A Positive Trend for the Fed’s Exposure to AIG
One of the key arrangements used to avoid the bankruptcy of American International Group (AIG) in the fall of 2008 was the creation of two special purpose vehicles (SPVs) named Maiden Lane II and Maiden Lane III. SPVs are legal entities whose operations are limited to the acquisition and financing of specific assets. More precisely, they are subsidiary companies with an asset/liability structure and legal status that makes their obligations secure even if the parent company goes bankrupt. Of course, if the assets are not valued correctly, the SPVs may not be able to pay off any creditors. In the case of Maiden Lane II and III, the creditor is the Federal Reserve Bank of New York, which made the loans that were used to purchase assets from AIG subsidiaries and counterparties.
Currently, the estimated values of those assets exceed the amounts of the respective loans that were extended, and the difference for both Maiden Lane portfolios grew further recently after the assets were revalued according to third-quarter fair-market estimates. Interestingly, asset revaluations in conjunction with the cash flowing in from the assets have been sufficient to maintain both a steady pay down of the loans and a steady if not rising value of the portfolio. Because the New York Fed will share in any profits remaining after the loans are paid in full, the prospects for a positive return on its investment look very good at this point.
Predicting the future value of the Maiden Lane portfolios requires an understanding of how the SPVs are structured. A little history might help with that. AIG was one of the hardest hit financial institutions when housing markets collapsed in 2008. In addition to holding housing-related securities, which were rapidly declining in value, AIG’s financial products unit had written insurance on those same types of securities. Inadequate capital reserves and the freezing of funding markets combined to push AIG to a precipice, and the Treasury and the Federal Reserve extended a series of aid packages to the company.
The two Maiden Lanes were created in November 2008 as part of a restructuring of the original assistance granted to AIG through the Federal Reserve Bank of New York. Maiden Lane II was formed to provide adequate liquidity to AIG subsidiaries. Those subsidiaries had borrowed to purchase securities, and by doing so had exposed themselves to the risk that their investments would fall in value. When the loans were set to be repaid and the investments had fallen in value, the subsidiaries needed to make up the difference between the amount they’d been loaned and their weakened investment. To ease these liquidity pressures, Maiden Lane II purchased the residential mortgage-backed securities (RMBS) investments from the subsidiaries.
The aim of Maiden Lane III was to help ease liquidity concerns for the Financial Products unit of AIG (AIGFP), which were associated with collateral demands on credit default swaps (CDS) that AIGFP had sold to investors. As the value of collateralized debt obligations (CDO) fell, AIGFP was required by the CDS contract to post collateral to their counterparties. The lower the value of the CDOs, the more AIGFP had to hand over. Maiden Lane III was used to purchase the CDOs for which the insurance was written, and as part of the transaction, AIGFP’s counterparties agreed to nullify their insurance contracts.
The Federal Reserve could not buy the RMBSs or CDOs directly because of statutory restrictions on the types of securities it is allowed to buy and the institutions to which it is allowed to lend. According the Federal Reserve Act, the Fed may only conduct open market operations (which means purchase or sell securities) with Treasury debt or securities that have the backing of a government agency. The securities in question were neither of those types. To remedy this situation, the Federal Reserve referred to Section 13(3) of the same Act, by which the Fed could lend to any financial institution in unusual and exigent circumstances. With this alternative available, the special purpose vehicles (SPVs) of Maiden Lane II and Maiden Lane III were created so that the Fed could make loans to those institutions. The Maiden Lanes are off-balance sheet institutions, in this case limited liability companies, with a loose affiliation to the New York Fed, their parent institution.
The structure of the loans to the SPVs was designed so that the value of the portfolios acquired by the Maiden Lanes could be maximized by a hired portfolio manager. Maiden Lane II received a six-year loan from the New York Fed for $19.5 billion to purchase RMBS with a fair market value of $20.8 billion from AIG subsidiaries. According to the agreement, proceeds between the time of the agreement and the time of the transaction made up for $0.3 billion of the difference, and the remaining $1 billion was deferred by the subsidiaries until the loan was repaid. Maiden Lane III received a six-year loan for $24.3 billion so that it could purchase CDOs with a fair market value of $29.6 billion from counterparties to AIGFP. Again, proceeds from the securities to the counterparties accounted for $0.3 billion of the difference as well as a $5 billion equity contribution from AIG. In both cases, the Maiden Lane vehicles purchased the securities at well-below par value, which happened to be $39.3 billion for Maiden Lane II and $62.1 billion for Maiden Lane III.
Estimates of the current net portfolio value can be inferred from the terms of the loan. The value of the Maiden Lane II portfolio sits at $16.47 billion, $13.45 billion of which is the remainder of the outstanding loan. On top of that is accrued interest, payable to the New York Fed in the value of $421 million, and then $1.065 billion in deferred payments and interest for AIG subsidiaries. Outside of some small management fees, the red and brown sections of the chart below illustrate potential profits for both the New York Fed and AIG subsidiaries. As of this writing, the New York Fed stands to gain almost $1.3 billion from its Maiden Lane II investment.
Similarly, the Maiden Lane III portfolio is now worth $23.53 billion. The outstanding balance on the loan from the New York Fed is about $14.3 billion, accrued interest for the New York Fed is $513 million, and another $5.335 billion is owed to AIG for its equity share and interest payments. That leaves $3.4 billion for the New York Fed and AIG to split in profits, with $2.3 of that amount scheduled to be distributed to the New York Fed.
These profit numbers are only approximations, though, and will be subject to future variations in asset values. Profits for the portfolios rest on the performance and profitability of the underlying RMBS and CDOs of the two vehicles. Over the course of the past year, the values have risen fairly steadily and increased after each quarterly revaluation. But these values are a product of the streams of payments that the securities provide, which could decline in the event of an increase in delinquencies, foreclosures, or prepayments. With mortgage rates and home values dropping or leveling off, these portfolios could struggle. It is also worthy of note that there are still four years left for these loans to be repaid, leaving plenty of time for the portfolios to fluctuate in positive and negative directions. While the results may look promising now, the portfolios should be viewed as a longer-term investment, even in the midst of a larger exit plan taking shape this winter.