The Fed's AIG Strategy Is Paying Off

"AIG" may be the only three-letter four-letter word in the English language. The company ran into huge problems by selling insurance on financial assets without setting aside reserves to pay out claims. When the financial storm hit, no single private-sector company proved to be as problematic, thanks to the toxic issues surrounding its payments to Goldman Sachs on credit default swaps; its absurd insistence on paying bonuses even as it racked up a $99 billion loss in 2008; and its general lack of oversight from executives. One figure rankles above all: $182 billion. That was the total financial aid extended by the Federal Reserve and Treasury Department to AIG.

Broadly speaking, the post-crisis bailout efforts have worked out better than expected. Many of the financial-market guarantees were lifted without having been used, and Treasury is turning a profit on the central component of the TARP. But AIG has loomed as a gigantic rebuttal to the optimists, a symbol of everything that went wrong.

It may not come as much relief to taxpayers, but the various efforts to prop up AIG are also working out much better than expected. The Fed and Treasury are still into AIG for a combined $127 billion. But—surprise!—a lot of it is coming back. And there's a not-too-farfetched scenario in which we come close to breaking even on our reluctant investment in the company.

Here's how: The Fed in September 2008 extended an $85 billion credit line to the company. AIG paid down $40 billion of that debt when the Treasury Department injected $40 billion of taxpayer funds into it. But even after the assist, AIG has effectively drawn down about $51 billion of that line. In March 2009, AIG turned over two of its crown jewels, AIA (Asian insurance operations) and Alico (the U.S. life-insurance unit) to the Fed in exchange for converting $25 billion of that credit into preferred shares in the two subsidiaries. Once the markets recovered, AIG would sell these two units and use the proceeds to pay back the Fed.

A year later, the Fed's strategy seems to have panned out. On March 1, AIG agreed to sell AIA to Prudential plc for $35.5 billion, including $25 billion in cash. A week later Met Life offered to purchase Alico for $15.5 billion, including $6.8 billion in cash. If both those transactions close this year, and if the stock AIG receives in payment holds up in value (two admittedly big ifs), AIG will generate about $51 billion. That's enough to pay off the Fed's $25 billion in preferred shares plus the remaining balance on the Fed's credit line by early 2011.

But wait, there's more. The Fed in November 2008 created two investment vehicles to remove toxic assets from AIG's balance sheets. The first, dubbed Maiden Lane II, borrowed $19.5 billion from the Fed and bought $20.8 billion in mortgage-backed securities at half their original price. The second, Maiden Lane III, borrowed $24.3 billion from the Fed and bought a portfolio of collateralized debt obligations (CDOs) from former AIG customers, also at about half their face value. Since then, the credit markets have recovered, and these two investment vehicles—hedge funds with concentrated positions, really—are generating enough income to pay off the loans (about $10 billion so far). Meanwhile, the assets, particularly the CDOs, have risen in value. Government sources suggest that the funds, managed by Black Rock, both have the capacity to pay back their loans, and, in the case of Maiden Lane III, to generate billions in profits for the Fed.

That leaves the taxpayers. Treasury bought $40 billion of preferred stock in AIG in November 2008, and in March 2009 said it would make up to $30 billion available to the company in new stock; AIG has drawn down about $8 billion of that commitment. The Fed's profits from Maiden Lane III could allow it to redeem about $10 billion of that $48 billion total. AIG has more cash coming in from the pending sale of yet another subsidiary, its Taiwanese insurance unit. And if AIG continues to recover, Treasury could convert its preferred shares into common stock, as it has done with Citi, and sell them into the market over time. But can AIG generate sufficient cash to replace the public's capital? That's the multibillion-dollar question. Nobody at Treasury or the Fed is bold enough to predict that taxpayers will ultimately be made whole. Some rough math suggests the final cost to taxpayers for the AIG debacle could be between $12 billion and $20 billion. Yes, that's a bitter pill to swallow. But it's a much smaller pill than we had imagined even a few months ago.