GAO-11-616 Financial Crisis: Review of Federal Reserve System …

GAO

United States Government Accountability Office

Report to Congressional Requesters

September 2011

FINANCIAL CRISIS

Review of Federal Reserve System Financial Assistance to American International Group, Inc.

GAO-11-616

Highlights of GAO-11-616, a report to congressional requesters

September 2011

FINANCIAL CRISIS

Review of Federal Reserve System Financial Assistance to American International Group, Inc.

Why GAO Did This Study

In September 2008, the Board of Governors of the Federal Reserve System (Federal Reserve Board) approved emergency lending to American International Group, Inc. (AIG)--the first in a series of actions that, together with the Department of the Treasury, authorized $182.3 billion in federal aid to assist the company. Federal Reserve System officials said that their goal was to avert a disorderly failure of AIG, which they believed would have posed systemic risk to the financial system. But these actions were controversial, raising questions about government intervention in the private marketplace. This report discusses (1) key decisions to provide aid to AIG; (2) decisions involving the Maiden Lane III (ML III) special purpose vehicle (SPV), which was a central part of providing assistance to the company; (3) the extent to which actions were consistent with relevant law or policy; and (4) lessons learned from the AIG assistance.

To address these issues, GAO focused on the initial assistance to AIG and subsequent creation of ML III. GAO examined a large volume of AIG-related documents, primarily from the Federal Reserve System--the Federal Reserve Board and the Federal Reserve Bank of New York (FRBNY)--and conducted a wide range of interviews, including with Federal Reserve System staff, FRBNY advisors, former and current AIG executives, AIG business counterparties, credit rating agencies, potential private financiers, academics, finance experts, state insurance officials, and Securities and Exchange Commission (SEC) officials. Although GAO makes no new recommendations in this report, it reiterates previous recommendations aimed at improving the Federal Reserve System's documentation standards and conflict-of-interest policies.

View GAO-11-616 or key components. For more information, contact Orice Williams Brown at (202) 512-8678 or williamso@.

What GAO Found

While warning signs of the company's difficulties had begun to appear a year before the Federal Reserve System provided assistance, Federal Reserve System officials said they became acutely aware of AIG's deteriorating condition in September 2008. The Federal Reserve System received information through its financial markets monitoring and ultimately intervened as the possibility of bankruptcy became imminent. Efforts by AIG and the Federal Reserve System to secure private financing failed after the extent of AIG's liquidity needs became clearer. Both the Federal Reserve System and AIG considered bankruptcy issues, although no bankruptcy filing was made. Due to AIG's deteriorating condition in September 2008, the Federal Reserve System said it had little opportunity to consider alternatives before its initial assistance. As AIG's troubles persisted, the company and the Federal Reserve System considered a range of options, including guarantees, accelerated asset sales, and nationalization. According to Federal Reserve System officials, AIG's credit ratings were a critical consideration in the assistance, as downgrades would have further strained AIG's liquidity position.

After the initial federal assistance, ML III became a key part of the Federal Reserve System's continuing efforts to stabilize AIG. With ML III, FRBNY loaned funds to an SPV established to buy collateralized debt obligations (CDO) from AIG counterparties that had purchased credit default swaps from AIG to protect the value of those assets. In exchange, the counterparties agreed to terminate the credit default swaps, which were a significant source of AIG's liquidity problems. As the value of the CDO assets, or the condition of AIG itself, declined, AIG was required to provide additional collateral to its counterparties. In designing ML III, FRBNY said that it chose the only option available given constraints at the time, deciding against plans that could have reduced the size of its lending or increased the loan's security. Although the Federal Reserve Board approved ML III with an expectation that concessions would be negotiated with AIG's counterparties, FRBNY made varying attempts to obtain these discounts. FRBNY officials said that they had little bargaining power in seeking concessions and would have faced difficulty in getting all counterparties to agree to a discount. While FRBNY took actions to treat the counterparties alike, the perceived value of ML III participation likely varied by the size of a counterparty's exposure to AIG or its method of managing risk.

