US Fed announcement on AIG bailout
By Jon Fernquest |
The central bank of the US (the Fed) took historic action this week to prevent the US Subprime crisis from getting worse.
The Fed provided the giant insurance and financial services company American International Group (AIG) with an $85 billion loan in exchange for 80% ownership (stake) in the company.
With this action the US government became effectively the owner of AIG, the largest insurance company in the world. This is a very rare event:
In lending up to $85 billion at a hefty interest rate – LIBOR plus 8.5 percentage points – to insurer AIG, the Federal Reserve once again relied on its rarely used legal authority under Section 13(3) of the Federal Reserve Act to lend to "any individual, partnership or corporation" in "unusual and exigent circumstance" provided the borrower "is unable to secure adequate credit accommodations from other banking institutions."Until its loan to then-ailing investment bank Bear Stearns in March, the Fed hadn't used that lending authority since the Great Depression, lending exclusively to commercial banks and other deposit-taking institutions. The relied on a different section of the Federal Reserve Act to offer loans – which weren’t actually made – to government-sponsored mortgage giants Fannie Mae and Freddie Mac. (Source: Wall Street Journal - Real Economics Blog - 09/16/08)
Reading the text of this historical announcement is instructive.
Here is the Fed's statement in full:
Fed Statement on AIG
Text of the Federal Reserve’s statement on AIGSeptember 16, 2008, 9:27 pm
The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under Section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.
The Board determined that, in current circumstances, 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 purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.
The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.
The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders. (Source: Real Time Economics blog at the Wall Street Journal)
Vocabulary:
the Fed, the Federal Reserve - the US central bank (See Wikipedia)
Federal Reserve Bank of New York - the largest and most important of the twelve Federal Reserve Banks of the United States (See Wikipedia)
Federal Reserve Act - the 1913 law that first created the Federal Reserve Bank in US (See Wikipedia)
Section 13(3) of the Federal Reserve Act - the part of US central banking law that allows the central bank to help companies that cannot find financing elsewhere:
3. Discounts for Individuals, Partnerships, and Corporations: In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe. (Source: Section 13(3))
American International Group (AIG) - the largest insurance company in the world based in New York City (See Wikipedia)
effectively X - X is a reasonable description and summary of situation X
LIBOR, the LIBOR rate - the "London Inter Bank Offer Rate" which is interest rate of London's wholesale money markets, the standard interest rate used in US financial markets, changes less than the prime rate, used to set variable-rate loans including credit cards and adjustable-rate mortgages (Source: DebtConsolidation.com)
a stake - owning part of something
a secured loan - property (security) can taken from the borrower if they fail to pay back a loan
fragile - easily broken (for example, the fragile flower vase)
financial market fragility - when financial markets can be easily broken
a facility - (banking terminology) an arrangement with a borrower to provide a particular kind of credit support to the borrower
liquidity - when a business has enough cash, or assets that can be quickly converted into cash, so that it can continue its day-to-day business operations, otherwise the business must go bankrupt (cease to exist) or undergo reorganisation by the courts (See glossary)
a liquidity facility - money that can be taken as a loan, a credit line
a credit line - the maximum amount that can be borrowed, the maximum amount that will be given as a loan to the borrower
meeting its obligations as they come due - pay back loans on time
accrue - gradually increasing in amount over time
the outstanding balance - the amount of the loan that has not been paid back yet
interest will accrue on the outstanding balance - interest charges will be added to the amount they have not paid back yet
permitted to draw up to $85 billion under the facility - the maximum amount that the company can get as a loan is $85 billion
collateral - property that you promise to give the lender if you cannot pay back a loan
loan is collateralized by all the assets of AIG - if AIG cannot pay back the loan, then the lender is given all the assets of AIG
subsidiaries - smaller companies owned by a larger company
regulated subsidiaries - rules about what the company can do with its assets (for example, insurance is a highly regulated industry in Thailand with specific assets backing insurance policies, assets that the company is not free to sell for other purposes)
an equity interest - owning the stock of the company, owning the company, not just a creditor who lent money
veto - the right to stop or forbid something
common shareholders - stock shares in a company that receive both dividends and voting rights at shareholding meetings
preferred shareholders - stock shares in a company that receive dividends but no voting rights at shareholding meetings
dividends - an annual payment to owner shareholders as a return on their investment based on how much money the company made that year
