Revised AIG Terms Begin Treasury Transfusions to 'Zombie' Firms

By Craig Torres

Nov. 11 (Bloomberg) -- The revised bailout of American International Group Inc. marks a new phase in the government's effort to shore up financial markets: It's the first time cash from the rescue fund Congress created last month has been committed to a failing company.

The Federal Reserve, which saved the insurer from collapse two months ago with an $85 billion loan, yesterday reduced that loan and offered lower rates, while the Treasury chipped in $40 billion from its bank-rescue fund to buy preferred shares. The new terms represent a departure for Secretary Henry Paulson, who until now has said he only wants to invest Treasury funds in ``healthy'' firms.

Taxpayers are ``keeping the zombie alive,'' said Robert Eisenbeis, chief monetary economist at hedge fund Cumberland Advisors and former director of research at the Atlanta Fed. ``We keep getting deeper and deeper into these holes.''

The shift is likely to vastly expand political demands for saving dying companies in the name of financial or economic stability. The administration of President-elect Barack Obama may soon have to consider credit or capital injections for other insurers, automakers, even retailers as the U.S. slides deeper into what could be the worst recession in a quarter-century.

``Are you going to do General Motors and Ford, and, if you do those, are going to go on and do retailers?'' said William Isaac, former chairman of the Federal Deposit Insurance Corp. and now chairman of the Secura Group LLC. `` Where does it stop? That is a very difficult decision we are going to face as a country.''

AIG's Losses

With the new bailout plan, the Treasury is conceding the initial rescue wasn't sufficient. It's investing funds from the so-called Troubled Asset Relief Program created by Congress to purchase preferred shares in a company that lost $24.5 billion in the third quarter, its fourth straight unprofitable quarter. Losses in the past year wiped out profit from 14 previous quarters.

In addition to the Treasury's purchase of preferred stock, the Fed will lend AIG $60 billion, and create two new emergency loan units to finance up to $52.5 billion of the company's securities. Between loans and the capital injection, the government's $152.5 billion commitment is almost double the Fed's initial $85 billion loan.

The security of the government's collateral, the assets of the company itself, is likely improving because the Fed is removing distressed securities from the company's balance sheet and the government is now a direct stakeholder.

`Changed Course'

``The way the loan was structured previously would have led to a liquidation of AIG, whether intended or not,'' said Dino Kos, a managing director at Portales Partners LLC, New York. ``Obviously, they have changed course.''

The New York Fed gave the original loan in September to prevent widespread default against AIG creditors in the same week that Lehman Brothers Holdings Inc. collapsed.

In a statement yesterday, the Fed said the revised terms ``establish a more durable capital structure and resolve liquidity issues,'' as well as ``protect the interests of the U.S. government and taxpayers.''

The Treasury, in a separate statement, called AIG a ``systemically important company.'' The insurer guaranteed about $372 billion of fixed-income investments as of Sept. 30.

Stability

``This action was necessary to maintain the stability of our financial system,'' Neel Kashkari, the interim assistant secretary who heads the Treasury's office overseeing the bailout, said yesterday at a Securities Industry and Financial Markets Association conference in New York.

Vincent Reinhart, resident scholar at the American Enterprise Institute and former director of the Monetary Affairs Division at the Fed Board, said yesterday's expansion of the AIG bailout shows that ``no one knows the general principles'' behind the Treasury's trouble-assets program.

First, Treasury said it would buy distressed assets. Then it began injecting capital directly into banks, and now, with AIG, into troubled financial institutions.

``Now we are outside solvent institutions. If you don't have a design principle it is very difficult to draw lines,'' Reinhart said. When the Obama administration takes over the Treasury, the new leaders ``can increase the size of these programs and the scope, and say we are only following logically the Paulson plan.''

Automakers

Democratic congressional leaders urged Paulson in a Nov. 8 letter to use the rescue funds to lend to automakers, a sign that the package's scope may be broadened further. Senator Carl Levin, Democrat of Michigan, said in an interview he believes the Treasury has the authority to use the bailout funds for that purpose. That could be made explicit by adding language to an economic-stimulus bill that will be considered when Congress returns next week for a post-election lame-duck session, he said.

Shares of General Motors Corp. fell 23 percent yesterday after a Deutsche Bank AG analyst said the stock may be worthless in a year.

The revised terms for AIG reduce the interest rate on the $60 billion Fed loan to the three-month London interbank offered rate plus 3 percentage points, from a previous spread of 8.5 percentage points.

The Fed also invoked emergency authority to set up two new emergency loan facilities, one to fund the purchase of residential mortgage-backed securities from AIG's portfolio, and a second to finance the purchase of hybrid credits that AIG wrote default insurance contracts against. In effect, the Fed is taking a direct role in unwinding a troubled insurance business of AIG.

The capital injection into AIG will come from a $100 billion pool authorized by Congress for Treasury to use at its discretion, rather than the $250 billion allocated to purchase stakes in the country's banks, a Treasury official said. The government will get a 10 percent dividend for its preferred shares in the insurer, the Treasury official said.

``The Fed and Treasury are saying there should be no penalty for bad performance,'' said Walker Todd, a former Cleveland Fed attorney who is now a senior research fellow at the American Institute for Economic Research in Great Barrington, Massachusetts. ``It creates the zombie finance phenomenon. The living dead keep on walking instead of taking a decent burial.''

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net;