Monday, September 15, 2008

AIG Hits for the Cycle: Downgraded by All Three Major Ratings Agencies in a Three Hour Span

Today was a big one on the richter scale. You don't get too many of these in your life, so I'm taking it all in while it is happening, painful as that may be. And the hits keep coming.

In addition to Lehman filing BK, the Dow dropping 500+ points (the S&P declined nearly 5%!), and Merrill being taken out for what was initially a 50+% premium and NOT f'ing BUDGING (it closed up $0.01 at $17.06) AIG is on the brink.

AIG is in real trouble. It is suffering from taking the wrong side of a massive, correlated bet on mortgage related assets (especially ABS CDOs) expressed via CDS. As these trades crater and create a hole in the middle of AIG's balance sheet, credit ratings agencies have threatened to downgrade AIG unless it raises funds to replenish that hole. AIG is letting on today that the size of its capital needs are somewhere between $40 billion and $75 billion. You know... pocket change.

The magnitude of AIG's potential capital shortfall combined with threat of downgrade of course has made the hole filling process much more difficult as the share price has cratered and credit spreads on AIG have launched out to distressed spreads. This has all but made raising capital via traditional means impossible. AIG is now contemplating selling some of its prized assets such as its aircraft leasing business, but a) comps are trading horribly (see ticker AYR) and b) it will take months to actually receive the cash from a sale that size.

So, AIG is in quite a bind. As a result, they asked the Fed for a $40-$50 billion loan, which it seems the Fed denied on the basis that AIG is not under the Fed's regulatory purview. AIG then managed to hoodwink the state of NY into allowing AIG to take its illiquid crap and use it as collateral to borrow $20 billion from its insurance subs. This is of course insanity as the policy holders are now being put at risk by a problem that has nothing to do with them or the entity with whom they have contracted (I smell.....lawsuits!). That of course does not solve anything as it just shuffles the losses around for a period of time. So, the Fed is apparently "encouraging" Goldman Sachs and JP Morgan to lead a consorsium in putting together a $70 billion (with a B) loan facility for AIG to tap (this of course is seperate and distinct from the cross collateralized $70 billion "Private Fed"/loan facility that 10 banks organized yesterday).

What I find just a remarkable "coincidence" about this new $70 billion facility is that it is being talked about a mere 24 hours after the Fed significantly expanded the acceptable collateral for its lending facilities. That expansion was of course a page A18 news event for the WSJ, basically lost in the commotion. However, the conspiracy theorist in me sees these two actions as highly connected. Basically, if JP Morgan and Goldman assemble this facility, my suspicion is they will take qualifying collateral from AIG, make a loan against that collateral at a modest spread to Fed borrowing rates, then take that collateral and post it to the Fed pocketing a largely risk free arb.

This of course is similar (though slightly different) to when the Fed allowed Bear to access it via JP Morgan as a conduit. The difference is a) the Bear deal was perfectly transparent; and b) JP Morgan didn't receive a spread, to the best of my knowledge.

Maybe I'm just seeing black helicopters, but it sure seems like a remarkable coincidence to me. This has Timothy Geithner's fingerprints all over it.

As an aside, I said when the Merrill deal was announced that this is the riskiest merger arb I've ever seen, so trading at a wide spread is perfectly rational. If somehow the MER/BAC deal breaks, Merrill is a zero and BAC may skyrocket. That's a dangerous deal to arb so the arbs are going to demand to get paid. The nearly $6 spread that exists today is a reflection of that. Ken Lewis today said that the break-up fee was "expensive" and intentionally so, but my guess is that he views the Merrill deal as a call option where the option price is the break-up fee. Probably a pretty rational approach, frankly.

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