML III, counterparties  would avoid the risk of exposure to AIG on potential future declines in  the value of CDOs protected by the company’s CDS contracts.
In addition, we identified other potential benefits of counterparty  participation in ML III. According to our review, before the government’s  intervention, AIG and some of its CDS counterparties collectively had  billions of dollars of collateral in dispute under the CDS contracts. Sale of  the CDOs and termination of the CDS contracts would eliminate those  disputes and their cost. Also, some counterparties had obtained hedge  protection on their CDS contracts with AIG. Likewise, termination of the  contracts would eliminate the costs of that protection.
Prior to discussions with counterparties on concessions, FRBNY asked  an advisor to estimate potential concession amounts. The advisor  developed three scenarios, with total concessions ranging from $1.1  billion to $6.4 billion, representing 1.6 percent to 9.6 percent of CDO  notional value. Individual counterparty discounts ranged from $0 to $2.1  billion (see table 5). The advisor also prepared an analysis of factors seen  as affecting individual counterparties’ willingness to accept discounts. For  instance, the analysis identified one counterparty as resistant to deep  concessions because a significant portion of its portfolio was high quality  with little expectation of losses.
At the time the Federal Reserve Board authorized ML III, the  understanding was that concessions would be negotiated with the  counterparties. We found differing accounts of the request for, and  consideration of, counterparty concessions. FRBNY officials told us that  they made a broader outreach effort to the counterparties, while  counterparties described a more limited effort.
FRBNY officials told us that in seeking concessions, they contacted 8 of  the 16 counterparties, representing the greatest exposure for AIG, in  discussions on November 5 and 6, 2008. According to FRBNY officials,  their initial calls were typically made to the chief executive officers or  other senior management of the counterparty institutions. In the initial  calls, FRBNY officials explained the ML III structure generally, and the  institutions identified the appropriate internal contacts for detailed  discussions. FRBNY officials said that they conveyed a sense of urgency  about working out pricing details and concessions.
FRBNY officials said that counterparties’ initial reactions to these  requests were negative, and that FRBNY officials asked the  counterparties to reconsider. After the initial contacts, some  counterparties called FRBNY to obtain more information on the  transaction, but these conversations did not include concessions,  according to the officials. FRBNY gave the counterparties until the close  of business Friday, November 7, to make an offer. Only one of the eight  counterparties indicated a willingness to consider concessions and  provided a concession offer, FRBNY officials told us. This willingness was  conditioned on all other counterparties agreeing to the same concession,  the counterparty told us.
Counterparties we spoke with provided a different account of FRBNY’s  effort to obtain concessions. As a starting position, they generally said  they opposed a request for concessions because their CDS contracts  gave them the right to be paid out in full if CDOs defaulted. As a result,  they said they had no business case to accept less than par.  Counterparties also cited responsibilities to shareholders, saying that  accepting a discount from par would run counter to these duties.  According to our interviews with 14 of the 16 counterparties, FRBNY  appears to have started the process of seeking discounts with attempts of  varying degrees of assertiveness to obtain concessions from five  counterparties.
In particular, according to our interviews, FRBNY requested a discount  from two counterparties, which said they needed to consult internally  before replying. These two counterparties said that FRBNY implied they  might not receive financial crisis assistance or discount window access in  the future if they did not agree to a discount. FRBNY officials disputed  these accounts. However, FRBNY made contact soon afterward seeking  to execute an ML III agreement without a discount, and FRBNY officials  did not provide any explanation for their change in position, according to  the counterparties we interviewed. Our interviews also indicated that  FRBNY requested “best offer” of a discount from two other  counterparties, and briefly referenced seeking a discount from another  counterparty, before similarly withdrawing its request with little or no  explanation, according to our interviews. Before that, one of the  counterparties asked to make an offer told us it was still considering a  range of possible discounts. The other said that it told FRBNY it would  accept a 2 percent concession, but at that point, FRBNY officials told the  counterparty they had decided against concessions, and that they would  provide par value instead. The remaining counterparties we contacted  indicated that FRBNY did not seek concessions from them. According to  FRBNY officials, however, the same message had been delivered to each  counterparty contacted. Similarly, the former FRBNY President said in  congressional testimony that a majority of all 16 counterparties had  rejected concessions.
Following discussions with counterparties, the then-FRBNY President and  Federal Reserve Board Vice Chairman, upon staff recommendation,  decided to move ahead with ML III without concessions. In making the  recommendation on the evening of Friday, November 7, 2008, FRBNY  officials described the challenges to obtaining concessions and their  concerns about continued negotiations. FRBNY officials told us that  taking additional time to press further for discounts could risk not reaching  agreement on the ML III transaction by the target date of November 10,  2008. The cost of not being able to announce the transaction as planned,  coupled with a resultant credit rating downgrade, would have been  greater than the amount of any concessions achievable in the best case,  they said. Although FRBNY did not continue to pursue concessions,  officials told us that ML III was nevertheless designed to allow repayment  of the FRBNY loan under extreme economic stress without them.  Therefore, FRBNY officials told us they were comfortable moving ahead  without concessions. The former FRBNY President said that officials  could not risk lengthy negotiations in the face of a severe economic crisis,  AIG’s rapidly deteriorating position, and the prospect of a credit rating  downgrade.
Counterparties approached for a concession told us that once FRBNY  dropped the request for a discount, they agreed to par value, and the  transactions moved forward as final details were resolved. Federal  Reserve Board officials told us that although the expectation was that  concessions would be obtained, securing such discounts was not a  requirement at the time ML III was authorized.
According to FRBNY officials and records we reviewed, there were a  number of reasons FRBNY decided not to pursue concessions:    Participation in ML III was voluntary, and coercing concessions was  inappropriate, given the Federal Reserve System’s role as regulatory  supervisor over a number of the counterparties.    There was no coherent methodology to objectively evaluate  appropriate discounts from par.    Getting all counterparties to agree to an identical concession would  have been a difficult and time-consuming process. Consistency was  important, both to maximize participation and to make clear that  FRBNY was treating the counterparties equally. Lengthy negotiations  would have been a challenge for executing ML III over 4 days by the  November 10 target.    FRBNY had little or no bargaining power given the circumstances.
The attempts at concessions took place less than 2 months after the  Federal Reserve System had rescued AIG, and the counterparties  expected that the government would not be willing to put the credit it  had extended to the company in jeopardy.
FRBNY officials said in congressional testimony that the probability of the  counterparties agreeing to concessions was modest. Even if they had  agreed, FRBNY did not expect them to offer anything more than a small  discount from par. FRBNY officials told us that setting aside any  attempts to coerce concessions, the economic basis for concessions was  relatively modest because AIG had been providing the counterparties with  collateral. Thus, any exposure of the counterparties upon an AIG default  would have been low compared to the notional size of the CDS  transactions.
Because some of the counterparties were French institutions, French law  also entered into concession considerations. FRBNY officials told us that  FRBNY had contacted French regulators for assistance, but that the  French regulators opposed concessions. Also at issue was whether  French law permitted discounts. FRBNY officials said that the French  regulator was forceful in saying concessions were not possible under  French law, and the former FRBNY President has testified that the  French regulator unequivocally told FRBNY officials that under French  law, absent an AIG bankruptcy, the French institutions were prohibited  from voluntarily agreeing to accept less than par value. FRBNY told us  that they did not conduct any legal analysis. Nevertheless, whatever an  analysis might have determined, if the French regulator was not willing to  support its institutions accepting concessions, then concessions would  not be possible, FRBNY officials told us. Given the desire for consistent  treatment of the counterparties, the French opposition effectively  prevented concessions, the officials said. However, in congressional  testimony, the then-FRBNY President said legal issues faced by the  French institutions were not the deciding factor.
A French banking official offered a different view to us. The official  declined to discuss conversations with Federal Reserve System officials,  citing French secrecy law. In general, though, the official provided a more  nuanced explanation of French law’s treatment of any concessions than  that cited by the former FRBNY President. According to the French  banking official, there could be legal liability if an institution accepted a  discount, with liability depending on individual facts and circumstances  and a key consideration being whether any discount involved all  creditors. In addition, one French institution told us its research  indicated French law would not have been a factor in concessions.
section_title: While FRBNY Sought to Treat Counterparties Alike, the Perceived Value of Maiden Lane III Participation Likely Varied Among Counterparties
paragraphs: In establishing ML III, FRBNY sought to broadly include the AIGFP  counterparty CDOs from the portfolio that was creating liquidity risk for  AIG, because the more that were included, the greater the liquidity relief  for the company. For various reasons, however, not all such CDOs were  acquired for inclusion in ML III. In acquiring CDOs for ML III, FRBNY  focused on the counterparties receiving the same total value as a way to  ensure equal treatment, without which officials said ML III would not have  been successful. Specifically, ML III paid counterparties an amount  determined to be the fair market value of their CDOs, while the  counterparties also retained collateral AIG had posted with them under  terms of the CDS contracts being terminated. The sum of these two  amounts was roughly equal to par value of the CDOs. Although FRBNY  applied this equal treatment approach consistently, the perceived value of  benefits derived from ML III participation likely varied because the  circumstances of individual counterparties varied. FRBNY officials agreed  there were differences among counterparty positions, but they said the  most important consideration was the overall value provided and that  taking account of individual circumstances would have been unfeasible  and too time-consuming given the time pressure of addressing the  financial crisis.
To select the CDOs to be purchased for inclusion in ML III, FRBNY  reviewed a list of CDOs protected by AIGFP CDS contracts. FRBNY’s  focus was multisector CDOs because these securities were subject to  collateral calls and were one of the main sources of AIG’s liquidity  pressure. FRBNY officials told us their strategy was for ML III to acquire a  large volume of CDOs from AIGFP’s largest counterparties so as to  attract other counterparties to participate. In addition, the concern was  that without the largest counterparties’ participation, ML III would not have  been successful. FRBNY officials said, however, that no formal analysis  was conducted to determine a specific CDO acquisition target amount  that would produce ML III success. Ultimately, about 83 percent by  notional value, or $62.1 billion of about $74.5 billion in CDOs, were sold  to ML III, according to information from an FRBNY advisor.
CDOs that ML III did not purchase were excluded due to decisions by  both FRBNY and counterparties. FRBNY did not include “synthetic”  CDOs due to questions of practicality and legal authority. It excluded  synthetics because they might not have met the Federal Reserve  System’s requirement to lend against assets of value, given that they  were not backed by actual assets. According to an FRBNY advisor,  excluded synthetics totaled about $9.7 billion in notional value.
AIG counterparties decided to exclude certain CDO assets for financial  and operational reasons. They elected to exclude euro-denominated  trades with a total notional value of $1.9 billion after the trades were  converted to dollars. For example, one counterparty told us that it elected  not to participate with some of its holdings because movement in foreign  exchange rates would have caused a loss, based on FRBNY’s structuring  of the transaction. Additionally, another counterparty told us that $500  million in assets were not included because the counterparty did not have  the underlying bonds and could not get them back for delivery to ML III.
To obtain the agreement of AIG counterparties to participate in ML III,  FRBNY sought to treat the counterparties consistently by providing each,  through the ML III structure, with essentially par value on their CDO  holdings, FRBNY officials told us. This value—for selling their CDOs and  terminating their AIG CDS contracts—was based on the sum of two parts:  (1) fair market value of the CDOs as determined shortly before ML III  acquired them and (2) collateral that AIG had posted with the  counterparties, which the counterparties retained. Under this structure,  ML III itself did not pay par value for the CDOs it acquired. Rather, it paid  fair market value, which at the time was below the initial, or notional,  values of the CDOs. FRBNY officials told us that providing the  counterparties with essentially par value based on these two components  was important to achieving the objective of broad counterparty  participation. They said that if counterparties had thought they were  getting different arrangements, they would not have elected to participate  in ML III, and FRBNY would not have achieved its goal of liquidity relief  for AIG.
The decision to provide the counterparties with essentially par value for  selling their CDOs and terminating their CDS protection on them, rather  than providing a lower level of compensation, was based on making them  whole under terms of their CDS contracts, FRBNY officials told us.  Because AIG had guaranteed the notional, or par, value in those CDS  contracts, FRBNY officials said it was appropriate to provide essentially  par value to the counterparties, which reflected the market value of the  covered CDOs plus the value of AIG’s CDS protection on those  securities. FRBNY officials explained that underlying their approach  was the assumption that AIG would have been able to make good on its  CDS obligations.
For the counterparties, the risk of AIG failing to fulfill its CDS obligations  had two elements: First, that AIG could not pay out on the contracts if  CDOs protected by the company were unable to repay all principal and  interest due at maturity, and second, that AIG could fail to make required  collateral postings as required under the CDS contracts. According to  FRBNY officials, of the two, failing to post collateral was the more  important risk because under the CDS contracts, AIG would not have  been required to make payouts following default on any principal  balances until the maturity of the CDOs, which could be years into the  future. On the other hand, a failure by AIG to post collateral when  required would have represented a more immediate dishonoring of its  CDS contracts.
FRBNY officials told us that the assumption underlying their approach for  providing par value—that AIG would make good on its CDS obligations— was appropriate because there was no realistic concern among the  counterparties that AIG, with its recent government support, would fail to  honor its CDS obligations. However, some counterparties we spoke with  said that when ML III was created, they did have concerns that AIG would  not be able to fulfill its CDS guarantees. For example, one counterparty  told us that it believed there was still a risk of losses based on an AIG  default because posting of collateral mitigated risk but did not eliminate it.  Another counterparty said that providing par value was attractive because  it provided an exit to a position it viewed as risky.
In addition to concerns that counterparties had about AIG’s ability to  honor its CDS contracts, market indicators at the time showed newly  elevated concern about AIG’s health. This can be seen in the cost of  obtaining CDS protection on AIG itself. On November 7, 2008, the last  business day before the announcement of ML III and other assistance on  November 10, 2008, premiums on CDS protection on AIG were near the  level reached on September 16, 2008, when the company was on the  verge of failure. Reflecting market perceptions of AIG’s financial health,  the premium costs on November 7 were about 43 times higher than the  cost at the start of the year.
Although FRBNY used the same approach in acquiring CDOs from all the  counterparties, the counterparties’ perception of the value of ML III  participation likely varied, according to FRBNY officials and analysis that  we conducted. FRBNY officials said that counterparties’ circumstances  differed based on factors such as size of exposure to AIG, methods of  managing risk, and views on the likelihood of continued government  support for AIG. As a result, counterparties would have perceived  different benefits and value from participating in ML III, FRBNY officials  said. The ML III combination of the market value of the purchased CDOs  and collateral retained had different value to different counterparties,  which might have created different desires to participate, they said.
In addition, there are other ways that counterparties might have been  differently situated before agreeing to participate in ML III. In particular,  we examined (1) the degree to which the counterparties had collected  collateral under their CDS contracts following declines in the value of their  CDO holdings and (2) the counterparties’ credit exposure to AIG based  on the quality of the CDO securities they held.
Differences in collateral collected under CDS contracts. FRBNY  officials told us that the measure of a counterparty’s exposure to AIG was  the amount of decline in CDO value that had not been offset by AIG’s  posting of collateral under its CDS contracts. For example, if two  counterparties each had $1 billion in CDOs and each group of CDOs had  lost $400 million in value, each counterparty would expect AIG to post  collateral to offset the loss in value. But if one counterparty had collected  the entire $400 million while the other had collected only $200 million, the  first counterparty would have fully collateralized its exposure, while the  second counterparty would have had uncollateralized exposure to AIG.
We found that prior to ML III, the counterparties had widely varying  uncollateralized exposure to AIG. Figure 4 shows each counterparty’s  uncollateralized exposure to AIG as of October 24, 2008, shortly before  ML III was announced. For each counterparty, it shows the percentage of  the loss in CDO value that had been covered by collateral collected from  AIG. Collateral posted included payments that AIG had made to its  counterparties using proceeds from the Revolving Credit Facility provided  by FRBNY in September 2008.
For example, as shown in the figure, as of October 24, a number of  counterparties were at or near full collateralization, as collateral posted  was at or near 100 percent of the decline in CDO values. Some of the  counterparties had actually collected more collateral than value lost.  Others, however, had collected less than half the CDO value lost. In all,  the amounts collected varied by more than a factor of four, ranging from a  low of about 44 percent to a high of about 197 percent. We found the  same pattern of differences among the counterparties when considering  total collateral requested by each counterparty, not all of which AIG may  have posted. FRBNY officials offered several caveats for our analysis  but agreed with the basic methodology of comparing collateral posted to  loss in CDO value. They said that overall, despite what collateral  postings might have been at a particular point, the collateral posting  process was working as intended, and amounts posted grew in advance  of the announcement of ML III.
An issue factoring into the collateral situation was disputes over the  amount of collateral AIG should have posted with its counterparties.  Collateral postings were based on declines in CDO values, and there  were disagreements over what the proper valuations should be. To the  extent that lower valuations (more CDO value lost) produced greater  collateral postings, counterparties had an interest in seeking lower  valuations. Similarly, to the extent that higher valuations (less CDO value  lost) meant smaller collateral postings, AIG had an interest in seeking  higher valuations. According to information we reviewed, on a CDO  portfolio of $71 billion (a preliminary portfolio somewhat different from the  final ML III portfolio), AIG and its counterparties had valuation differences  totaling $4.3 billion. Among a group of 15 counterparties, 9 had valued  their assets differently than AIG. FRBNY officials told us they viewed the  amount of collateral in dispute as relatively minor, but counterparties told  us they viewed disputed amounts as significant.
Varying AIG exposure due to credit quality of underlying assets.  Analysis conducted by an FRBNY advisor indicated that CDOs the  counterparties sold to ML III were expected to incur widely varying losses in  value during periods of economic stress. These differences arose from the  varying quality of assets underlying the CDOs. FRBNY officials stressed to  us that such differences in quality were reflected in the fair market value  that ML III paid for the CDOs and that counterparties held collateral based  on declines in CDO values. From the perspective of individual  counterparties, these differences illustrate dissimilar circumstances among  the counterparties in the time before ML III was established. Figure 5  shows, in descending order, that the amount of value expected to be lost in  each counterparty’s CDO portfolio during extreme economic stress ranged  from a high of 75 percent to a low of 1 percent. Eleven of the 16  counterparty CDO portfolios were expected to lose at least 50 percent of  their value during such periods of extreme stress.
FRBNY’s advisor estimated, for instance, that counterparty 1’s CDO  holdings would lose 75 percent of their notional value during extreme  stress. By contrast, counterparty 16’s CDO portfolio was projected to lose  only 1 percent of its value. The advisor’s analysis also indicated a wide  range of expected losses for the base and stress economic cases. For  the base case, projected losses ranged from 0 percent to 52 percent of  CDO portfolio value. For the stress case, expected losses ranged from 0  percent to 67 percent.
Another indicator of differing asset quality can be seen in widely varying  credit ratings among the CDOs that counterparties sold to ML III. An  FRBNY advisor examined CDO credit ratings, grouping them into 11  categories. Figure 6 focuses on 3 of those 11 categories, showing the  percentage of each counterparty’s holdings that fell into the highest-,  middle-, and lowest-rated groupings.
In general, the analysis shows a relatively level amount of assets in the  middle-rated category, with variance in the best and lowest ratings. For  example, counterparty 5 had about 40 percent of its holdings in the  highest-rated category, with about as much in the lowest-rated group. But  counterparty 15 had about twice as much in the highest category as the  lowest. One counterparty had 98 percent of its CDO portfolio in the top  rating category, while another had none. Eleven counterparties’ CDO  portfolios contained “nonrated” positions, which meant that the credit  quality of those assets was unknown and their risk potentially higher. All  else being equal, CDOs with lower credit ratings would be expected to  produce higher losses compared to more highly rated positions.
In addition, the FRBNY advisor also noted differences among the  counterparties’ situations shortly before ML III was announced. For  example, according to records we reviewed, the advisor noted that in a  nonstressed economic environment, one counterparty’s portfolio was of  higher quality, and that the counterparty expected there would be  recoveries in value of the assets. For another counterparty, the advisor  noted that its portfolio, overweighted with subprime assets, was forecast  to experience higher losses in all economic scenarios, and  disproportionately worse performance under extreme stress. In another  case, the advisor noted that based on the counterparty’s situation, it  would likely have been satisfied with its position without ML III  participation.
Another difference among AIG counterparties’ positions prior to their  participation in ML III was that some had obtained hedge protection on  AIG generally or had obtained protection specifically on their AIG CDS  positions. Therefore, their overall risk posture was different from that of  counterparties that had not obtained such hedge protection.
FRBNY officials told us they agreed that the counterparties and their CDO  holdings were not similarly situated. The officials said that the  counterparties generally started out in similar positions, where each had  CDS protection on the notional, or par, values of their CDO holdings. As  the financial crisis intensified, the value of the CDOs declined, some more  than others, and as a result, the counterparties’ relative positions  diverged. The crisis was the differentiator, they said. As the value of the  underlying assets changed, the value of AIG’s CDS protection became  different, the officials said. Despite the counterparties’ dissimilar  situations, FRBNY officials said the goal was to make sure the  counterparties agreed to terminate their CDS contracts in order to stem  liquidity pressure on AIG, and the approach they took, based on par  value, was the best way to accomplish this given constraints at the time.  They said that while some underlying CDOs may have been of differing  quality, these CDOs also had the benefit of AIG’s CDS protection, which  promised to protect their value.
The counterparties’ differing situations and varying perceptions of the  benefit of ML III participation might have offered an opportunity to lower  the amount FRBNY lent to ML III if FRBNY had been able to negotiate  individually with the counterparties based on their individual  circumstances. However, FRBNY officials told us that trying to negotiate  tailored agreements by counterparty would have been unworkable and  too time consuming given the pressure of the financial crisis. According to  the officials, trying to determine the economic implications of each  counterparty’s position would have been speculative, as different parties  would have made different arguments about the costs or benefits of the  ML III transaction based on their individual circumstances. Further, they  said that taking note of such positions would have led to different deals  with different parties on the basis of how each had chosen to manage  risk. While negotiations might have been possible, they would have been  long and complicated and there was no time for such talks.
In reaching agreement with the AIG counterparties on ML III, FRBNY  provided counterparties with varying opportunities to negotiate some  terms. FRBNY officials said that after the first set of eight counterparties  agreed to participate in ML III on the par value basis, FRBNY provided  transaction documents to them and then negotiated some details with  them. Over the course of the weekend preceding November 10, 2008,  ahead of the release of AIG’s quarterly earnings report, FRBNY had  separate conversations with the eight counterparties representing the  most significant exposure for AIG. FRBNY officials told us that these  counterparties had the opportunity to suggest amendments to contract  language, and FRBNY incorporated some of their comments into the final  contracts. According to FRBNY and counterparties we spoke with, the  negotiated items generally involved clarifications and technical items, not  material economic terms. While in principle, ML III was an easy  transaction to describe, there were important details to be worked out,  involving such matters as timing and delivery of the CDOs at issue,  FRBNY officials told us.
After agreements were reached with the first group, FRBNY contacted the  next group of counterparties, whose holdings FRBNY officials said were  not significant compared to those of the first group. FRBNY officials told  us that ML III needed to have the same contract with all the  counterparties. According to our interviews, counterparties in the second  group asked for changes, but FRBNY declined. For example, one  counterparty told us it wanted to make procedural changes and clarify  certain terms. FRBNY would not do so, saying that other counterparties  with larger exposures had already commented on the terms. FRBNY  made clear it was up to the counterparty to decide whether it wanted to  engage on the terms offered, executives of the counterparty told us. Our  review also identified at least one instance where a counterparty in the  first group of eight was allowed to amend contract language after signing  ML III agreements. FRBNY characterized the changes as technical and  clarifying.
section_title: The Federal Reserve’s Actions Were Generally Consistent With Existing Laws and Policies, but They Raised a Number of Questions
paragraphs: The actions of the Federal Reserve System in providing several rounds of  assistance to AIG involved a range of laws, regulations, and procedures.  First, we found that while the Federal Reserve Board exercised its broad  emergency lending authority to aid AIG, it did not make explicit its  interpretation of that authority and did not fully document how its actions  derived from it. Second, after government intervention began, FRBNY  played a role in the federal securities filings that AIG was required to  make under SEC rules. We found that although FRBNY influenced AIG’s  filings, it did not direct the company’s decisions about what information to  file for public disclosure about key details of federal aid. Finally, in  providing assistance to AIG, FRBNY implemented vendor conflict-of- interest procedures similar to those found in federal regulations, but  granted a number of waivers to conflicts that arose. In addition, we  identified a series of complex relationships involving FRBNY, its advisors,  AIG counterparties, and service providers to CDOs in which ML III  invested that grew out of the government’s intervention.
subsections: section_title: The Federal Reserve Exercised Its Broad Emergency Lending Authority to Aid AIG but Did Not Fully Document Its Decisions
paragraphs: When the Federal Reserve Board approved emergency assistance for  AIG beginning in September 2008, it acted pursuant to its authority under  section 13(3) of the Federal Reserve Act. At the time, section 13(3)  authorized the Federal Reserve Board, in “unusual and exigent  circumstances,” to authorize any Reserve Bank to extend credit to  individuals, partnerships, or corporations when the credit is endorsed or  otherwise secured to the satisfaction of the Reserve Bank, after the bank  obtained evidence that the individual, partnership, or corporation was  unable to secure adequate credit accommodations from other banking   institutions. The Reserve Bank making the loan was to establish the  interest rate in accordance with section 14(d) of the Federal Reserve Act,  which deals with setting of the Federal Reserve discount rate.
In authorizing assistance to AIG, the Federal Reserve Board interpreted  its broad authority under section 13(3) as giving it significant discretion in  satisfying these conditions. The statute does not define “unusual and  exigent circumstances,” and, according to our review, the Federal  Reserve Board believes it has substantial flexibility in assessing whether  such circumstances exist. The statute also does not define an inability “to  secure adequate credit accommodations from other banking institutions”  or set forth any standards for Reserve Banks to use in making this  determination.
As a result, Federal Reserve Board staff have stated that the Federal  Reserve Board would be accorded significant deference in defining this  standard. The Federal Reserve Board notes that its Regulation A—which  governs extensions of credit by Reserve Banks, including emergency  credit—does not require any specific type of evidence and bases the  finding about credit availability on the “judgment of the Reserve Bank.”
