I don’t mean to intrude upon the jurisdiction of the financial blogs. If you’d like to know more about the financial aspect of the AIG loan, here’s The Big Picture and the Economist’s View, both of which link all over the place.

I’d like to talk about the legal structure of the "loan," given its resemblance to an entity that plaintiffs’ attorneys like myself frequently encounter: the insurance guaranty assocation. As we’ll see below, the loan creates obligations similar to those of a guaranty association, but with a problematic twist: the federal government now not only must decide how to conserve capital available for future insurance claimants, but also what to do with the assets and value of the insurance company itself, two functions typically given to different parties in ordinary insurance company liquidations.

More below.

[UPDATED: The powers that be have deigned to fill us in on the details. The loan is quite traditional, despite prior reporting, and the Federal Reserve does not hold an interest unless and until the loan is not repaid in 24 months. The below analysis thus still applies, but not until that default in two years.

UPDATED AGAIN: It’s happened already (so much for two years!), we now directly own $40 Billion of AIG.]

Here’s part of the Federal Reserve’s statement:

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.

Pretty harsh; 850 basis points puts the "loan" at over 10% right now, and it only lasts two years. Moreover, with the taxpayers now owning 80% of the business (why not 100%?), the purpose is not to keep the business afloat but rather to have an orderly liquidation. [Update: ownership does not change unless and until a default in 24 months; Updated again: The US has already taken $40 Billion in ownership, see above update.]

AIG isn’t the first insurance company to go under; as the NCIGF points out, "Since 1976, there have been about 600 insolvencies of property and casualty insurers." When an insurer goes under on the state level, two processes go into motion: 

  1. The insurer goes into bankruptcy and a governmental conservator / receiver is appointed, like in the Thabault v. PriceWaterhouseCoopers suit, where the Insurance Commission for Vermont is the receiver for the defunct Ambassador Insurance Company.
  2. The insurer’s obligations are picked up by a state-run non-profit guaranty association, like The Pennsylvania Property and Casualty Insurance Guaranty Association (PP&CIGA).

The two then work in tandum, with the receiver trying to get money wherever they can and the guaranty association operating to ensure at least some compensation for the claimaints against parties insured by the defunct insurer.

Both insurance receivers and insurance guaranty associations have a reputation for being aggressive. In Thabault, the Commissioner in Vermont just had a $182.9 million verdict against the insurer’s negligent accountants affirmed by the Third Circuit. In Pennsylvania, just last year PP&CIGA was reprimanded by the Pennsylvania Supreme Court for its “slash and burn approach to protecting PPCIGA’s assets." Carrozza v. Greenbaum, 591 Pa. 196, 215, 218 (2007).

So why didn’t that happen here? Two reasons.

First, there’s no Federal guaranty assocation. Nothing, nada. There’s no structure in place at all for the Federal government to assume operational responsibility for AIG’s coverage. Maybe the old Resolution Trust Corporation could come back, as some big names have proposed, but they don’t know how an insurance company operates, so that’s probably not a good idea for AIG.

Second, as the Bankruptcy Litigation Blog has covered quite thoroughly, the 2005 BAPCPA amendments fundamentally altered bankruptcy for financial contracts:

To provide enhanced protection to the financial services industry, Congress added or expanded the Code’s definitions for such industry staples as "forward contracts" (§101(25)), "repurchase agreements" (§101(47)), and "swap agreements" (§101(53B)). Various other Code provisions were amended or added to reflect Congress’s desire to enable a nondebtor party–without hesitation–to terminate, liquidate or accelerate its securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements or master netting agreements with the debtor.

That renders the "automatic stay" that normally comes with bankruptcy useless with regard to a wide variety of financial contracts, which were the source of AIG’s problems. If AIG declares bankruptcy, it opens itself up to a fantastically disordered liquidation. So bankruptcy is out of the question, too.

But why do I think the Federal Reserve is acting like a guaranty assocation? As the D&O Diary points out,

 Finally, I must address the interests of policyholders. On Tuesday, AIG released a statement (here) that its insurance subsidiaries "remain adequately capitalized and fully capable of meeting their obligations to policyholders." Along those lines, it is important to keep in mind that AIG’s current predicament is not the result of insurance losses, so the separately capitalized insurance companies’ ability to meet its obligations essentially remains unchanged.
Moreover, the collateral securing the Fed’s lending facility does not include the insurance companies’ assets, so even if the parent company heads south in a big way despite the $85 billion loan, the insurance companies’ existing surplus should remain to address policyholder claims, subject of course to the effects of claims payment.

In the days ahead it will be very important to understand how the current operating circumstances will affect the insurance companies and their operations, and in particular whether there are any other implications for policyholder surplus and the insurance companies’ claims paying ability.

In theory, the insurance companies are protected. Their assets are apparently not even part of the collateral for the Federal Reserve loan. But there’s a problem, as raised earlier in Kevin’s post:

The government wants to get repaid, so it wants the "orderly sale" of the businesses to produce sales values sufficient to effect repayment. That implies that the operating companies should continue operating. But among the insurance companies, for example, there are many practical questions that only active and engaged management can decide – risk appetite, level of pricing aggressiveness, extent of reinsurance, limit exposures, prohibited classes, and so on. All of these decisions must now take place under potentially unusual conditions, in effect under the supervision of a government appointed caretaker/liquidator?

Therein lies the rub: general insurance is its only profitable sector, so it’s the only source of new funds. Which raises a couple questions:

  1. Will AIG file for bankruptcy if the current credit facility is not enough to keep operational? Doing so will, as discussed above, likely result in a total collapse as counterparties abandon their obligations.
  2. Will the Federal Reserve attempt to use the insurance arm as a profit center to fund payments to the Federal Reserve or other creditors? Doing so imperils the reserve available for future claimants on the policies.
  3. Will the Federal Reserve sell off the insurance arm? Doing so imperils the Federal Reserve’s loan as well as the demands of other creditors.

That leaves the Federal Reserve balancing its own interests against those of claimants, the very sort of problem avoided by the normal receiver / guaranty association split. Who do you think will win out?