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AIG: Implications of the rescue package
A USD 85 billion loan from the Fed has averted the immediate sale of a near-defunct AIG, the leading insurer of the world. But this may give a wrong signal – that companies which mismanage their business will be rescued by the US government.

THE FEDERAL Reserve has finally agreed to give USD 85 billion of loan to the near-defunct and largest insurer in the world, viz, AIG. This act has provided enormous relief to the financial markets of the world. Still one does not know what awaits the ill-fated institution. The Fed move to give loan to the ailing institution comes at a price – it involves the transfer of 79.9 per cent of the company’s stake to the government and the loss of the CEO, Robert Willumstad’s job.

While announcing the bailout package in the late hours of Tuesday (Wednesday morning in India) the board of the Fed maintained that a "disorderly failure of AIG" could add to financial market fragility, lead to "substantially high borrowing costs" and erode household wealth and economic performance. Though AIG claimed that it was a solid company with over USD one trillion in assets and substantial equity, its shares had tumbled on the American exchanges by a whopping 94 per cent. AIG shares, ruling at USD 56.30 each on January 2, closed at USD 3.75 per share on September 16.

Though the Federal Reserve loan has averted the immediate sale of the assets of AIG which otherwise would have been sold at throwaway prices resulting in the company’s liquidation, repaying the two-year loan carrying an interest rate of LIBOR+8.5 percentage points will be a Herculean task for the company. Even then, asset liquidation will most likely be the only way out for AIG to repay the humongous Fed loan. Assets of AIG in American General Finance and in the aircraft leasing unit, the International Lease Finance Corp may be used to repay the Fed loan. It means AIG may not be as large and as solvent as it is now. Nevertheless, it has been widely accepted that the Fed action has avoided an estimated industry loss of over USD 180 billion had AIG been allowed to collapse.

But the question is what prevented the US government from rescuing Lehman Brothers given that the cost of the bailout (approximately USD 60 billion) would have been lower? It may be recalled that a week earlier the US government, under the aegis of its Treasury Department, had nationalised the largest mortgage writer / bond issuer of the US, Freddie Mac and Fannie Mae (F&F). It cost it USD 200 billion. The two institutions had been enmeshed in a liquidity crunch. Earlier this March, Fed lent USD 29 billion to Bear Stearns which was sold to JP Morgan Chase.

Probably the US government was convinced that the fall of Lehman Brothers would not pose a serious threat to the world of finance even though Lehman was a top-ten counterparty in the credit default swap contracts with a notional value of USD 800 billion. Thanks to intense lobbying on the part of the three rescued companies, viz., F&F and AIG, in tandem with the media, they were able to project their impending demise convincingly by explaining that it was a potential systemic risk which could devour several such inter-related organisations spread across the various geographies.

The fall of Lehman Brothers, it was said, would only have a domino effect while a possible AIG collapse would have been more catastrophic. It would have triggered problems in the USD 62 trillion credit default swap market. Credit default swaps are contracts which seek to protect bond-holders against default on the part of the seller. The seller of credit default swaps (like AIG) pays the buyer of the swap the face value of the bond in exchange for the underlying securities or its cash equivalent, should the issuer fail to honour the debt agreement.

Fed’s bailout package to such an ailing player implies that a safety net is available even if the player bets wrong in the market and hence may induce uncontrolled behaviour on the part of other players / financial institutions. When investors assume that government will take over the losses of such players, the result is a higher-than-socially-desirable volume of funds flowing into these players. This thinking would mean that the upside goes to the player and its shareholders and the government supposedly contends itself with the downside risk. This poses a higher level of risk than makes economic sense.

Meanwhile, as it always happens when America sneezes, the rest of the world caught a cold. The virus of financial turmoil has already spread to other countries. News that the leading mortgage lender of UK, HBOS, is in the process of being sold to TSB Bank of UK, confirms this. The impact of Lehman’s fall, the sale of Merrill Lynch and finally the bailout package for AIG have been felt worldwide. Market indices of several countries are yet to come out of the blues inflicted by this financial tsunami. Trading on the indices of Russia was stopped for the second day on Thursday – no thanks to an unprecedented fall in its index, viz., Micex, by more than 25 per cent in the last two days. Back home, our indices closed on Wednesday, registering a fall of around 1.89 per cent. It is rightly said that misfortunes never come single.

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