The U.S. government takeover puts AIG effectively into conservatorship, similar to the action recently taken on the GSEs—the government will get a 79.9% equity stake in the company, dividends may be suspended, and senior management will be replaced. The Federal Reserve Bank of New York will extend a loan of $85 billion.
The U.S. government took another historical step last night in taking over the insurance giant, American International Group (AIG). The company was in dire straits and faced a liquidity crisis, as rating agencies downgraded AIG liabilities. The sheer size of AIG, with about $1 trillion in assets and liabilities at the end of 2007, with extensive and intricate financial linkages to domestic and overseas markets, dictated a different approach than the one taken for Lehman Brothers. According to the Federal Reserve statement, "A disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance."
The U.S. government will take a 79.9% stake in the company and previous shareholders will be effectively wiped out. The government is using a "conservatorship" option, similar to the one used for the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. The company will still operate as a going concern, with various assets and business units reviewed over time for possible disposition. But there will be no "fire sale" of assets.
As part of the takeover package, the Federal Reserve Bank of New York will lend up to $85 billion to AIG. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers. The AIG facility has a 24-month term and interest will accrue on the outstanding balance at a rate of three-month LIBOR plus 850 basis points. The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary nonregulated subsidiaries.
This takeover of AIG forestalls to some extent the recent dangerous escalation of the crisis in the U.S. financial markets—a crisis that has been seriously harming the performance of the economy for over a year now. Nevertheless, the risks to the country's financial system and the economy remain massive, and downward pressure on financial asset prices—and the value of their underlying collateral—continues to mount.
The economic backdrop to this latest explosion in the U.S. financial system is troubling—industrial production is on track to decline sharply in the third quarter (for the second consecutive quarter), consumption spending is expected to contract, and the unemployment rate is ramping up sharply. Perhaps even more troubling, credit conditions continued to tighten during the summer months, and the growth of credit has slowed down to recessionary levels. Major downside risks to the economy, with diminishing inflation risks, are plain for anyone who has eyes to see.