As noted, the statute authorizes Reserve Banks engaging in section 13(3)  emergency lending to establish interest rates in accordance with section  14(d) of the Federal Reserve Act. Section 14(d), which authorizes Federal  Reserve banks to establish rates for discount window lending, is  implemented by Regulation A. Federal Reserve Board staff have  stated that while Regulation A contains provisions relating to the rate for  emergency credit from Reserve Banks, these provisions do not limit its  power to authorize lending under section 13(3) in other circumstances  and under other limitations and restrictions. The Federal Reserve Board’s  rationale is that section 13(3) further allows it to authorize a Reserve  Bank to extend credit to an individual, partnership, or corporation “during  such periods as the said board may determine” and “subject to such  limitations, restrictions, and regulations as the  may prescribe.” As  a result, the Federal Reserve Board has stated that it has complete  statutory discretion to determine the timing and conditions of lending  under section 13(3). Federal Reserve Board officials told us that the  interest rate the Reserve Bank recommends to the Federal Reserve  Board is based on the facts and circumstances of a particular instance of  lending, and that the rate need not be the discount rate itself. Section  14(d) has never been viewed as linking the interest rate on section 13(3)  lending to the then-prevailing discount rate, a Federal Reserve Board  official told us.
The Federal Reserve Board views the section 14(d) rate-establishing  provision as procedural, an official told us, because the Reserve Bank  extending the loan proposes the rate and the Federal Reserve Board  must approve it. The official said that more analysis on rates takes place  at the Reserve Bank level than at the Federal Reserve Board. Factors  taken into account when setting rates include risk and moral hazard. For  example, one FRBNY official described the Revolving Credit Facility as  being akin to debtor-in-possession financing—that is, it has a high interest  rate, aggressive restrictions on AIG’s actions, a short term, and a  substantial commitment fee. These features were consistent with section  13(3), the official said, because if a loan is risky, there must be sufficient  protection for the Reserve Bank making it.
Section 14(d) also directs that rates be set “with a view of accommodating  commerce and business.” Federal Reserve Board officials told us their  view is that if the section 13(3) requirements for such factors as unusual  and exigent circumstances and inability to obtain adequate financing from  other banking institutions are met, then the section 14(d) directive of “with  a view of accommodating commerce and business” is automatically  satisfied.
Rates on the Federal Reserve Board’s section 13(3) lending to aid AIG  have varied, as shown in examples in table 6.
Internal correspondence we reviewed discussed an FRBNY rationale for  setting interest rates, noting that different rates could be expected based  on the approach officials were taking. Under this approach, FRBNY set  rates for its lending to SPVs that provided assistance to AIG according to  risk and matching of the interest rate to characteristics of assets that were  related to a particular loan. For example, FRBNY loan facilities held  securities with floating rates that paid interest monthly based on the  1-month LIBOR rate. Hence, officials concluded that using the 1-month  LIBOR rate as a base for the interest rates associated with emergency  loans to those facilities was appropriate. In other cases, considerations  were different. For the restructuring of the Revolving Credit Facility, the  rationale for reducing the interest rate included stabilizing AIG, boosting  its future prospects, and satisfying credit rating agency concerns. For the  final, unused emergency lending facility, which dealt with securitizing  cash flows from certain insurance operations, the rationale advanced was  AIG’s ability to pay.
The statute also does not impose requirements on the amount or type of  security obtained by a Reserve Bank for section 13(3) lending, other than  requiring that the loan be secured “to the satisfaction” of the lending bank.  The Federal Reserve Board has stated that the absence of objective  criteria in the statute leaves the extent and value of the collateral within  the discretion of the Reserve Bank making the loan. As one Federal  Reserve Board official told us, the security accepted by the Reserve Bank  could range from equity stock to anything with value. As with interest  rates, the security on emergency lending associated with AIG assistance  has varied. For example, the Revolving Credit Facility was secured with  assets of AIG and of its primary nonregulated subsidiaries, and ML III  used the CDOs purchased from AIG counterparties as security for the  SPV. For the facility approved but not implemented, the security would  have been cash flows from certain AIG life insurance subsidiaries.
Although the statute has no documentation requirements, we requested  documentation of the Federal Reserve Board’s interpretation of its section  13(3) authority generally, as well as for each of its five decisions to extend  aid to AIG in particular. While the Federal Reserve Board provided some  documentation, it did not have a comprehensive analysis of its legal  authority generally under section 13(3), and it did not maintain  comprehensive documentation of its decisions to act under that authority  to assist AIG. In particular, we found the Federal Reserve Board’s  interpretation of its emergency lending authority to be spread across  various memorandums, with limited analysis and varying degrees of  detail. For the specific decisions to assist AIG, the documentation  provided some support underlying use of the section 13(3) authority, but  such analysis was absent in some cases and incomplete in others. For  example, for the Revolving Credit Facility, Federal Reserve Board  minutes and other records we reviewed noted that the discussion of terms  included collateralizing the loan with all the assets of AIG and of its  primary nonregulated subsidiaries but did not include documentation of  FRBNY’s determination that the loan was secured to its satisfaction. For  ML II and ML III, there was no documentation of how the interest rates on  the loans to each vehicle were established. For the proposed facility to  securitize life insurance subsidiary cash flows, information we reviewed  stated that it was well established that AIG was unable to secure  adequate credit accommodations from other sources and that, with a  projected fourth quarter 2008 loss exceeding $60 billion, it was unlikely to  find adequate credit accommodations from any other lender. However,  there was no documentation that AIG was, in fact, unable to secure  adequate credit from other banking institutions.
Federal Reserve Board officials underscored that section 13(3) loans by  nature are done on a fast, emergency basis. They told us the Board does  not assemble and maintain documentary support for its section 13(3)  lending authorizations. According to the officials, such information, while  not specifically identified, can generally be found among the overall  records the agency keeps and could be produced if necessary, much as  documents might be produced in response to a lawsuit. Further, the  officials told us, any necessary evidence or supporting information was  well understood by the Federal Reserve Board and FRBNY during the  time-pressured atmosphere when section 13(3) assistance was approved  for AIG, beginning in September 2008 and continuing into 2009. As a  result, it was not necessary to compile a formal assembly of evidence, the  officials told us.
As noted previously, recent legislation has amended section 13(3) since  the Federal Reserve Board approved emergency lending for AIG. In the  Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank Act), Congress limits future use of section 13(3) lending to  participants in programs or facilities with broad-based eligibility and  restricts assistance to individual companies under specified  circumstances. The act also mandates greater disclosure about section  13(3) lending, requiring the Federal Reserve Board to establish, by  regulation and in consultation with Treasury, the policies and procedures  governing such emergency lending. In addition, the establishment of  emergency lending programs or facilities would require prior approval of  the Secretary of the Treasury. The Federal Reserve Board is also  required to report to Congress on any loan or financial assistance  authorized under section 13(3), including the justification for the exercise  of authority; the identity of the recipient; the date, amount and form of the  assistance; and the material terms of the assistance.
As part of our recent review of the Federal Reserve System’s  implementation of its emergency lending programs during the recent  financial crisis, we identified instances where the Federal Reserve Board  could better document certain decisions and processes. As a result, we  recommended that the Federal Reserve Board set forth its process for  documenting its rationale for emergency authorizations and document its  guidance to Reserve Banks on program decisions that require  consultation with the Federal Reserve Board. These actions will help  address the new reporting process required by the Dodd-Frank Act and  better ensure an appropriate level of transparency and accountability for  decisions to extend or restrict access to emergency assistance.
section_title: The Federal Reserve Influenced AIG’s Securities Filings About Federal Aid but Did Not Direct the Company on What Information to File
paragraphs: During the financial crisis, questions arose about FRBNY’s involvement in  AIG’s exclusion of some ML III-related information from its federal  securities filings—counterparty transaction details and the description of a  key ML III design feature.
In December 2008, after ML III was created, AIG filed two Form 8-K  statements with SEC related to ML III, following consultations with  FRBNY. The filings included the Shortfall Agreement but not the  agreement’s Schedule A attachment, which contained ML III counterparty  and CDO deal information. As noted earlier, under the Shortfall  Agreement, ML III transferred about $2.5 billion to AIGFP for collateral  adjustment purposes. This amount was based on what FRBNY officials  described as excess collateral that AIGFP had posted to the  counterparties, based on fair market values determined for the CDOs in  the ML III portfolio.
SEC noted the Schedule A omission and told AIG that under agency  rules, it must include the schedule for public disclosure or request  confidential treatment of the information in it. Subsequently, AIG filed a  confidential treatment request (CTR) for the information.
FRBNY became involved in AIG’s ML III filings after the company had  failed to consult FRBNY or its advisors on an earlier company filing on the  Revolving Credit Facility, which contained inaccurate information about  details of the facility. FRBNY objected to the information, and AIG  corrected its filing and agreed to consult on future filings in advance. The  ML III agreement contained a confidentiality clause in which AIG  generally agreed to keep confidential nonpublic information and to  provide notice of any proposed disclosure. AIG executives told us that  they expected FRBNY, given its role in assisting the company, to review  securities filings and other information involving the Federal Reserve  System. FRBNY officials told us they concurred that if counterparty  information was to be released, it would be reasonable for FRBNY, as a  co-venturer, to have the ability to express an opinion.
We found that FRBNY, through its counsel, in November 2008 told AIG it  did not believe the Shortfall Agreement needed to be filed at the time.  When that effort was unsuccessful, and AIG moved to file the agreement  nonetheless, FRBNY then urged that the Schedule A counterparty  information be omitted from the company’s filings. FRBNY was also  influential in shaping AIG’s arguments to SEC in support of the  company’s request to keep the counterparty information confidential. In  particular, FRBNY and its advisers made what they described as  significant comments and edits to AIG filings regarding the information  claimed as confidential, according to FRBNY officials and  correspondence we reviewed. After AIG filed its CTR and SEC officials  had reviewed and commented on it, FRBNY remained active in pursuing  the CTR matter. Officials discussed making direct contact with SEC on  the information they did not want the company to disclose. When SEC  requested a telephone conference with the company to discuss the  issues, FRBNY officials and its counsel began considering what  information FRBNY should present to SEC, after first checking with AIG  about the matter.
FRBNY’s public arguments for confidentiality were twofold: that the  counterparty information was commercially sensitive for the parties  involved but did not provide material information to investors, and that  disclosure could hurt the ability to sell ML III assets at the highest price,  potentially to the detriment of taxpayers and AIG. In addition to these  publicly stated reasons, FRBNY staff in internal correspondence also  discussed other rationales for withholding Schedule A information. One  was unspecified policy reasons, which officials later told us may have  referred to the general practice of keeping the identities of discount  window borrowers confidential. Another was that disclosure could attract  litigation or Freedom of Information Act requests. A third such rationale  was that seeking confidential treatment for all of Schedule A, and not just  portions, could be a useful negotiating strategy because seeking  protection for the entire document could make SEC more likely to grant  such a request. FRBNY officials told us these other rationales were  opinions voiced during internal discussions before FRBNY took a formal  position. According to FRBNY officials, there was also concern that  release of the information for ML III could lead to demands for release of  similar information for other Federal Reserve System emergency lending  facilities—ML II, which was created to deal with problems in AIG’s  securities lending program, and Maiden Lane, a vehicle created in March  2008 to facilitate JPMorgan Chase & Co.’s merger with Bear Stearns.
As part of its involvement, FRBNY participated in three teleconference  calls with SEC officials about AIG’s CTR filing, according to SEC records  and officials. On January 13, 2009, the day before AIG filed its request  with SEC, FRBNY officials at their request spoke with SEC to explain the  ML III transaction. Another call came on March 13, 2009, when  representatives of AIG and FRBNY contacted SEC to say that AIG  intended to file an amended CTR in response to SEC comments on the  original request. The third call, on April 22, 2009, took place at SEC’s  request to discuss AIG’s competitive harm arguments. SEC, AIG, and, at  AIG’s request, FRBNY participated in that call. According to SEC,  discussions with FRBNY were at the staff level.
While SEC was reviewing AIG’s CTR, the company considered dropping  its request, thus making all the contested information public. However,  FRBNY officials convinced the company not to do so. By that point,  FRBNY was willing to have some information released, such as  counterparty names and amounts paid, but did not want to release other  material, such as information related to individual securities, according to  correspondence we reviewed. The specific concern was that release of  security-specific information could allow market participants to identify ML  III holdings. FRBNY officials told us they made their opinion known to  AIG, and that such communication was appropriate given that FRBNY  was a major creditor to ML III. AIG concurred with FRBNY’s concerns,  according to an FRBNY communication.
According to interviews and information we reviewed, underlying  FRBNY’s desire that AIG not file sensitive ML III information with SEC  was concern that such information could then be requested by Congress  and ultimately be made public. This was because SEC rules require that  applicants for CTRs consent to furnishing the information claimed as  confidential to Congress, among others. SEC officials told us that  although there are no records of Congress requesting such information,  their best recollection is that Congress has never sought information filed  in a CTR with the agency.
SEC’s handling of AIG’s confidentiality request was routine, SEC officials  told us, albeit under unusual circumstances. SEC officials told us they  viewed FRBNY’s involvement with the agency as that of a counterparty to  an agreement with a company required to make filings. In such a  situation, it is not common for a counterparty to contact SEC, officials told  us. In addition, FRBNY’s participation was more active than would be  expected of a counterparty, they said. Officials said the agency processed  AIG’s CTR using its normal CTR review process, and that SEC’s review  of the request was prompt. But circumstances were unusual for several  other reasons, SEC officials told us. First, the AIG filings had been  targeted for heightened scrutiny as part of special review efforts arising  out of the financial crisis and government aid to private companies. These  efforts involved continuous review of selected companies’ filings. Second,  FRBNY—which FRBNY officials characterized as a federal  instrumentality—was an involved party. Third, in response to FRBNY  concerns, SEC allowed a special drop-off procedure for the CTR aimed at  protecting the information from disclosure. This action came after SEC  had declined FRBNY requests for special ways to provide the information  for SEC review, such as by SEC officials going to FRBNY offices to  review relevant material or FRBNY officials showing SEC the information  at SEC headquarters but outside the normal filing system. Finally, the  case reached SEC’s associate director level and eventually the SEC  Chairman. Officials told us that due to AIG’s high public profile, the  Chairman was advised immediately before the CTR determination on the  Schedule A information. SEC officials told us this was not typical. It is rare  for SEC staff to brief the Chairman on a CTR determination, they said, but  that was done in this case due to anticipated publicity for the matter.
AIG’s original CTR sought confidential treatment for all of the Schedule A  information. On May 22, 2009, SEC granted the company’s request, but  only in part. SEC officials said AIG’s initial CTR was too broad, and the  agency, through its review process, narrowed the scope of the request.  As part of its review, SEC officials provided AIG with detailed comments  and questions after reviewing its request and also monitored information  that was already publicly available to determine if AIG’s CTR should be  amended to reflect that availability.
SEC officials said that notwithstanding FRBNY’s unusual involvement,  they examined the case from the usual standpoint of investor protection,  in which the key issue was harm to AIG. Any harm to the Federal  Reserve System was not an SEC issue, officials told us. The agency  determined that the following elements of the Schedule A information  should not be treated confidentially, and thus should be disclosed:    amount of cash collateral posted;    CDO pricing information that reflected the securities’ loss in market  complete Schedule A information for 10 CDOs, including CUSIP  identifier, tranche name, and notional value, as related information  had previously been made public;  totals for notional value, collateral posted, and revised values based  on market declines for all CDOs; and    all Schedule A titles and headings.
Except for the 10 CDOs cited, SEC permitted confidential treatment of the  following information for each of the other CDOs listed in Schedule A:  CUSIP number, tranche name, and notional value. However, the SEC  action eventually became moot, as on January 29, 2010, AIG amended  its 8-K filings to fully disclose Schedule A.
We also found that the desire to keep Schedule A-type information  confidential was not a new position for AIG. Before ML III and any  government assistance, AIG had sought protection for similar information  on the basis that it was confidential business information. Specifically, in  response to an unrelated request for information from SEC, AIG in August  2008 requested that CDO-related information be kept confidential. “As a result of this transaction, the AIGFP counterparties received 100 percent of the  par value of the Multi-Sector CDOs sold and the related CDS have been terminated.”
At the request of FRBNY’s outside counsel, AIG omitted this language from  its filing, company executives told us. This omission led to criticism that  FRBNY was seeking to conceal information about payments to AIG’s  counterparties. AIG executives told us the company omitted this  language because of concerns that it misrepresented the transaction, as  ML III itself was not paying par value. Instead, as noted, ML III paid an  amount that, when combined with collateral already posted by AIG to the  counterparties, would equal par value (or near par value). In internal  correspondence, FRBNY also said “par” was inaccurate, as counterparties  paid financing charges and had to forgo some interest earnings. Thus, the  amount received was less than par when all costs were considered; in  some cases, the difference was in the tens of millions of dollars.
We found that two units of SEC—the Division of Corporation Finance and  the New York Regional Office—examined the deletion of the par value  statement and concluded there was no basis for an enforcement action  for inadequate disclosure. SEC staff considered whether AIG’s filing  provided enough information for investors to see that the sum of the  collateral counterparties kept and the payments from ML III amounted to  100 percent of value. SEC has not brought any enforcement action  concerning this issue.
In February 2010, FRBNY issued a memorandum formalizing its process  for reviewing AIG’s securities filings. The memorandum emphasizes that  AIG is solely responsible for the content of its filings, and that any FRBNY  review is to promote accuracy or protect taxpayer interests. It also  specifies material to be subject to review.
Ultimately, according to both AIG and FRBNY, the company retained  responsibility for its own filings. Based on our review, we found that while  FRBNY’s involvement was influential, it was not controlling. AIG did not  comply with all FRBNY requests about information in its filings. Also, later  in the process, after Schedule A information was released publicly, an  AIG executive reported to an SEC official that FRBNY had told the  company to make its own decision on whether to disclose full Schedule A  information in filings with SEC. According to AIG executives, there was no  occasion when AIG strongly disagreed with a course advocated by  FRBNY but adopted FRBNY’s position nonetheless. SEC enforcement  staff found that AIG exercised independent judgment. The staff examined  correspondence related to AIG filings, and their review showed that  although FRBNY had a viewpoint it was not reluctant to express, AIG  nevertheless remained actively involved in the process and exercised its  own independent judgment on what its filings should say. More broadly,  although FRBNY was aware of criticism that ML III funds were provided to  unnamed counterparties or foreign institutions, we found no evidence that  FRBNY urged AIG to withhold information in order to conceal identities or  nationalities of the counterparties.
According to FRBNY officials, FRBNY’s involvement with AIG illustrated the  dual role of a central bank as a public institution that sometimes must also  carry out private transactions as a private market participant. In our review,  we considered whether FRBNY’s involvement in AIG’s securities filings was  consistent with what might be expected in the private-sector under similar  circumstances. We found that in broad terms, FRBNY’s activities appear to  be consistent with actions of a significant business partner.
The government assumed multiple roles in assisting AIG. Through its  arrangement for initial aid, a government vehicle became the company’s  majority equity investor. Its emergency lending also made it a significant  creditor to AIG. In addition, FRBNY was a joint venturer with AIG in ML III.
In the private-sector, any of these roles could provide a basis for  involvement in a company’s affairs. Majority shareholders can have  significant influence—for example, by naming the board, which exercises  control over significant aspects of a company’s business. A company might  consult with a majority owner on business decisions and might share draft  securities filings. Creditor involvement in company affairs can be extensive,  particularly in times of stress. Credit agreements can include detailed  affirmative and negative covenants—requirements to take, or refrain from,  certain actions—through which creditors can shape and constrain  financing, management, and strategic decisions. Agreements often require  corporations to provide extensive financial information to the creditor. In the  case of joint venturer, the academic research we reviewed does not  discuss the influence that private-sector counterparties may have over  each others’ SEC filings. However, individuals with whom we spoke  indicated sharing draft filings in a merger and acquisition context is  common. Parties to a joint venture may share draft filings as well.
The circumstances of Federal Reserve System aid to AIG preclude a  direct private-sector comparison for several reasons. Majority ownership  of large public companies is unusual. The trust agreement for the  government’s AIG holdings placed limitations on the trust’s role as  shareholder. In addition to any assistance relationship with AIG, the  government, via OTS, has also had a regulatory relationship with the  company. The government also had goals in the AIG intervention beyond  those of typical private-sector actors: attempting to stabilize financial  markets and the broader economy. Nevertheless, through its various  actions, the government provided significant resources to AIG and took  on significant risk in doing so. A private party in similar circumstances  could be expected to become involved in company affairs.
section_title: While FRBNY Implemented Updated Vendor Conflict-of-Interest Procedures in Providing AIG Assistance, Aid Gave Rise to Complex Relationships that Posed Challenges
paragraphs: To provide emergency assistance that the Federal Reserve Board  approved for AIG, FRBNY contracted for financial advisors to perform a  range of activities for the Revolving Credit Facility and ML III. FRBNY  retained its principal financial advisors for the Revolving Credit Facility  and ML III in September and October 2008. According to FRBNY officials,  they awarded contracts for at least two of the advisors without competitive  bidding, due to exigent circumstances. They said there was insufficient  time to bid the services competitively as advisors were needed to quickly  begin setting up the program.
For the Revolving Credit Facility, the principal financial advisors were  Ernst & Young and Morgan Stanley, which were engaged for these main  duties:  structuring the loan documentation between FRBNY and AIG after the  company accepted FRBNY’s initial loan terms on September 16,  2008;    providing advisory services for AIG asset sales;    performing valuation work on AIG securities posted as collateral to  secure the Revolving Credit Facility;  calculating AIG cash flow projections to monitor the company’s use of  cash, plus actual and predicted draws on the Revolving Credit Facility;    advising FRBNY on how to address rating agency and investor    monitoring Revolving Credit Facility requirements on information AIG  must provide to FRBNY to identify any instances where AIG did not  comply.
For ML III, FRBNY’s three primary financial advisors have been Morgan  Stanley, Ernst & Young, and BlackRock, Inc., which were engaged for  these main duties:    developing alternate designs for ML III;  identifying CDO assets for inclusion in ML III;  valuing CDO securities under economic stress scenarios;    advising FRBNY on how to structure the transaction to address rating  agency and investor concerns; and    managing the ML III portfolio for FRBNY.
FRNBY has also contracted for two other vendors to provide key services  for ML III: Bank of New York Mellon performs accounting and  administration for the ML III portfolio, and another vendor, Five Bridges  Advisors, conducts valuation assessments.
One of the factors FRBNY considered when selecting vendors was  potential conflicts of interest. In general, potential and actual conflicts of  interest can arise at either the personal or organizational levels. A  personal conflict could arise, for example, through the activities of an  individual employee, whereas an organizational conflict could arise  through the activities of a company or unit of a firm. Our work focused on  potential organizational conflicts of interest that involved the Revolving  Credit Facility and ML III. When FRBNY engaged its Revolving Credit  Facility and ML III advisors, FRBNY had its Operating Bulletin 10 as  guidance, which applies to vendor selection but did not include provisions  on vendor conflicts. By contrast, Treasury, which has also engaged a  number of vendors in implementing TARP, in January 2009 issued new  interim guidelines for its management of TARP vendor conflicts of  interest. The Treasury regulations provide that a “retained entity”— generally, an individual or entity seeking or having a contract with  Treasury—shall not permit an organizational conflict of interest unless the  conflict has been disclosed to Treasury and mitigated under an approved  plan, or unless Treasury has waived the conflict.
However, even though FRBNY guidance did not have provisions on  vendor conflicts, FRBNY officials told us that they held internal  discussions to identify potential advisor conflicts that could arise. FRBNY  also identified some activities, such as providing advisory services, as  presenting a greater risk of conflict than other activities, such as  administrative services where there is no discretionary or advisory role.  As a result, FRBNY subjected the advisors to greater conflict of interest  scrutiny. Based on its internal discussions, FRBNY identified a number of  potential conflicts, including two main types of conflicts for advisors other  than its investment advisor:  instances in which AIG or its subsidiaries seek entities serving as  FRBNY advisors to assist them, for matters in the past, present, or  future; and  instances in which potential buyers of AIG assets seek entities serving  as FRBNY advisors to assist them, for matters in the past, present, or  future.
Without specific conflict policies for its advisors in its established  guidance, FRBNY relied upon contract protections and what officials said  was day-to-day vendor management to address certain conflict situations.  For example, one advisor’s agreement with FRBNY provided that when a  potential buyer of AIG assets, also known as a “buy-side” firm, sought  transaction advisory services from the advisor, the advisor was to  determine if it could perform all services for each party objectively and  without compromising confidential information. Upon determining it could  be objective, the advisor was to notify FRBNY and AIG of the names of  each potential buyer and provide an opportunity for FRBNY and AIG to  discuss the scope of services the advisor would provide to the would-be  buyer. Another advisor’s agreement similarly provided for seeking  FRBNY’s consent before entering into transactions that would create a  conflict. Contractual conflict mitigation procedures included separation of  employees conducting work for FRBNY from those doing buy-side  advisory work, as well as information barriers to prevent sharing of  confidential information between FRBNY engagements and the advisor’s  other work. One advisor’s engagement agreement also had a provision  giving FRBNY the right to audit the advisor’s performance and determine  whether it was in compliance with requirements. According to FRBNY, it  performed conflict of interest reviews of four advisors providing AIG- related services.
Similarly, the ML III investment management agreement of November 25,  2008, by and among FRBNY, ML III, and BlackRock, noted potential  conflicts and provided mitigation procedures involving employee  separation of duties and information barriers. Among other things,  BlackRock employees engaged for ML III are not permitted to perform  managerial or advisory services related to ML III assets for third parties or  to provide valuation services for third parties for those assets without  FRBNY’s consent. BlackRock is also barred from recommending or  selecting itself as a replacement collateral manager for any ML III  CDO. Further, it cannot knowingly purchase for ML III any asset from a  portfolio for which it serves as an investment advisor or knowingly sell an y  ML III assets to portfolios for which it serves as an investment adv However, BlackRock may aggregate trading orders for ML III-related  transactions with similar orders being made simultaneously for other  accounts the advisor manages, if aggregating the orders would benefit  FRBNY.  isor.
In addition to the contract provisions, in December 2008 FRBNY asked its  Revolving Credit Facility advisors to disclose potential and actual conflicts  arising from their duties and to provide a comprehensive plan to mitigate  such conflicts. The mitigation plan was to include implementation steps,  conflict issues that were reasonably foreseeable, and identification of how  the advisor would notify FRBNY of conflicts identified in the course of  their duties. FRBNY requested this information to assist it in developing  an approach to managing conflicts related to AIG assistance and other  Federal Reserve System emergency facilities created to address the  financial crisis. In response, the advisors provided general information  on their conflict-of-interest policies and procedures, according to FRBNY  officials. Officials told us that FRBNY did not make the same request of  one of its ML III advisors because FRBNY had been working with the  advisor on a frequent basis for some time and the officials felt they  understood the advisor’s conflict issues and policies.
