The Numbers

When the Federal Reserve lent $85 billion to AIG on September 16th, the government received a 79.9% equity interest.  On October 8th, the Fed agreed to give the company $37.8 billion more.  In November, AIG received even more money.  The fact that the government isn’t legally obliged to guarantee all AIG debt does not mean that the government isn’t guaranteeing lots and lots of AIG debt.  A debt guarantee is exactly what the provision of emergency cash is.

Any meaningful liability at the company is now guaranteed, to a large extent, by the federal government by virtue of their numerous emergency lending facilities.

Another blogger explains it well:

A small but unexplained detail in the federal government’s nationalization of Fannie, Freddie, and AIG has been that the deals have been structured so that the Fed or Treasury ends up owning no more than 79.9% of the nationalized entities’ stock (or having warrants that, if exercised, would produce the same result). So what is the source of the 79.9% threshold? Why didn’t the government do a 99.99% dilution of shareholders (and thereby a full de facto taking)?

It turns out that the explanation is not related to 80% being the threshold before the Fed/USG would have to carry the entities on their own books. Federal Accounting Standards are silent on the issue, but the Congressional Budget Office is already treating Fannie/Freddie like USG assets/liabilities (consistent with GAAP).

Instead, the explanation is tax. Section 163 of the Internal Revenue Code generally provides that interest paid on debt is tax-deductible for federal income tax. But there’s an exception. If the interest is paid on a loan from an entity that controls 80% or more of the voting power and value of a corporations’ total shares, then the interest is not tax-deductible. Fannie and Freddie are generally tax-exempt. They are, however, subject to federal income tax. AIG, of course, has no tax-exempt status, whatsoever.

Because the bailout deals were structured so that the Fed or Treasury will make sizable loans to the nationalized entities, they had to be careful not to reach the 80% threshold, lest the nationalized entities (which still pay taxes) lose their tax deduction for the interest paid on the Fed/Treasury loans (LIBOR +850 on $85BN for AIG–that’s a lot of interest).

The company tried to sell off units, but to no avail.  This is why the government brought in Edward Liddy – to sell off some units to increase cash flow.  But no units could be sold at high enough prices for the sale to matter.

Debt liquidation would have been the way to go.

Categories: CRDaily

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