Wednesday, 12 November 2008

That AIG bailout again

AIG wrote CDS protection to a bunch of banks. Spreads have blown out and AIG is not AAA, so they have to post collateral. They couldn't, so the FED lent it to them at Libor + 850. That was last month's story.

This month's story is a new bailout. Let's see if we can follow the story in the WSJ:
Many banks that previously bought protection from the insurer on securities backed by now-troubled mortgage assets stand to recoup the bulk of their investments under a plan by AIG and the Federal Reserve Bank of New York to buy around $70 billion of those securities via a new company. These securities are collateralized debt obligations backed by subprime-mortgage bonds, commercial-mortgage loans and other assets.

...

The banks also will sell the CDOs to the new facility at market prices averaging 50 cents on the dollar. The banks that participate will be compensated for the securities' par value in exchange for allowing AIG to unwind the credit-default swaps it wrote.
So the Journal is suggesting that the new facility will buy the securities and cancel the CDS AIG has written. Note that that does not just get the banks off AIG counterparty risk: it also frees up funding for the underlying assets. If eventual recoveries are greater than market prices predict, then the new entity at least gets to keep the difference. Still, it does seem a strange way to proceed. Even if you thought that it was important to ensure that the protection buyers did not lose - clearly a key feature of the bailout - why would you buy the underlyings rather than simply loan AIG money to meet collateral calls and recapitalise them if necessary?

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