Over the course of FRBNY assistance to AIG, FRBNY’s advisors have  disclosed a number of conflict situations, both when first engaged and  subsequently while performing their duties. These have involved several  kinds of conflicts, which FRBNY has waived or permitted to be  mitigated. When signing their agreements with FRBNY, one advisor  disclosed two buy-side advisory engagements that were underway.  FRBNY permitted the arrangements, provided that employee separation  and information barriers be created and that the advisor not provide  FRBNY with advisory services related to certain potential AIG  divestitures. However, FRBNY’s consent still allowed some potential  sharing of information between separate employee teams at the advisor.  Two advisors had teams providing advisory services to AIGFP when  FRBNY engaged them. Both FRBNY and AIG agreed to waive the  potential conflicts. One advisor was working on a broad range of advisory  and tax services for AIG. Another was involved in analysis of certain AIG  CDOs and the RMBS portfolio associated with AIG’s securities lending  program. One ML III advisor reported that it was a collateral manager for  certain CDOs in which ML III was an investor, and it was allowed to  continue subject to conditions.
FRBNY officials told us their general approach to conflict issues such as  these was to rely on information barriers, which are intended to prevent  sensitive information from being shared among people or teams, and to  avoid having the same people work in potentially conflicting roles, such as  both buy-side and sell-side engagements. We note, however, that such  precautions involve a trade-off: all else equal, these measures may  protect against conflicts, but they can also preclude application of skills or  resources that would otherwise be available.
FRBNY and its advisors also set up regular communications for  addressing conflicts. For example, one advisor would provide FRBNY  with a weekly list of projects requested by AIG subsidiaries or potential  acquirers of AIG assets. After considering whether it could accept the  project, the advisor would seek waivers from FRBNY when necessary.  FRBNY officials told us that they discussed the projects, addressed  concerns, and raised questions as needed. The advisor would also get  approval of the project proposals from AIG. Another advisor likewise  presented potential project requests to FRBNY as they arose. This  process was written into a new engagement letter in November 2010.  Conflict provisions for another advisor included advisor identification of  conflict situations to FRBNY and use of appropriate trading limitations.
As part of its conflict management process, FRBNY commissioned  compliance reviews for several Revolving Credit Facility and ML III  advisors in order to assess the advisors’ policies and identify potential  conflicts. One review found several instances in which the advisors  allowed employees to work on an engagement for an AIG subsidiary, but  these situations were disclosed to FRBNY and the staff in question were  reassigned. Another review that covered several Federal Reserve System  lending facilities noted that the ML III investment management agreement  did not require conflict policies and procedures tailored specifically for ML  III. Due to the complexity of ML III assets and the presence of third parties  that could influence the portfolio, the report said that FRBNY should  consider requiring an advisor to revise its policies and procedures to  address unique issues raised by ML III, including potential conflicts and  mitigating controls. As discussed later, in May 2010, FRBNY implemented  a new vendor management policy to serve as a framework to minimize  reputational, operational, credit, and market risks associated with its use  of vendors.
Our review of advisor records showed that FRBNY’s Revolving Credit  Facility advisors have requested at least 142 waivers for AIG-related  projects and buy-side work. FRBNY has granted most of these waiver  requests. According to FRBNY officials, overall figures on conflict waiver  requests and outcomes are not available because FRBNY did not begin  tracking the requests until about January 2010, about 16 months after  government assistance began.
According to the records, one advisor made at least 132 conflict waiver  requests to FRBNY for the period of 2008 to 2011. The work requested  covered an array of advisory projects involving AIG business units. The  records did not indicate how many requests FRBNY granted consent for,  but according to FRBNY officials, FRBNY granted a large majority of  them on the condition of employee separation and information barriers.
Another advisor initially made 10 conflict waiver requests but later  dropped one. The remaining nine requests covered at least the 2009– 2011 period, with five related to work requested by AIG and four related  to work on behalf of potential buyers of AIG assets. The AIG projects  were for such matters as assisting with asset sales and raising funds for  subsidiaries. The buy-side projects related to acquisition and financing of  AIG assets. FRBNY granted four waiver consents for AIG-related work  and two for buy-side transactions. For example, according to FRBNY, it  denied one of the conflict waivers in an instance where the advisor  provided FRBNY with sell-side advice and deal structuring for a potential  AIG asset sale. The advisor requested a waiver to participate in financing  to assist the buy-side client to the transaction. According to FRBNY,  officials decided that the advisor had been too involved in providing  FRBNY with advice and thus turned down the waiver request. In another  case, the advisor was in a situation where it had multiple roles involving  an AIG subsidiary. One unit of the advisor recommended AIG sell the  subsidiary, while another recommended AIG conduct an initial public  offering of stock. The advisor was providing FRBNY with advice at the  same time it was advising a potential purchaser. The conflict issue  became moot when the sale idea was abandoned, but before that,  FRBNY had decided not to allow a conflict waiver, officials told us.
In cases such as these, FRBNY officials said they considered separation  of duties to be a significant mitigating factor, because individuals with  access to AIG-related information would not be staffed to other potentially  conflicting engagements.
FRBNY’s interests as an ML III creditor and its interest in the health of  AIG have created competing interests because the interests of ML III and  AIGFP overlap: (1) AIGFP owns tranches in the same CDOs in which ML  III owns tranches and (2) AIGFP has been an interest rate swap  counterparty to certain CDOs in which ML III is an investor. These  interests have resulted in circumstances where ML III and AIGFP have  either worked together or instead have had conflicts due to divergent  interests. FRBNY has identified instances in which decisions made that  reflect the overlapping interests could have led to a total of as much as  $727 million in losses or foregone gains for ML III. However, ML III gains  could have come at the expense of AIGFP, the health of which is also of  interest to the Federal Reserve System.
In December 2009, FRBNY’s Investment Support Office documented 10  such instances in 2008 and 2009, including the following:  In three instances, the ML III portfolio lost a total of $72.5 million, with  AIGFP gaining at least $59.3 million. For example, in one instance,  ML III and AIGFP together held voting rights to control a CDO. A  default occurred, and FRBNY’s ML III advisor sought AIGFP’s  consent to “accelerate” the CDO, a process that would have directed  cash flows to the benefit of both ML III and AIGFP. However, AIGFP  declined to cooperate because it was in a dispute with the CDO  manager on another transaction. FRBNY believed AIGFP did not want  to antagonize the manager by voting to accelerate the CDO, which  would have reduced the manager’s fee income.
In three instances, ML III saw total gains of $5.6 million. For example,  in one instance, AIGFP agreed to vote with ML III to direct a CDO  trustee to terminate a CDO manager and replace it with a new  manager at reduced cost.
In two instances, FRBNY refrained from taking action, in its role as  managing member of ML III, for the benefit of AIGFP. This resulted in  foregone ML III gains of up to $660 million. At issue was potential  termination of interest rate swap protection AIGFP provided on certain  CDOs in which ML III was an investor. FRBNY’s Risk Advisory  Committee considered the issue in February 2009, deciding that ML  III should refrain from exploring termination of the interest rate swaps,  because there was a potential loss at AIGFP that would not be offset  by the gain to ML III, and because there was concern that terminating  the swap protection could have encouraged other market participants  to do the same, to AIGFP’s detriment, the committee indicated. The  $660 million was a maximum potential gain for ML III, assuming the  swap termination would have been successful, FRBNY officials told  us, although they expected AIG to vigorously oppose any attempts to  terminate.
Overall, FRBNY officials told us that if different choices had been made in  these instances, then AIGFP rather than ML III would have suffered  losses, which would have had direct and indirect implications for the  Federal Reserve System and the larger public interest.
We also reviewed a number of other relationships that resulted from  FRBNY’s assistance to AIG. These involve (1) the continuing involvement  of AIG’s CDS counterparties with CDOs in which ML III is an investor; (2)  other relationships among parties involved in AIG assistance, such as  FRBNY vendors and advisors; (3) regulatory relationships; and (4) cross- ownership interests. Figure 7 depicts a number of these situations, which  are discussed in further detail in the sections following.
Links to AIG counterparties. Our review identified continuing indirect  relationships between FRBNY and the AIG counterparties that sold CDOs  to FRBNY’s ML III vehicle. The AIG counterparties have acted as trustees  and collateral managers to CDOs in which ML III is an investor. They  have also been interest rate swap counterparties to these ML III CDOs  and had other continuing relationships. For example, our review of public  data and information obtained from an FRBNY advisor showed that five  AIG counterparties have provided either CDO trustee or collateral  manager services to CDOs in which ML III is an investor. The AIG  counterparties thus continued to have involvement with ML III and  FRBNY via FRBNY’s management of the assets in ML III.
For trustee services, our analysis identified four AIG counterparties that  sold assets to ML III that were trustees for CDOs in which ML III is an  investor. These counterparties accounted for 66 percent of the trustees  for CDOs in which ML III invests. For example, Bank of America, which  sold CDOs with a notional value of $772 million to ML III, was trustee for  71, or 40 percent, of the CDOs in which ML III invests. Trustee duties  involve interaction with the ML III investment manager, BlackRock; the  ML III administrator, Bank of New York Mellon; and by extension, FRBNY.  FRBNY officials said the fact that counterparties act as trustees shows  that the trustee business is highly concentrated, meaning that such  relationships are difficult to avoid. They also said they see little conflict  because the job of a trustee is largely ministerial. Table 7 provides a  breakdown of the trustees of CDOs in which ML III is an investor, showing  AIG counterparties among them.
Our analysis also identified an additional AIG CDS counterparty—Societe  Generale, which sold CDOs with a notional value of $16.4 billion to ML  III—as accounting for 31, or 17 percent, of all collateral managers in the  ML III portfolio. As described previously, in the case of AIGFP’s dispute  with a collateral manager, issues can arise with collateral managers.  FRBNY officials told us that collateral managers work for a CDO and its  trustee, not the CDO investors, and that investors have no right to direct  the collateral manager. However, some CDOs permit investors with  sufficient voting rights to direct a trustee to replace a collateral manager if  certain conditions have been met, officials said.
Another area of continuing relations involves interest rate swap  counterparties. As described earlier, interest rate swaps help manage  interest rate risk. Through December 31, 2008, three AIG counterparties  had a total of five swap arrangements with CDOs in which ML III was an  investor. To the extent that these swap counterparties’ interests diverge  from ML III’s interests, similar to the AIGFP swap case discussed  previously, issues can arise.
According to FRBNY and an advisor, AIG counterparties that sold CDOs  to ML III have also been involved with AIG’s asset sales, the proceeds of  which have paid down federal assistance, such as the Revolving Credit  Facility. For example, one counterparty was involved in the divestiture of  AIG’s ALICO, Star, and Edison life insurance subsidiaries. Additionally,  four other counterparties provided advisory services to AIG, according to  the advisor. FRBNY officials told us they did not view such assistance in  asset sales as raising an issue.
Another continuing relationship arose temporarily through placement of  ML III cash in an investment account offered by an AIG counterparty. For  example, according to a December 2008 advisor memorandum, in  November and December 2008, ML III’s portfolio holdings generated  cash flows of approximately $408 million, which were placed in the AIG  counterparty’s investment fund. Later, according to FRBNY, it moved  most cash into U.S. Treasury bills, using the counterparty’s fund as a  short-term holding account. FRBNY officials said the relationship was not  a concern, and that they chose the fund because it had flexibility for  withdrawals and offered the best return.
Advisor or vendor relationships. FRBNY advisors or vendors have also  acted as service providers to CDOs in which ML III is an investor. For  example, as noted previously, one ML III advisor reported to FRBNY that  it was collateral manager for CDOs in which ML III was an investor.  Specifically, the advisor managed other investor accounts that held 11  CDOs managed by other parties and in which ML III held a senior  interest. According to FRBNY, the notional value of the assets was  approximately $539 million. The advisor also managed one ML III CDO  for which ML III held the super senior tranche, which had a notional value  of about $800 million. The advisor sought a conflict waiver, and FRBNY  consented, stipulating that the advisor would not make management  decisions or take a position contrary to the interests of ML III and that the  advisor would immediately seek to sell the CDO positions in question  where permissible.
Our review also identified instances in which this advisor has managed  other ML III-related CDO assets that it said presented a potential for  conflicts and where the advisor did not seek waivers from FRBNY. At the  time ML III was established, the advisor was investment manager for  clients owning approximately eight junior tranches in CDOs for which ML  III held the senior tranches. FRBNY officials said that under the structure  of the assets, neither the advisor nor ML III is able to influence the CDO  holdings.
