A recent report from the Government Accountability Office (“GAO”) illuminates both the structure of the government bailout of AIG and the financial condition of the company. The September 2009 report, “Status of Government Assistance Provided to AIG,” is available here. As is by now familiar, the federal government holds nearly an 80 percent interest in AIG.  Pursuant to the Troubled Asset Relief Program (“TARP”), codified at 12 U.S.C. §§ 5201 et seq., the GAO monitors and reports on the Department of Treasury’s assistant to AIG—the largest participant in TARP, and currently the sole participant in TARP’s Systemically Significant Failing Institutions Program. The September 2009 report relates the results of the performance audit conducted by the GAO from March 2009 to September 2009.

The GAO reports that as of June 30, 2009, AIG had assets of approximately $830 billion and $50 billion in revenues for the six preceding months, and AIG and its subsidiaries had 106,000 employees (shedding 10,000 employees over the first half of this year). GAO-09-975 at 5. AIG remains the largest domestic life insurer and the second-largest domestic and property/casualty insurer in the U.S. Id. The report provides a fascinating schematic of AIG’s Byzantine organizational structure. Id. at 6-7. 

The GAO relates that AIG’s liquidity problems in 2008 owed to two circumstances. First, AIG Financial Products Corporation (“AIGFP”) was a prominent participant in the derivatives market, holding $15 billion of outstanding commercial paper and $447 billion of collateralized debt obligations (“CDOs”). Second, AIG maintained a large securities lending program that was operated by its insurance subsidiaries, primarily the life insurance companies, pursuant to which the companies loaned securities in return for cash collateral that was in turn invested in residential mortgage-backed securities. Id. 

From July 2008 through early September 2008, AIG faced increasing pressure on its liquidity following a downgrade in its credit ratings in May 2008, due in part to losses from its securities lending program. The deterioration in its financial condition was the product of declines in its securities lending reinvestment portfolio and the declining values of CDOs, against which AIGFP had written credit default swap protection. These conditions stemmed from the downward spiral of mortgage-backed securities that began in 2007. In July and August 2008, AIG was compelled to use an estimated $9.3 billion of its cash reserve to repay securities-lending counterparties that terminated existing agreements and to post additional collateral required by the trading counterparties of AIGFP. Id. at 12. 

The GAO further relates that AIG was unsuccessful in its attempts to raise additional capital in the private markets in September 2008. Id. As a result, on September 15, 2008, the rating agencies downgraded AIG’s debt rating, which in turn created a need for an additional $20 billion to fund its added collateral demands and transaction on termination payments. In consequence, AIG’s share price fell from $22.76 on September 8 to $4.76 per share on September 15. In response, the report relates that insurance regulators prohibited AIG’s insurance subsidiaries to lend funds to the parent companies under a revolving-credit facility and demanded that any outstanding loans be repaid and that the facility be terminated. Id. at 11-12.

The GAO recites the contingencies that informed the Federal Reserve’s decision to provide assistance to AIG. First, the Federal Reserve was concerned that the disorderly failure of AIG would have further undermined business and investor confidence. Id. at 19. Second, AIG’s default on its obligations to trading counterparties could have seriously disrupted the ability of the financial system to operate effectively through its counterparty relationships with important market participants. Id. at 20. Third, the failure of AIGFP could have led to billions of dollars of losses at bank counterparties that bought CDS contracts from AIG. Id. at  22.

Animated by these concerns about the systemic risks posed by AIG’s failure, the Federal Reserve and Department of Treasury agreed to make in excess of $182 billion of federal assistance available to AIG. The government also has made investments in AIG to stabilize its capital position. Id. p. 27. On November 10, 2008, the Department of Treasury purchased $40 billion of AIG preferred shares. Id. at 34. What is more, the GAO reports that on April 17, 2009, the Department of Treasury provided AIG with a $29.835 billion Equity Capital Facility and AIG in turn issued to the Department 300,000 shares of fixed-rate, noncumulative perpetual preferred stock and a warrant to purchase an additional 3,000 shares of AIG common stock. Id. at 35.

As collateral for its assistance, the Federal Reserve Bank of New York (“FRBNY”) has drafted credit agreements that impose certain conditions to secure the loans. AIG has pledged a portion of its assets, including its ownership interest in its domestic and foreign insurance subsidiaries as collateral on the Revolving Credit Facility. Id. p. 36. The GAO cautions that AIG’s ability to divest its assets to make repayment “relies heavily on conditions in financial markets.” Id. at 36.

