Fed makes ‘a killing’ on AIG contracts

http://www.ft.com/cms/s/0/a70659d4-0543-11df-a85e-00144feabdc0.html

Fed makes ‘a killing’ on AIG contracts
By Henny Sender in New York
Published: January 20 2010 00:00

The Federal Reserve is sitting on billions of dollars in paper profits from its controversial effort to unwind credit insurance contracts that AIG provided to banks such as Goldman Sachs, people familiar with the matter said.

The Fed rescue has generated criticism because the banks received 100 cents on the dollar for credit insurance they bought from AIG on collateralised debt obligations – financial instruments that promise the buyer cash flows from pools of bonds or loans. This had led to claims that AIG’s rescue was a “backdoor bail-out” of big banks.

However, the central bank is in a position to reap profits from this part of the rescue, which involved the purchase of the underlying CDOs by a New York Fed-financed vehicle, called Maiden Lane III, so that the insurance contracts written on them could be terminated.

At the time of their purchase, the CDOs had a face value of $62.1bn and a market value of $29.6bn. Now, the estimated market value of the CDOs is at least $45bn (£27.5bn), according to several people with direct knowledge of the portfolio.

“With the rally in the credit markets and tightening spreads, the Fed has made a killing – on paper,” said one person familiar with the portfolio.

The people familiar with the portfolio said that it would be difficult to sell all the CDOs because they are generally illiquid. A rapid sale of CDOs could also depress their prices.

At the time of the Fed intervention, the value of the CDOs insured by AIG was falling dramatically and AIG was facing a credit downgrade. AIG was being forced to post more collateral with the banks to which it sold credit insurance and the Fed feared that these demands would wipe out the insurer.

Following the rescue, the value of the CDOs in Maiden Lane III continued to fall, sinking to $20.7bn by March 31 2009. The portfolio’s value rose to $22.4bn by the end of September, the last date for which official statistics are available.

Maiden Lane III was funded with a $24.3bn loan from the New York Fed and $5bn in equity from AIG. Because the CDOs have continued to throw off cash, the balance on the Fed loan is now about $17bn, people familiar with the matter said.

If the CDOs in Maiden Lane III were sold, the proceeds would pay off the Fed loan first, followed by the AIG investment. The Fed would receive 67 per cent of any additional profits, and AIG 33 per cent.

The improvement in the Maiden Lane III portfolio comes as Fed officials face continuing controversy over the circumstances of the bail-out.

US Treasury secretary Tim Geithner, who was New York Fed president at the time of the AIG rescue, is set to testify at a hearing on the matter by The House Oversight and Government Reform Committee on January 27.

AIG declined to comment.