We also found that the ML III administrator, Bank of New York Mellon,  has also been a trustee for individual CDOs in which ML III is an investor.  This means Bank of New York Mellon has had interests that could  diverge. Bank of New York Mellon has been the trustee for 50 CDOs in  which ML III is an investor, or 28 percent of all trustees, according to our  analysis. As an individual CDO trustee, Bank of New York Mellon is  involved in such tasks as performing compliance tests on the composition  and quality of CDO assets; identifying CDO events of default; and  liquidating CDOs upon events of default at the direction of CDO holders,  subject to certain conditions. As the administrator for the overall ML III  portfolio, Bank of New York Mellon’s income would depend on the CDO  assets held in the ML III portfolio. But as noted previously, as trustee to  individual CDOs, it could be called upon to determine if CDOs are in  default, which can lead to liquidation if requisite conditions are met.  Such liquidations could reduce overall portfolio assets, and hence, the  administrator’s income. FRBNY officials said that this divergence of  incentives is inherent in the CDO trustee business, and they emphasized  that as the ML III administrator, Bank of New York Mellon had no  authority to make ML III decisions.
According to FRBNY, Bank of New York Mellon performed custodial and  administrative services and had no discretion, and thus was considered to  present a low conflict risk. In the case of an ML III advisor managing  individual CDOs, or related assets, FRBNY officials told us they examined  individual situations as necessary.
Finally, our review also identified other relationships. For example, an ML  III advisor has had service contracts with the AIG counterparties that sold  CDOs to ML III. FRBNY officials told us they did not consider these  relationships to be of concern because the advisor was not involved in  direct negotiations with counterparties with respect to ML III purchases of  CDOs. Also, there are one or two instances where interests in Maiden  Lane—the vehicle for another Federal Reserve System emergency  program—hold tranches of CDOs in ML III, FRBNY officials told us. In  some cases, the interests of Maiden Lane LLC and ML III could diverge,  similar to the situations described earlier relating to AIGFP and ML III.  According to FRBNY, it manages from the standpoint of its overall loans  for assistance. FRBNY officials also said that it would be rare that a loss  to Maiden Lane LLC would be greater than the gain to ML III.
According to FRBNY officials, they would have avoided any involvement  with the various parties if practicable. They said that the relationships we  identified, the majority of which stemmed from arrangements that existed  before ML III was established, reflected areas that did not raise concern.  From FRBNY’s perspective, after AIG’s counterparties no longer owned  the CDO positions sold to ML III, those counterparties had no ongoing  interest in ML III’s structure or interactions with FRBNY related to ML III.  FRBNY officials said that positions that ML III held in the CDOs came with  the rights and obligations the CDO structure itself stipulated, as well as  the trustees and collateral managers then involved—all of which predated  FRBNY’s involvement. They acknowledged that FRBNY’s ML III  investment manager presented the potential for conflict but said that  adequate measures were taken to avoid actual conflicts.
Regulatory relationships. The Federal Reserve System oversees two of  FRBNY’s advisors, which means that while FRBNY has been receiving  advice from the advisors, it also has been responsible for oversight of  them. According to FRBNY, it has maintained its AIG monitoring team  separately from staff who perform supervisory duties. The AIG monitoring  staff has no contact with those involved in supervision, officials told us. In  addition, officials told us that FRBNY policy requires bank supervisory  information to be kept separate from other operations, including separate  computer systems.
As an example of attention to separation of supervisory duties, FRBNY  officials cited the case of MetLife, which in 2010 acquired AIG’s ALICO  unit. MetLife is a bank holding company regulated by the Federal Reserve  System. At the time of the acquisition, there were inquiries from an  FRBNY MetLife team to the AIG team. When that happened, officials said  they immediately put in place an information barrier to make clear that  supervisory decisions would not be affected by information the AIG team  had. Officials saw the matter as a serious potential conflict because  FRBNY had an interest in seeing the acquisition being completed, as that  would aid repayment of federal lending, while at the same time, it had a  supervisory responsibility for MetLife.
Cross-ownership. Cross-ownership occurs when parties have ownership  interests in each other—for example, if a company owns stock in another  firm and that firm owns stock in the first company. According to academic  literature we reviewed, such reciprocal ownership can create mutual  interests among the parties or interests that might not have been present  absent the ownership, which can diminish independence between the  parties. Our review found that a number of AIG CDS counterparties,  FRBNY advisors, and service providers to CDOs in which ML III is an  investor have held cross-ownership interests in each other, both at the  time ML III was established and more recently.
For example, we found that as of December 31, 2008—the end of the  quarter during which ML III was planned and formed—FRBNY ML III  advisor Morgan Stanley had stock holdings in nine AIG CDS  counterparties totaling at least $1.4 billion. Among those nine  counterparties, four have been service providers to CDOs in which ML III  is an investor (such as trustees or collateral managers, as discussed  previously). Morgan Stanley’s largest counterparty holding was Bank of  America, valued at $925 million. At the same time Morgan Stanley held its  equity ownership in these nine counterparties, the nine counterparties  had equity ownership in Morgan Stanley valued at about $1.1 billion, our  review found. The counterparties’ ownership ranged from a low of $6.7  million for counterparty HSBC to a high of $384.2 million for Goldman  Sachs.
Similarly, and more recently, we identified cross-ownership between AIG  CDS counterparties and FRBNY ML III advisor BlackRock. In particular,  we found that 12 counterparties owned BlackRock stock worth at least  $998 million, based on information available as of April 2011—3.8 percent  of BlackRock’s outstanding shares. Among these 12 firms, 5 have been  service providers to CDOs in which ML III is an investor. The largest AIG  CDS counterparty owner of BlackRock stock was Barclays, with holdings  valued at $603 million. At the same time these 12 counterparties owned  BlackRock stock, BlackRock had equity ownership interests in them worth  $44.3 billion. BlackRock’s ownership ranged from a low of $248 million for  Calyon (later renamed Credit Agricole) to a high of $8.4 billion for HSBC.
BlackRock and Merrill Lynch, an AIG CDS counterparty, have had  business interests in addition to investment interests. In September 2006,  BlackRock merged with the investment management unit of Merrill Lynch.  Later, Merrill Lynch became one of the largest recipients of ML III  payments. At year-end 2008, Merrill Lynch owned about 44 percent of  BlackRock’s common stock. In September 2008, Bank of America  announced its acquisition of Merrill Lynch. Bank of America was also an  AIG CDS counterparty that received payments from ML III. According to  BlackRock’s 2008 year-end SEC filing, Merrill Lynch would vote its  BlackRock shares according to the recommendation of BlackRock’s  board of directors.
Similarly, we found that cross-ownership extends to FRBNY advisors and  service providers (that is, CDO trustees and collateral managers) for  CDOs in which ML III is an investor. For example, we found that 15 of 52  CDO service providers owned BlackRock stock valued at $624 million,  based on information available as of April 2011, with holdings equal to 2.4  percent of BlackRock’s outstanding shares. Among these providers, for  example, was State Street Global Advisors, which had the largest  BlackRock stake, worth $300 million, or 1.2 percent of BlackRock’s  outstanding shares. At the same time, BlackRock held State Street stock  worth $293 million, or 1.1 percent of shares outstanding.
FRBNY officials told us that they had not considered the cross-ownership  issue, either before or after executing ML III, but that by itself, it was not  of concern. First, they distinguished BlackRock from other entities, saying  BlackRock is an investment management company that owns securities  on behalf of clients, which accounts for most of the holdings we identified.  However, we note that BlackRock would still have an interest in the  performance of client holdings from the standpoint of management fees  and client satisfaction with investment performance. Second, the officials  said that entities have subdivisions, such as affiliates or subsidiaries;  therefore, relationships among parties are not necessarily as linked as  they might appear. For example, they distinguished between BlackRock  Solutions, the portion of BlackRock that has been FRBNY’s advisor, and  other operations of BlackRock, Inc., the BlackRock corporate entity.  However, according to BlackRock federal securities filings, BlackRock  Solutions is not a distinct subsidiary of the parent, and instead operates  as a “brand name” for certain services the company provides. While  different units could nonetheless be affiliated within an overall corporate  structure, the relevance or impact of any such affiliations is not clear,  FRBNY officials said. Overall, FRBNY officials compared the cross- ownership issue to the former large investment banks, which could  provide both advisory services and sales and trading functions. The  officials noted that while there were considerable interconnections of  interests, the point at which they become unacceptable is not clear.
Overall, while our review indicated FRBNY devoted attention to conflict of  interest matters involving assistance to AIG, FRBNY‘s decision to rely on  private firms for key assistance in designing and executing aid to the  company introduced other challenges. For example, FRBNY established  conflict of interest standards that permitted waivers, and it has granted a  number of waiver requests. But because a system for tracking conflict  waiver requests was not implemented until about 16 months after  assistance began, FRBNY officials cannot provide a comprehensive  account of such requests and their dispositions. Also, the relationships we  identified among FRBNY, its advisors, and the AIG CDS counterparties  raise questions in light of officials’ statements that one goal was to avoid  continuing relationships with firms involved in AIG assistance. Given the  time pressure of the financial crisis and FRBNY’s decision to rely upon  private firms, FRBNY had to develop policies and procedures on an ad  hoc basis. While FRBNY was attuned to conflict of interest issues, its  procurement policy did not address vendor or other nonemployee  conflicts of interest. As FRBNY officials told us, it is not necessarily  clear at what point interrelations between parties becomes a matter for  concern.
In our recent report on the Federal Reserve System’s emergency lending  programs, which included assistance to AIG, we found that the emergency  programs brought FRBNY into new relationships with institutions that fell  outside of its traditional lending activities, and that these changes created  the possibility for conflicts of interest for vendors, plus FRBNY employees  as well. FRBNY used vendors on an unprecedented scale, both in the  number of vendors and the types of services provided. FRBNY created a  new vendor-management policy in May 2010, but we found that this policy  is not sufficiently detailed or comprehensive in its guidance on steps  FRBNY staff should take to help ensure vendor conflicts are mitigated.  FRBNY staff have said that they plan to develop a documented policy that  codifies practices FRBNY put in place during the crisis. The lack of a  comprehensive policy for managing vendor conflicts, including relationships  that cause competing interests, could expose FRBNY to greater risk that it  would not fully identify and appropriately manage vendor conflicts of  interest in the event of future crises. In that report, we recommended that  FRBNY finalize this new policy to reduce the risks associated with vendor  conflicts. FRBNY officials said they plan to document a more  comprehensive policy for managing vendor conflict issues.
section_title: Initial Federal Reserve Lending Terms Were Designed to Be More Onerous than Private Sector Financing
paragraphs: FRBNY officials have said that when they provided the first assistance to  AIG—the $85 billion Revolving Credit Facility—they adopted key terms of  an unsuccessful private-sector lending package. Our review, however,  found that the initial federal lending was considerably more onerous than  the contemplated private deal. After accepting the terms of government  lending—which included restrictions on some company activities—AIG  reduced some investment activities but did not fail to meet any legal  obligations, the company said.
subsections: section_title: The Revolving Credit Facility Was More Expensive than the Failed Private Loan Plan and Was Intended to Be Onerous
paragraphs: FRBNY officials told us that after an agreement could not be reached on  private financing for AIG, they adopted key economic terms of the private- sector loan syndication plan for the Federal Reserve System’s initial  assistance—the Revolving Credit Facility. Our review, however, showed  that the terms of the FRBNY loan were more expensive in key respects  and that the government intended them to be onerous. The initial cost of  the Revolving Credit Facility created financial challenges for AIG and its  ability to repay FRBNY. In response, the Federal Reserve System twice  restructured its loan before the company fully repaid it in January 2011.  According to both FRBNY officials and AIG executives, it was apparent at  the time the Revolving Credit Facility was offered that restructuring would  be necessary, although Federal Reserve Board officials told us that they  believed the $85 billion credit facility had solved the company’s problems  until economic conditions deteriorated further.
FRBNY officials told us that some of the Revolving Credit Facility’s initial  loan terms were different from those of the failed private-sector plan but  that key economic terms, such as the interest rate and fees were the  same. FRBNY also stated publicly on its website that the interest rate was  the same as the private-sector plan, and an FRBNY advisor also said that  the credit facility’s terms were those that had been outlined in the private- sector plan. FRBNY officials told us that the Federal Reserve System  used the private-sector terms because it did not have sufficient time to do  otherwise prior to extending government aid, and that in the process, they  took a signal from the private sector on what was appropriate in light of  the risk. Given the situation, according to an FRBNY internal fact sheet,  officials attempted to assess AIG’s situation and take into account the  terms of the private-sector lending plan, before finalizing the FRBNY loan  offer to the company.
Our review, however, showed that key economic terms of the Revolving  Credit Facility were more expensive than those of the private plan, until  loan terms were subsequently modified. For example, as shown in table  8, the rate on drawn amounts was two percentage points higher, and the  FRBNY loan included a fee on undrawn amounts, which the private- sector plan did not. Apart from the financial terms, the Revolving Credit  Facility also provided a longer term than the private plan.
In an e-mail sent to the then-FRBNY President about a month after the  Revolving Credit Facility was authorized, an FRBNY official cited the  interest rate as being high and expressed concern about the Federal  Reserve Board imposing such a rate in approving the lending. In our  review, FRBNY officials could explain only the increase in the base rate,  from LIBOR plus 6.5 percentage points to LIBOR plus 8.5 percentage  points. The officials said an advisor made that increase, on the theory that  the loan had become more risky since the failed private-sector attempt.  The rationale was that market turmoil had increased in the day before  Federal Reserve Board approval of the loan, following the Lehman  bankruptcy, and that it would be FRBNY alone, rather than a syndicate of  lenders, that would extend the credit. Otherwise, the officials were unable  to provide us with an explanation of how other original terms for the  Revolving Credit Facility became more expensive, such as the undrawn  amount fee. FRBNY officials also told us there were some reservations  internally about the initial interest rate on the Revolving Credit Facility. As  FRBNY officials described to us, the rate would be high whether AIG  used the facility or not, reflecting the 8.5 percent rate on undrawn  amounts. Despite internal concerns, there were no efforts to seek  changes at the time the loan was approved, FRBNY officials said.