The GAO report describes the extensive involvement of the government in AIG’s management and corporate governance. FRBNY representatives attend all AIG Board of Directors meetings as observers and monitors AIG’s operations. Id. at 37. As a condition of its initial $85 billion credit facility, the Federal Reserve established a trust for the sole benefit of the United States Treasury through which the government became the majority equity investor in AIG. Id. Following the execution of the trust agreement in January 2009, the government’s stock was convertible into approximately 77.9 percent of the issued and outstanding shares of common stock of AIG. Id. at 38. The GAO notes that the Trust “is intended to prevent inherent conflicts of interest that could arise from direct government or Federal Reserve control of AIG.” Id.

The FRBNY loan agreement precludes AIG from incurring additional debt, paying dividends, and making capital expenditures without the approval of FRBNY. Id. at 39. What is more, as part of its equity investments, the Department of Treasury requires that if AIG does not pay dividends due for four dividend periods, which need not be consecutive, the Department has the right to directly elect the greater of two directors or a number of directors equal to 20 percent of the total number of directors to the AIG Board of Directors. Id. at 39. The GAO reports that as of September 2009, AIG had not declared and paid the three scheduled dividend payments since the inception of the preferred equity investments. Id. AIG is further obligated to pay dividends of 10 percent per annum on Treasury’s cumulative share investment. Id. at 40.

The GAO remarks that The Federal Reserve and Treasury “carry significant exposure as a result of the assistance to AIG.” Id. at 42. “The ongoing potential of systemic risk remains a concern until AIG is restructured and market conditions improve.” AIG’s repayment of its government assistance “depends heavily on AIG’s ability to successfully divest assets.” Id. at 42.

The GAO does provide some positive news. The agency reports that AIG’s property and casualty companies have maintained levels of adjusted capital in excess of requirements with virtually no direct federal assistance. Id. at 48. These companies are expected to constitute AIG’s core business after the company restructures and divests its other operations. Id. The GAO cautions that the “sustainability of any positive trends of AIG’s operations and repayment efforts is not yet clear.” Id. at 51. “The government’s ability to recoup the federal assistance money depends on the long-term health of AIG, its sale of certain businesses, and the maturation or sale of assets…” Id.

Given the extent of the government’s ownership of AIG, it is of interest that the New York Times reports that AIG “has morphed into a playground for speculators.” Susan Pulliam and Tom Lauricella, Traders Seek Fortune in AIG, a Stock Once Left for Dead, NY Times, Sept. 23, 2009. The Times reports that AIG has become the focus of speculative traders. Over the past two months, the price of AIG’s common shares has wildly oscillated between $13 and $55. Id.

AIG has taken measures to increase the value of the remaining 20 percent of the company’s equity. On July 1, 2009, AIG implemented a “reverse stock split,” in which 20 shares became one. Id. The Times reports that this conversion effected an increase in the company’s share price from $1.16 to roughly $20 a share. Over the past two months, the trading volume in AIG shares has “soared amid speculative trading.” Id. 

Amid these developments, AIG’s former CEO, Maurice Greenberg, has presented a proposal to the House Oversight and Government Reform Committee to restructure the government’s assistance to AIG. David Denoit and Jessica Holzer, Greenberg Pitches AIG Rescue Revamp, Wall St. J., Sept. 21, 2009. The Journal reports that Greenberg’s proposal entails reducing the government’s ownership of AIG to 20 percent, a reduction of the interest rates AIG pays to the Federal Reserve and the Department of Treasury, and an extension of the term of the loan. Greenberg’s proposal is intended to ensure that AIG would not be compelled to conduct a “fire sale” of its assets. Id.

As part of its restructuring, AIG announced today the sale of its Taiwan life insurance unit to a Hong Kong investor group for $2.15 billion. Bettina Wassener, A.I.G. Sells Taiwan Unit for $2.15 Billion, NY Times, Oct. 14, 2009. 

It is also of note that AIG has benefited from a quiet hurricane season. The 2009 hurricane season has yielded a single U.S. hurricane, Tropical Storm Claudette, which struck Florida last month. Jame McGee, Berkshire AIG Benefits from Absence of Atlantic Hurricanes, Bloomberg.com, Sept. 30, 2009. This development will boost AIG’s third-quarter earnings. In 2008, AIG paid $12.5 billion in claims resulting from Hurricane Ike. Id. Thus, AIG “is expected to report operating earnings of 24 cents a share, compared with a loss of $68.40 a share in the year-earlier.” Id. 

As with so much of the news involving AIG and the insurance industry, the unusually tranquil hurricane season is a mixed blessing. A decrease in hurricane claims will likely reduce insurers’ ability to increase prices. Indeed, insurance rates may fall as much as 10 percent when companies renew their insurance agreements in 2010. Id.