AIG reports surprising Q2 profit
Here’s something I didn’t expect at all: AIG reported a surprising Q2 profit of $2.30 per share. The international insurance corporation has been tanking lately, and had to be bailed out for about US$180 bn, the largest of any Wall St financial corporation. Now that US$180 bn is quoted by the press quite often, but a closer examination finds that AIG owes only about US$70 bn at most. How is this possible? I wasn’t aware of this until I checked the details. ProPublica explained as follows:
The government hasn’t handed over the full $180 billion because AIG has yet to fully tap two “lines of credit,” which are like credit cards with really, really big credit limits. One line of credit is from Treasury (with a $30 billion limit) and the other is from the Fed ($60 billion). The company has drawn only $1.5 billion from the Treasury, and $43.5 billion from the Fed, for a subtotal of $45 billion.
Take away the money in the credit line AIG has yet to tap, and you’re left with the total government outlay of $134 billion. But AIG does not actually have to repay all that. Instead it would have to shell out $85 billion, smaller because it excludes two large purchases by the Federal Reserve of toxic assets that were crippling AIG. The Federal Reserve (through a specially created legal entity) owns those assets outright.
So, what about that $85 billion? That’s composed of $40 billion in taxpayer dollars the Treasury Department used to buy preferred shares in AIG, plus money AIG has drawn from the two credit lines: $1.5 billion more from the Treasury and $43.5 billion from the Fed.
AIG recently announced one way to cut down on what it owes the Fed: by giving the Fed a $25 billion stake in two of its crown jewel subsidiaries. According to an AIG spokeswoman, Christina Pretto, the deal, announced last month, would reduce the company’s outstanding debt with the Fed from $43.5 billion down to less than $18 billion.
If that deal were to go through, AIG’s total debt would fall to about $59 billion, a much smaller sum than is typically used to describe AIG’s troubles. That’s not to minimize the complexity of AIG’s entanglement with the government, which in addition to all these billions has also received a nearly 80 percent equity stake in AIG. But we hope that provides some clarity on the true extent of the AIG bailout — at least the bailout so far.
Despite that, a debt of US$70 bn, however it may be owed still outstrips all other Wall Street firms. Now of course the question we’re all interested is: how exactly did AIG make its profits? Despite declining premiums, most of its profits were due to an appreciation of the same financial instruments which brought about its downfall, credit default swaps:
Total revenue rose 48 percent, to $29.53 billion from $19.93 billion a year earlier. However, premiums fell during the quarter.
The company said its profit was driven by the stabilizing value of some of its riskier investments, including in its AIG Financial Products Corp. portfolio, the much-maligned division responsible for many of the transactions that prompted the government bailout last fall.
AIG’s near-collapse last fall was because of risky contracts such as credit default swaps, which act as insurance to protect an investor against default on an investment such as a mortgage-backed security. The financial-products division was able to increase the value of remaining swaps on its books by $636 million during the quarter, thanks to improving credit markets. In the second quarter of 2008, AIG cut the value of those holdings by $5.57 billion.
If there’s anyone AIG should thank, it’s Bernanke. The Fed Chairman spearheaded an activist Fed (which ironically has the name “Reserve”) in easing credit flow in the formerly frozen markets. That doesn’t mean the worst of AIG’s troubles are over though. As Lucky pointed out to me earlier, AIG’s toxic assets namely the derivatives on securities such as the MBS’s (whose value plummeted when housing prices fell and mortgage payers defaulted) still remains on its balance sheets, except that they are now “less toxic” compared to before.
Apart from Bernanke, AIG also has the Treasury to thank. Lower insurance premiums and reduced underwriting fees helped make the ailing insurance giant more competitive in the markets:
It may be premature to discuss the terms of TARP repayment, but if AIG ever seeks to repay its government debt, it might be a good time to start thinking of how best to value its warrants held by the Treasury. Unlike Goldman Sachs, which I wrote about earlier, a huge veil of mystery surrounds AIG’s financial derivatives contracts. For one thing, not all its contracts are based in the US. A substantial amount (valued at US$200 bn) are held in European banks:
European banks including Societe Generale SA and BNP Paribas SA hold almost $200 billion in guarantees sold by New York-based AIG allowing the lenders to reduce the capital required for loss reserves. The firms may keep the contracts to hedge against declining assets rather than canceling them as AIG said it expects the banks to do, according to David Havens, managing director at investment bank Hexagon Securities LLC.
Some would point out that the US$200 bn worth of derivatives refer only to the notional value of the swaps. In other words, that’s the maximum amount AIG would have to pay to its counter-parties in the extremely unlikely event all the insured mortgages and corporate loans default and are valued worthless. Still the fact that most of these swaps were long term mean that any valuation of AIG’s warrants would involve some estimation of their long-term values:
The average weighted length of the European swaps protecting residential loans is more than 25 years, while the span tied to corporate loans is about 6 years, AIG said in a regulatory filing. Contracts covering corporate loans in the Netherlands extend almost 45 years, and the swaps on mortgages in Denmark, France and Germany mature in more than 30 years.
A more interesting consideration one might think is whether the federal government’s decision to honour AIG’s counterparties at 100 cents to the dollar might have induced these banks to not want to cancel those contracts, thereby creating a moral hazard for AIG’s counter-parties to take risks knowing full well that the Treasury would back up its contracts:
“For counterparties to voluntarily terminate those contracts makes no sense,” Havens said in an interview. “There’s no question that asset values have soured on a global basis. With the faith and credit of the U.S. government backing those guarantees, why would they give that up?”
Still it’s not likely that we should expect the federal authorities to continue backing AIG until all existing CDS terminates or expires. AIG is currently 80% owned by the public. Once that number comes down to a more manageable level like Citi’s, we should be seeing the feds step back to allow Adam Smith’s invisible hand to works its magic.