Tuesday, December 1, 2009

As a Result of AIG, Is The Fed on the Hook to Bailout the World?

Sometimes you learn the damnedest things by reading footnotes. Marla Singer and Geoffrey Batt over at ZeroHedge have been reading the Office of the Special Inspector General for the Troubled Asset Relief Program's (SIGTARP's) November 17, 2009 report "Factors Affecting Efforts to Limit Payments to AIG Counterparties" (Pdf).

They found some pretty interesting footnotes that might prompt a question or two for Ben Bernanke at his Senate reconfirmation hearing, scheduled for Thursday.

This is how Singer and Batt lead off:
Buried in the depths of page 26 of the Office of the Special Inspector General for the Troubled Asset Relief Program's (SIGTARP's) November 17, 2009 report "Factors Affecting Efforts to Limit Payments to AIG Counterparties" hidden in footnotes 33 and 34 is something of a mystery. It might be the beginning of an interconnected financial chain involving Dubai, the Federal Reserve, AIG, Basel I, Eastern Europe and even Switzerland and which, even if it doesn't worry you, probably should. Or it might be nothing at all.
They conclude with a number of questions:

...AIG is still on the hook- and hadn't planned to be.

This raises a number of questions:

If the European banks that bought swap protection from AIG are still relying on this protection to meet their capital requirements, and AIG might be unable to make good on the agreements, are these banks actually out of Basel I compliance as we type this?

Are the banks still able to use swap protection to reduce their collateral requirements because of the implicit or explicit backing of AIG by the Federal Reserve?

If this situation existed in September-November 2008, as it certainly appears to have, how exactly can the Federal Reserve claim in good faith that it lacked the leverage to negotiate with these banks from a position of strength? (One assumes that many of the same names collecting payment from AIG were also AIG swap protection buyers of the sort mentioned in the SIGTARP report). Failure to back up an insolvent AIG would have resulted in near-immediate Basel I non-compliance as the protection offered by these swaps, and on which these banks depended for their reduced capital requirements, evaporated- a near death sentence.

Or had these banks somehow, and in the middle of the credit crisis, managed to boost their capital to levels that made the swaps unimportant?

If so, why keep them on the books now, instead of unwinding them?
Since it doesn't seem likely that a teetering AIG could make good on these agreements without substantial assistance is the Fed is currently the ultimate backstop for AIG?

Does this mean that the Fed is effectively underwriting these swap agreements?
Will the Fed post collateral if deteriorating credit conditions at AIG (today's -$11 billion news suddenly seems especially daunting if the potential insurance shortfall has an effect on credit ratings) or general credit market issues require it? Or are we missing something significant? By September 30, 2008 AIG had already posted $974 million in collateral for its "Foreign Regulatory Capital" portfolio.

What if European banks are hit with more losses from, oh, we don't know, say... Dubai? Deleveraging, risk reduction and credit tightening would have an effect on LIBOR, the Eurobond market and, of course, Eastern Europe. Might not that sort of contagion easily spread to, say, Switzerland, which enjoyed the other side of the carry trade for years by lending Swiss Franc like mad to any Eastern European mortgage borrower who could sign documents?

Could it be that the Fed, once again, might have to bail out the world?
Or maybe we are just missing something obvious

You can read the full Singer-Batt analysis, including the smoking footnotes, here.

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