WASHINGTON BUREAU — Federal Reserve System officials started out underestimating the cost of bailing out American International Group Inc., according to the Office of the Special Inspector for the Troubled Asset Relief Program.

Because of the miscalculations made back in September 2008, and because the Fed acted more as a source of financing for AIG, New York, (NYSE:AIG) than as a regulator, the Fed wound up paying more than it should have to close out the collateralized debt obligations underlying AIG’s credit default swaps portfolio, SIGTARP officials conclude in a new report.

The Fed provided AIG with access to more than $85 billion Sept. 17, 2008, in exchange for 79.9% of the company’s stock.

One obstacle that kept the Fed from getting the Sept. 17 deal done quickly was a private deal that AIG negotiated with J.P. Morgan Chase & Company, New York.

AIG accepted a J.P. Morgan offer for a deal that called for AIG to pay an 11% interest rate on a $75 billion loan. When that deal fell through, the Fed inherited it and added another $10 billion to the total.

The Fed did not realize until later that the interest rate was punitive and that the deal would have to be renegotiated, SIGTARP officials write.

The government also underestimated “the enormous impact that rating agencies had on the AIG bailout,” officials write.

AIG’s AIG Financial Products unit sold $72 billion in CDOs to counterparties without holding the reserves that a regulated insurer would have had to maintain if it had written an equivalent amount of insurance coverage, officials write.

The AIG credit default swaps debacle indicates the importance of transparency when the government interacts with a private firm, officials write.

But Fed and Treasury Department officials believed that failing to bail out AIG “posed considerable risk to the entire financial system and would have significantly intensified an already severe financial crisis and contributed to a further worsening of global economic conditions,” officials write.

Fed and Treasury officials were mostly concerned about the impact on the American retirement system, “and determined that AIG’s failure would have a global retail impact,” notably on stable value funds and variable rate annuities, officials write.

To guarantee a minimum return, stable value fund issuers usually wrap the funds in insurance contracts. About $38 billion of stable value fund wrap contracts issued to more than 200 wrap contract counterparties would have been at risk if there had been no bailout, officials write.

The counterparties included trustees and investment managers of company retirement plans and 401(k) plans, including the biggest, best known mutual funds and the retirement plans of the biggest public companies.

In addition, institutional investors and money market funds would have taken a $20 billion hit if commercial paper issued by AIG had failed, officials write.

But the decision to bail out AIG as a company put constraints on what the Fed could do when it closed out the CDS counterparty deals, officials write.

“The Federal Reserve Bank of New York was confronted with a number of factors that it believed limited its ability to negotiate reductions in payments effectively, including a perceived lack of leverage over the counterparties because the threat of an AIG [failure] had already been removed by the FBNY’s prior assistance to AIG.”

In the fall of 2008, as the rating agencies were threatening to downgrade AIG and its CDS, counterparties were demanding high interest rates to keep the AIG CDS.

The New York Fed decided at that point that it had to buy out the CDS counterparties under terms favorable to the counterparties, SIGTARP officials write.

New York Fed loans to AIG, and moves to buy assets through special financing vehicles, “effectively transferred tens of billions of dollars of cash from the government to AIG counterparties even though senior policy makers contend that assistance to AIG’s counterparties was not a relevant consideration in fashioning the assistance to AIG,” SIGTARP officials write.

But the New York Fed believes that the government will ultimately be made whole despite the New York Fed’s weak bargaining position, officials write.

On Sept. 30, AIG’s loan balance was $19.3 billion, and the fair market value of the portfolio the Fed bought from AIG’s counterparties was $25.3 billion.

But, “while the FBNY may eventually be made whole on its loans to the [special financing vehicle], it is difficult to assess the true costs of the Fed’s actions until there is more clarity as to AIG’s ability to repay all of its assistance to the government,” officials write.

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For more information about the special purpose vehicles used to help unwind AIG transactions, see these articles: