The US Fed under Ben Bernanke has taken the unprecedented and controversial step of taking control of giant insurer AIG. What brought AIG to its knees and was Bernanke's move warranted? By Vivek Sharma

Early this week, the US Federal Reserve did something completely unprecedented and, until recently, almost unimaginable in free market economies. Chairman Ben Bernanke made an offer to the board of diectors of insurance company AIG, to acquire majority control in the insurer and extend a desperately needed credit line to help the company tide over a severe liquidity crisis.

The offer, which an AIG director reportedly described as onerous, was tilted completely in favour of the Fed and demanded the ouster of the current CEO. After deliberations, the AIG board accepted the offer. It didn't have much choice, the other option was to declare bankruptcy the next day.

Never before has a Fed chairman acted like the CEO of a vulture fund, swooping in to pick up companies in distress at garage sale valuations. That too an insurance company which is out of the Fed's purview and not a bank over which it has regulatory authority. The central bank having majority ownership of a commercial entity may not be very surprising in many countries, including India where the RBI owned our biggest bank SBI until recently. But in the US, such 'socialist' practices were unthinkable and nearly blasphemous.

But, these are extraordinary times and required extraordinary measures. Just like the AIG board, the Fed also didn't have much of a choice. The Fed determined that, "a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance". The choice was either bail out AIG or risk a complete financial meltdown.

What brought AIG down?

Now, AIG is not just another insurer. Since it was founded nearly a century ago, not in New York but in distant Shanghai, AIG has grown to become the second largest insurer in America and the world's biggest. With operations in over 130 countries and a customer base of 74 million worldwide, the company has a balance sheet size in excess of $1 trillion.

Like other insurers, AIG is mainly in the business of life, commercial and property insurance besides retirement products. There is no sudden increase in claims in any of these businesses, anywhere in the world. In fact, these business lines of AIG remain very healthy, are market leaders in many countries and hold much value. All those subsidiaries, like the joint ventures with Tata group in India, are well capitalised and can service all potential claims.

However, unlike most other insurers, AIG also had a business of insuring investors in bonds and credit derivatives against defaults. This business was under a separate division called AIG Financial Products or AFP and mostly issued derivative instruments called credit default swaps or CDS. Investors seeking risk protection bought CDS from issuers like AFP, which stood guarantee against any default by the issuer in case of a bond or retail borrower in case of a credit derivative like mortgage-backed securities.

CDS issuers like AIG enjoyed AAA credit ratings and hence the default risk on the insured securities was considered almost eliminated.

When defaults are low, CDS is a good business for issuers with healthy cash flows. As the popularity of derivatives like CDS increased, AIG expanded this business furiously and easily became the market leader. At the peak, AFP had underwritten bonds and credit derivatives worth nearly $500 billion.

Then the sub-prime crisis hit and defaults started rising. AIG started shelling out huge sums to settle the claims and made increasingly higher provisions, quarter after quarter. To make it worse, the company also had other businesses directly related to US mortgages and suffered huge losses there as well. This steady erosion forced AIG to raise more than $20 billion in additional capital earlier this year. At the beginning of the April-June quarter, the company had more than $15 billion in additional capital. By the first week of September, that excess capital was wiped out and the company was desperately seeking nearly $25 billion in additional funds to protect itself from further credit rating downgrades.

$25 billion doesn't appear like a big deal for the AIG group which has investments of over $750 billion. But, all that money is insurance premium received from its main businesses and set aside to cover future liabilities. AIG, the parent company, has no access to even a small part of it.

For AIG, the cash crunch hit at the worst possible time when the credit crisis was worsening and capital was extremely hard to come by. Desperate attempts to find private investors failed and finally pushed AIG into the hands of the Fed.

Takeover or a controlled liquidation?
The Fed's takeover of AIG is not an open ended, sweetheart deal. Existing shareholders will see their holdings cut to a fifth of what they were and the Fed will get an 80-per cent stake without paying a dollar.

The $80 billion in credit support comes at a very heavy cost, LIBOR plus 850 basis points. That is more than 11.5 per cent interest at current levels of LIBOR and will certainly be quite profitable for the Fed if AIG repays the loan without defaults.

But, it is not the opportunity to earn a big profit that interests Fed. It doesn't envisage that AIG will repay this loan from regular business cash flows. The Fed statement makes it clear that the loan is secured by all the assets of AIG and has to be "repaid from the proceeds of the sale of the firm's assets". So, the almost usurious interest rate is to force AIG to liquidate its assets within the loan period of two years. The high interest cost doesn't leave AIG with any other options.

If the Fed wants AIG to be liquidated anyway, why not just allow the company to collapse right now? The Fed is not worried about a failure per se, but a "disorderly" failure will be of serious concern. If left alone, AIG will be forced to liquidate its valuable business assets at very low valuations to meet its liabilities.

It is quite possible that it will not be able to raise sufficient cash to meet its CDS obligations. That would be disastrous for CDS holders, many of them struggling global banks. The remaining value of credit derivatives, after the big write downs, in their books is mostly based on the protection offered by products like CDS.

This will erode market confidence even further and unleash another wave of write-downs. For financial markets which are thoroughly shaken, that will be a doomsday scenario.

On the other hand, the Fed's credit facility will enable AIG to meet its immediate cash requirements. The company gains time, up to two years, to liquidate its assets. It is possible that markets would have stabilised when AIG starts looking for potential buyers and hence can avoid a fire sale. This is a far less risky and infinitely more preferable option than letting AIG go bankrupt. In other words, the Fed preferred the slow death of AIG to a quick kill.

Some day, hopefully, the world will thank Bernanke for this bold move.