Although FRBNY officials could not fully explain the rate discrepancy we  identified, they told us nonetheless that in general, they intended the  original Revolving Credit Facility terms to be onerous, as a way to  motivate AIG to quickly repay FRBNY and to give AIG an incentive to  replace the government lending with private financing. Without reconciling  the changing terms of the lending, the former FRBNY President told us  that FRBNY provided for appropriately tough conditions on AIG. An  FRBNY advisor also described the terms as onerous and said the market  recognized them as such. Similarly, as noted, AIG initially objected to the  terms, in particular, the interest rate and the 79.9 percent equity stake the  company gave up. Many of the terms of the Revolving Credit Facility  resembled those of bankruptcy financing, FRBNY officials said, and their  objective was to devise terms that reflected the company’s condition, the  nature of its business, and the large exposure the government faced.  According to the officials, they had to balance that AIG would need to  maintain its daily business operations against the exposure FRBNY faced  with its loan and the contemplated source of repayment, namely asset  sales. The officials said they also constructed the economic terms based  on what private-sector lenders would have considered appropriate for the  risk involved. An AIG advisor characterized the loan as aggressive and  unprecedented, but said AIG was in a price-taking position, and that  notwithstanding the high cost, the loan nevertheless allowed AIG to  survive.
In addition to the economic terms highlighted in table 8, the credit  agreement for the Revolving Credit Facility also imposed a number of  affirmative and negative covenants, or obligations. Under the terms of an  accompanying security agreement, AIG granted a lien against a  substantial portion of its assets, including its equity interests in its  regulated U.S. and foreign subsidiaries. AIG’s insurance subsidiaries  did not pledge any assets in support of the facility, as noted in a Federal  Reserve System internal fact sheet, and the subsidiaries themselves did  not act as guarantors of the loan. This arrangement was established  because officials wanted to better ensure that AIG’s insurance  subsidiaries would be well capitalized and solvent, according to the fact  sheet. The agreements did not require AIG’s foreign subsidiaries to  become guarantors, according to FRBNY. The credit agreement also  stipulated repayment of FRBNY’s loan with proceeds from asset sales or  the issuance of new debt or equity. In addition, officials told us there  were other restrictions barring AIG from making large capital expenditures  or providing seller financing on asset sales without FRBNY’s consent.  Finally, the agreement also included a negative covenant that provided  protection for the government on how AIG could use the government’s  TARP equity investment.
FRBNY officials told us the loan structure proved durable and achieved its  purpose of providing AIG with needed liquidity while protecting FRBNY’s  position as a creditor. In a secured lending facility such as the Revolving  Credit Facility, it is not unusual to negotiate a range of restrictions to  protect the lender, the officials said. Nonetheless, the structure created  challenges for AIG shortly after its creation. Concerns remained, for  example, about the level of AIG’s debt, the rate on the Revolving Credit  Facility, and the company’s ability to sell off assets to repay the lending.  FRBNY officials told us that the amount AIG initially withdrew from the  Revolving Credit Facility ($62.5 billion) and how quickly it did so (slightly  more than 2 weeks) demonstrated the depth of the company’s problems.  Thus, rating agency concerns were not unexpected, although officials  said they were surprised by how quickly those concerns arose. In  addition, Federal Reserve Board staff comments cited an issue with the  loan, namely, that it required AIG to use proceeds of the Revolving Credit  Facility to meet preexisting liquidity needs and not for investment in  assets that would generate returns. Thus, as officials told us, rather than  repaying FRBNY from productive activities funded by the loan, AIG had to  repay the Revolving Credit Facility by selling assets. This requirement  ultimately proved difficult to fulfill given the challenges AIG faced in  carrying out its asset-sales plan.
FRBNY and AIG both told us they understood at the time the Revolving  Credit Facility was established that it was only an interim solution and that  additional assistance, or restructuring of the assistance, would be  required. According to FRBNY officials, the Revolving Credit Facility was  a necessary step to forestall AIG’s immediate problems, and the loan  gave them time to consider more targeted solutions. FRBNY officials also  highlighted the uncertainties that remained after the initial loan, including  the condition of the broader economy, as well as the reactions of AIG’s  counterparties to Federal Reserve System assistance. In particular, AIG’s  securities lending counterparties were terminating their contracts,  resulting in increased draws on the Revolving Credit Facility early on.  According to AIG executives, while the Revolving Credit Facility  addressed the company’s immediate liquidity problems, it also created an  unsustainable situation, given the company’s high debt levels, downward  pressure on credit ratings, and illiquid markets in which to sell assets.
While FRBNY and AIG considered the need for additional government  assistance immediately after the Revolving Credit Facility, Federal  Reserve Board officials told us that a number of factors accounted for  why the Federal Reserve Board determined restructuring became  necessary only after economic conditions worsened following  authorization of the initial lending. According to Federal Reserve Board  officials, markets continued to deteriorate in October and November  2008, resulting in increased cash demands from AIG and heightened  prospects for a downgrade. Market conditions worsened more than they  expected, officials noted, making it necessary to revisit the terms of the  Revolving Credit Facility. In particular, it was important at that point to  make the interest rate less burdensome.
As noted, the Federal Reserve System twice restructured the terms of the  Revolving Credit Facility in order to, among other things, improve AIG’s  capital structure and enhance the company’s ability to conduct its asset  sales plan. As shown in table 8, the November 2008 restructuring  included reductions in the interest rate and the undrawn amount fee, as  well as an extension of the loan’s maturity. According to an FRBNY  internal fact sheet from November, the lower interest rate and  commitment fee on undrawn amounts reflected AIG’s stabilized condition  and outlook following Treasury’s $40 billion TARP investment in preferred  stock. In addition, according to the fact sheet, the Federal Reserve Board  extended the loan’s maturity in order to provide AIG with additional time  to sell assets and to repay FRBNY with the proceeds. The restructuring  also reduced AIG’s degree of indebtedness and improved its ability to  cover interest payments, the fact sheet said, which were key measures  for the marketplace and rating agencies in assessing AIG’s future risk.  FRBNY’s commitment to lend to AIG under the Revolving Credit Facility  was reduced to $60 billion.
The March 2009 restructuring included, as noted, a further reduction of  the amount available under the Revolving Credit Facility. As part of this  restructuring, FRBNY received preferred interests in two SPVs created to  hold all of the outstanding common stock of two life insurance holding  company subsidiaries of AIG. In addition, officials eliminated the LIBOR  floor on the interest rate for the Revolving Credit Facility, potentially  reducing the cost of the loan. Following these changes, the amount  available to AIG under the Revolving Credit Facility was further reduced.  On January 14, 2011, FRBNY announced full repayment of the Revolving  Credit Facility and exchange of the 79.9 percent controlling equity interest  in AIG for common stock. FRBNY officials told us repayment of the loan  was, as expected, the product of AIG asset sales.
section_title: After Accepting the Federal Reserve’s Loan Terms, AIG Says It Restricted Some Investment Activities but Otherwise Stayed Current on Obligations
paragraphs: After the Federal Reserve Board approved assistance for AIG, questions  arose about the company’s treatment of financial counterparties and its  ability to meet its obligations. We examined this issue from the standpoint  of whether, after receiving federal aid, AIG failed to perform on legally  required obligations. FRBNY officials said that while they monitored  company activities as part of oversight following the rescue, they did not  direct AIG on how to treat its counterparties, and company executives told  us they did not fail to honor existing obligations. However, AIG executives  told us that the company did reduce its investments in certain projects.
As noted previously, AIG’s loan agreements imposed a number of  restrictions (negative covenants) on the company’s activities. For  example, the credit agreement for the Revolving Credit Facility generally  barred the company from creating or incurring new indebtedness. It also  placed restrictions on payment of dividends and on capital expenditures  greater than $10 million. In addition, FRBNY officials told us other  restrictions arose from the credit agreement, as amended, although they  were not explicitly contained in the agreement. For instance, the AIG  parent company ordinarily could inject capital into subsidiaries that were  not guarantors of FRBNY’s loan without FRBNY’s consent. However,  FRBNY officials said they had concerns about funds going to AIGFP.  Thus, according to the officials, in a separate letter agreement with the  company, they required that any loan, advance, or capital contribution to  AIGFP would require consent.
Apart from the loan agreements and related items, the Federal Reserve  System and Treasury did not place any additional limitations on AIG’s  activities or its use of cash, such as the ability to make loan payments or  to fulfill previously committed obligations, company executives told us.  Similarly, short of actual restrictions, the Federal Reserve System and  Treasury did not impose any limitations that caused AIG to forego  activities it otherwise would have undertaken, the executives said. AIG  executives also told us that AIG did not act, or fail to act, due to  restrictions arising from federal aid. More specifically, the executives said  AIG has not failed to perform any legally required obligations to parties  such as creditors, joint venture partners, and other counterparties. In  particular, AIG’s credit agreement with FRBNY stipulates that AIG is not  to be in default of contractual obligations, the executives said.
However, the AIG executives distinguished between the obligations  described in the previous paragraphs and investment-based decisions not  to make additional contributions of capital to certain projects, or to  discontinue payments on certain projects and allow lenders to foreclose  on them, so that the lenders took over the projects under terms of lending  agreements. AIG has made such business decisions, involving a number  of projects, when it judged them to be in the best interest of the company,  its stakeholders, and FRBNY as AIG’s lender, the executives told us.  They said that in such instances, AIG has not had any obligation to  continue funding under any contract and had the ability to make  payments if it chose to do so. Citing one real estate development project  as an example, the executives characterized the situation as a bad real  estate decision by the banks involved.
FRBNY became involved in ongoing AIG business activities by attending  meetings of steering committees AIG set up in certain business units, as  one way to obtain information officials felt was necessary to inform  judgments FRBNY needed to make under the credit agreements, FRBNY  officials told us. For instance, FRBNY would ask for information to  understand the company’s risk position or utilization of proceeds from  government lending. However, FRBNY did not substitute its judgment for  company executives’ judgment, officials told us, and did not direct AIG’s  activities. Instead, FRBNY officials told us they focused on issues of  interest as a creditor to the company and, as such, would probe company  assumptions or analyses. Officials told us that although they did not  exercise control, in some instances, AIG reconsidered ideas after  discussions with FRBNY. FRBNY never indicated whether AIG should not  pay a particular lender or counterparty, officials told us. Instead, FRBNY’s  interest was broader and involved evaluating whether a proposed use of  capital made sense from a broad context and in light of competing  demands for capital, they said. FRBNY encouraged AIG to make  decisions based on economics, which sometimes was at odds with  narrower interests of managers in particular business units, FRBNY  officials said. AIG executives characterized this FRBNY review of its  corporate initiatives as constructive, typical of a creditor-borrower  relationship, and said they could not recall an instance when AIG wanted  to pursue a course that they believed made good business sense but  FRBNY did not agree.
section_title: The AIG Crisis Offers Lessons That Could Improve Ongoing Regulation and Responses to Future Crises
paragraphs: As with past crises, the Federal Reserve System’s experience with  assisting AIG offers insights that could help guide future government  action, should it be warranted, and improve ongoing oversight of  systemically important financial institutions. Already, the Dodd-Frank Act  seeks to broadly apply lessons learned from the financial crisis in a  number of regulatory and oversight areas. For example, the act contains  oversight provisions in the areas of financial stability, depository  institutions, securities, brokers and dealers, and financial regulation. In  addition, our review of Federal Reserve System assistance to AIG has  identified other areas where lessons learned could be applied:  identifying ways to ease time pressure in situations that require  immediate response,    analyzing collateral disputes to help identify firms that are coming  conducting scenario stress testing to anticipate different impacts on  the financial system.
subsections: section_title: Actions Could Be Taken Earlier to Reduce Time Pressure
paragraphs: As discussed earlier, time pressure was an important factor in Federal  Reserve System decision making about aid to AIG. For example, the  Federal Reserve Board made its initial decision on the Revolving Credit  Facility against the urgency of expected credit rating agency downgrades  in mid-September 2008, which would have imposed significant new  liquidity demands on the company. Similarly, FRBNY chose among ML III  design alternatives based largely on what could be done quickly.
Time pressure also played a key role in decisions whether federal aid was  appropriate. As noted, the Federal Reserve Board’s emergency lending  authority under section 13(3) of the Federal Reserve Act was conditioned  on the inability of borrowers to secure adequate credit from other banking  institutions. In AIG’s case, the company and the Federal Reserve System  sought to identify private financing over several days in September 2008  leading up to the first offer of government aid to the company. But entities  contemplating providing financing to AIG said the process forced them to  compress what ordinarily would be weeks’ worth of due diligence work  into only days. As the scope of the financial crisis and AIG’s situation  evolved, potentially large investments were being considered in an  environment of uncertain risk. When FRBNY stepped in to try to arrange  bank financing—at which point AIG’s identified financial need had grown  substantially—there was even less time to act, and the Federal Reserve  Board quickly moved to extend its offer of assistance.
While unforeseeable events can occur in a crisis, easing time pressure  could aid future government decision making and the process of seeking  private financing. In AIG’s case, the Federal Reserve System could have  eased time pressure two ways. First, it could have begun the process of  seeking or facilitating private financing sooner than it did—the day before  the Federal Reserve Board approved the Revolving Credit Facility—as  warning signs became evident in the months before government  intervention. Second, given the warning signs, it could have compiled  information in advance to assist would-be investors or lenders. Potential  private-sector financiers told us the process would have benefited from  both more time and information.
An example of the kind of information that would be useful in a crisis can  be seen in recent rulemaking by the Federal Reserve Board and the  Federal Deposit Insurance Corporation. As part of Dodd-Frank Act  implementation, the two agencies proposed that large, systemically  significant bank holding companies and nonbank financial companies  submit annual resolution plans and quarterly credit exposure reports. A  resolution plan would describe the company’s strategy for rapid and  orderly resolution in bankruptcy during times of financial distress. A  company would also be required to provide a detailed listing and  description of all significant interconnections and interdependencies  among major business lines and operations that, if disrupted, would  materially affect the funding or workings of the company or its major  operations. The credit exposure report would describe the nature and  extent of the company’s credit exposure to other large financial  companies, as well as the nature and extent of the credit risk posed to  others by the company. Such information was of interest to those  contemplating providing financing to AIG ahead of federal intervention, as  well as to government officials themselves.
This information could also benefit ongoing regulation of financial entities,  whether by the Federal Reserve System or other financial regulators, but  it could be of particular benefit to the Federal Reserve System, given its  broad role in maintaining the stability of the financial system. Such efforts  could also improve the quality of information that the Financial Stability  Oversight Council is now charged with collecting from, among others,  financial regulatory agencies, pursuant to the Dodd-Frank Act. Under  terms of the legislation, the Federal Reserve Board Chairman is a  member of the Financial Stability Oversight Council, whose purpose is to  identify risks to financial stability that could arise from distress, failure, or  ongoing activities of large, interconnected bank holding companies or  nonbank financial companies; promote market discipline; and respond to  emerging threats to the stability of the U.S. financial system. The law  created an Office of Financial Research within Treasury to support the  Council and its member agencies.
section_title: Analyzing Collateral and Liquidity Issues Could Help Identify Warning Signs
paragraphs: Requirements to post collateral figured prominently in the difficulties in  AIGFP’s CDS business that spurred the creation of ML III. Leading up to  government intervention, AIG was in dispute with some of its  counterparties on the amount of collateral the company was required to  post with them under terms of AIG’s CDS contracts. A number of the  counterparties told us that they were in disagreement with AIG over  billions of dollars of collateral they claimed the company owed them. For  example, one counterparty told us it had contentious discussions with AIG  over collateral, and another said it made multiple unsuccessful demands  for payment. Records we reviewed also indicated that market  mechanisms for valuing assets had seized up, which AIG told us  contributed to the disagreements over the amount of collateral to be  posted.
This experience suggests that identifying, monitoring, and analyzing  collateral issues may offer opportunities for enhancing regulators’ market  surveillance or developing warning signs that firms are coming under  stress. A large AIG CDS counterparty told us that it was not clear that  regulators appreciated the significance of collateral disputes involving the  company. Collateral disputes can be a warning sign and usually involve  valuation conflicts. While regulators generally are expected to look for  such things as fraud and problems in economic modeling, whether they  are attuned to looking closely at collateral disputes and the warnings they  might yield is not clear, the counterparty said. In AIG’s case, the duration  of the dispute and sharply differing views of values were unusual, the  counterparty said.
The idea of tracking collateral issues is gaining some attention among  financial regulators. For example, the Financial Industry Regulatory  Authority has recently issued guidance for broker-dealers that lists  “notable increases in collateral disputes with counterparties” among  factors that could be warning flags for funding and liquidity problems.
More sophisticated monitoring of financial firms’ liquidity positions could  likewise be valuable, a former Treasury official who was involved in AIG  assistance told us. Proper assessment of liquidity requires not just  knowing how much cash is available, the former official said, but also the  amount of cash a firm would have available in the event that all parties  with the potential to make calls on the firm were to do so. In AIG’s case,  neither the company nor regulators understood the situation in this way,  but this kind of assessment should be an essential part of future  regulatory oversight, the former official said.
section_title: Scenario Stress-Testing Could Increase Analytical Insights
paragraphs: In general, risk analysis that involves thoughtful stress testing can allow  for better-informed and more timely decision making. For example, in  evaluating elements of federal assistance to AIG, FRBNY and an advisor  analyzed expected performance and outcomes under varying conditions  of economic stress. Similarly, we reported on the Supervisory Capital  Assessment Program that was established through TARP, which  assessed whether the 19 largest U.S. bank holding companies had  enough capital to withstand a severe economic downturn. Led by the  Federal Reserve Board, federal bank regulators conducted stress tests to  determine if these banks needed to raise additional capital. These  experiences underscore the value of stress testing generally, and the  particular circumstances of AIG’s difficulties suggest an opportunity to  expand and refine such testing in order to better anticipate stress in the  financial system. In AIG’s case, FRBNY officials cited the company’s  financial interconnections and the multifaceted nature of the financial  crisis as contributing to the need for federal assistance. Similarly, the  Federal Reserve Board Chairman has highlighted the risks presented by  large, complex, and highly interconnected financial institutions. More  sophisticated stress testing that incorporates comprehensive measures of  financial interconnectedness and different crisis scenarios could offer the  opportunity to study expected outcomes of financial duress, not only for a  single institution but for a range of institutions as well. Such testing could  allow regulators to better understand the potential systemic impacts of  crises or actions, which, among other things, could help them in their new  role to monitor systemic risk under the Dodd-Frank Act. The Dodd-Frank  Act requires annual or semiannual stress testing by the Federal Reserve  Board or financial companies themselves, according to type of institution  and amount of assets. The AIG experience underscores the importance  of interconnectedness in such analysis.
section_title: Agency and Third Party Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Federal Reserve Board for its  review and comment, and we received written comments that are  reprinted in appendix II. In these comments, the Federal Reserve Board  generally agreed with our approach and results in examining the Federal  Reserve System’s involvement with AIG within the context of the overall  financial crisis at the time, and it endorsed the lessons learned that we  identified in our work. Regarding regulators taking earlier action to reduce  time pressure during a crisis, the Federal Reserve Board stated that it has  established a new division to focus on market pressures and  developments that may create economic instability, and is otherwise  working to identify threats to financial stability. Regarding the opportunity  that collateral disputes may offer for enhancing regulators’ market  surveillance or for developing warning signs that firms are coming under  stress, the Federal Reserve Board stated that it is working with other  financial regulators to implement changes in supervision and regulation of  derivatives markets, including requirements governing collateral posting.  Regarding the notion that risk analysis that involves thoughtful stress  testing—especially focusing on interconnections among institutions—can  allow for better-informed and more timely decision making, the Federal  Reserve Board stated that it has begun development of an annual stress  testing program for large financial firms within its supervisory purview. In  response to our findings that Federal Reserve System assistance to AIG  gave rise to overlapping interests and complex relationships among the  various parties involved, the Federal Reserve Board said it is exploring  opportunities to improve its approach to potential or actual conflicts of  interest that can arise from such interests and relationships. The Federal  Reserve Board and FRBNY also provided technical comments, which we  have incorporated as appropriate.
In addition, we provided a draft of this report to Treasury for review and  comment, and we also provided relevant portions of the draft to AIG,  SEC, and selected others for their review and comment. We have  incorporated comments from these third parties as appropriate.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days after its  date. At that time, we will send copies to the Chairman of the Federal  Reserve Board, interested congressional committees, and others. In  addition, this report is available at no charge on the GAO website at  http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact me at (202)-512-8678 or williamso@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found  on the last page of this report. GAO staff who made major contributions to  this report are listed in appendix III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: To examine the sequence of events and key participants as critical  decisions were made to provide federal assistance to American  International Group, Inc. (AIG), we reviewed a wide range of AIG-related  documents. We obtained these documents primarily from the Board of  Governors of the Federal Reserve System (Federal Reserve Board) and  the Federal Reserve Bank of New York (FRBNY), including records they  have provided to Congress. These documents included e-mails,  information relating to options and plans for aiding AIG, research,  memorandums, financial statements, and other items. We also obtained  information from congressional testimonies of the former FRBNY  President and officials of the Federal Reserve Board, FRBNY, the former  Secretary of the Department of the Treasury (Treasury), and former AIG  executives. In addition, we reviewed Federal Reserve Board and FRBNY  announcements, presentations, and background materials. We also  reviewed our past work and the work of others who have examined the  government’s response to the financial crisis, including the Congressional  Oversight Panel, the Special Inspector General for the Troubled Asset  Relief Program (SIGTARP), and the Financial Crisis Inquiry Commission.  We conducted interviews with many of those involved in federal  assistance to AIG, to obtain information on their participation in the events  leading up to federal assistance for AIG, as well as their perspectives on  the condition of AIG and the financial markets at the time. From the  regulatory sector, we interviewed Federal Reserve Board and FRBNY  officials, a former Federal Reserve Board Governor, a Reserve Bank  President, current and former officials from state insurance regulatory  agencies, SIGTARP staff, current and former Treasury officials, and an  official of the Federal Home Loan Bank system. From the private sector,  we interviewed current and former AIG executives, representatives from  FRBNY advisors, an AIG advisor, AIG business counterparties, credit  rating agencies, potential private-sector financiers, and academic and  finance experts. In addition, we obtained written responses to questions  from the former Office of Thrift Supervision, the former FRBNY President,  and a former senior Treasury official.
To examine decisions involving the selection and structure of the Maiden  Lane III vehicle (ML III), we obtained and reviewed relevant documents  from the Federal Reserve Board, FRBNY, and others, as noted earlier. In  addition, we reviewed filings submitted by AIG to the Securities and  Exchange Commission (SEC). We also conducted interviews with parties  identified earlier. In addition, we obtained written responses to questions  from the Autorite de Controle Prudentiel, a French banking regulator. We  analyzed the information obtained from documents and interviews to  identify the options for assistance considered by Federal Reserve System  officials. We followed up with Federal Reserve System officials to  understand their rationale for selecting the as-adopted ML III vehicle. To  determine the extent to which FRBNY pursued concessions from the  counterparties, we interviewed Federal Reserve Board and FRBNY  officials and 14 of the 16 counterparties that participated in ML III. Bank of  America and Merrill Lynch were unable to provide information on the  concession issue.
To examine the extent to which key actions taken were consistent with  relevant law or policy, we reviewed AIG-related documents indicated  earlier to identify key actions taken. More specifically, to understand the  Federal Reserve Board’s authority to provide emergency assistance to  nondepository institutions and related documentation issues, we reviewed  legislation including the Federal Reserve Act of 1913, as amended, and  the Dodd-Frank Wall Street Reform and Consumer Protection Act of  2010. We interviewed Federal Reserve Board officials to obtain their  interpretation of the Federal Reserve Board’s authority. Further, to  determine FRBNY’s involvement in AIG’s securities disclosures on the  federal assistance, we reviewed relevant SEC records and interviewed  SEC officials. Relevant documents we reviewed included e-mails,  memorandums, disclosure filings, regulations and procedures, and  material connected with AIG’s request for confidential treatment of ML III- related information. Finally, to evaluate the effectiveness of FRBNY  policies and practices for managing conflicts of interest involving the firms  that provided services to FRBNY, we reviewed FRBNY vendor  agreements and FRBNY’s Operating Bulletin 10, which address  procurement issues, as well as FRBNY’s employee Code of Conduct. We  also reviewed documentation of on-site reviews of advisor and vendor  firms and obtained documentation related to waivers granted to the firms.
To determine relations among companies involved with ML III, we  obtained and analyzed equity stock holdings data for the firms. We  conducted interviews with a number of the parties indicated earlier—in  particular, with Federal Reserve Board officials, FRBNY officials and  advisors, SEC officials, a representative of the SEC Inspector General’s  office, AIG executives, AIG counterparties, and academic experts.
To examine criteria used to determine the terms for key assistance  provided to AIG, we reviewed AIG-related documents indicated earlier, to  understand the nature of the assistance and the terms. We compared the  terms of a contemplated private-sector loan syndication deal with the  original terms for FRBNY’s Revolving Credit Facility, and we also  discussed differences between the two sets of terms with FRBNY  officials. To review AIG’s treatment of various creditors and other  significant parties after receiving federal assistance, we reviewed the  FRBNY credit agreement, as amended, to understand the restrictions that  were applied to AIG. To obtain information on FRBNY’s involvement in  AIG’s decisions on meeting obligations and making investments, we  conducted interviews with FRBNY officials, AIG executives, and those  involved in AIG-supported real estate development projects.
To identify lessons learned from AIG assistance, we relied generally on  our analysis of information obtained from all the sources cited earlier and  comments obtained from a number of interview subjects. We inquired  generally about what the process of providing assistance to AIG might  suggest for any future government interventions, as well as specifically  about such matters as reducing time pressure in critical decision making  and improving analytical insights into conditions at individual financial  institutions and in financial markets at large.
We conducted this performance audit from March 2010 to September  2011 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Karen Tremba, Assistant  Director; Tania Calhoun; Daniel Kaneshiro; Marc Molino; Brian Phillips;  Christopher H. Schmitt; Jennifer Schwartz; Wade Strickland; and Gavin  Ugale made major contributions to this report.