While the Federal Reserve Board exercised broad emergency lending authority to assist AIG, it was not required to, nor did it, fully document its interpretation of its authority or the basis of its decisions. For federal securities filings AIG was required to make, FRBNY influenced the company's filings about federal aid but did not direct AIG on what information to disclose. In providing aid to AIG, FRBNY implemented conflict-of-interest procedures, and granted a number of waivers, many of which were conditioned on the separation of employees and information. A series of complex relationships grew out of the government's intervention, involving FRBNY advisors, AIG counterparties, and others, which could expose FRBNY to greater risk that it would not fully identify and appropriately manage conflict issues and relationships.

As with past crises, AIG assistance offers insights that could help guide future government action and improve ongoing oversight of systemically important financial institutions. While the Dodd-Frank Wall Street Reform and Consumer Protection Act seeks to broadly apply lessons learned from the crisis in a number of areas, AIG offers other lessons, including identifying ways to ease time pressure by seeking private sector solutions sooner or compiling needed information in advance, analyzing disputes concerning collateral posting as a means to help identify firms coming under stress, and conducting stress tests that focus on interconnections among firms to anticipate financial system impacts.

The Federal Reserve Board generally agreed with GAO's findings and provided information on steps taken to address lessons learned that GAO identified.

United States Government Accountability Office

Contents

Letter

Appendix I Appendix II Appendix III Tables

1

Background

4

The Possibility of AIG's Failure Drove Federal Reserve Aid after

Private Financing Failed

12

FRBNY's Maiden Lane III Design Likely Required Greater

Borrowing, and Accounts of Attempts to Gain Concessions

From AIG Counterparties are Inconsistent

56

The Federal Reserve's Actions Were Generally Consistent With

Existing Laws and Policies, but They Raised a Number of

Questions

87

Initial Federal Reserve Lending Terms Were Designed to Be More

Onerous than Private Sector Financing

123

The AIG Crisis Offers Lessons That Could Improve Ongoing

Regulation and Responses to Future Crises

132

Agency and Third Party Comments and Our Evaluation

137

Objectives, Scope, and Methodology

140

Comments from the Board of Governors of the Federal

Reserve System

143

GAO Contact and Staff Acknowledgments

146

Table 1: Participants in First Phase of AIG Private-Financing

Attempt, by Type

26

Table 2: Estimates of AIG's First-Phase Liquidity Needs, September

2008

30

Table 3: Sources of ML III Value Provided

63

Table 4: Division of Earnings Considered for Maiden Lane III, as of

October 26, 2008

66

Table 5: Maiden Lane III Counterparty Concession Scenarios

70

Table 6: Rates on Selected Federal Reserve AIG-Related Lending

90

Table 7: ML III CDO Trustees that Were Also AIG Counterparties

115

Table 8: Comparison of the Terms of the Private Lending Plan and

Federal Reserve Revolving Credit Facility

125

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GAO-11-616 Financial Crisis

Figures

Figure 1: Timeline of Events and Contacts Prior to Initial Federal

Reserve Assistance in September 2008

14

Figure 2: Actual and Projected Cumulative Draws on Revolving

Credit Facility, as of October 2, 2008

46

Figure 3: Maiden Lane III Structure and Alternatives

58

Figure 4: Differences in AIGFP Counterparty Collateralization, as of

October 24, 2008

81

Figure 5: Differences in Expected Losses by Counterparty for

Extreme Stress, as of November 5, 2008

83

Figure 6: Differences in CDO Credit Ratings by Counterparty, as of

October 29, 2008

84

Figure 7: Roles and Relationships among the Federal Reserve, Its

Advisors, and Other Parties

114

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GAO-11-616 Financial Crisis

Abbreviations

AIG AIGFP Bear Stearns CDO CDS CTR CUSIP

Federal Reserve Board

FHLB FRBNY Lehman LIBOR ML II ML III NYSID OTS RMBS SEC SIGTARP

TARP Treasury

American International Group, Inc. AIG Financial Products Corporation Bear Stearns Companies, Inc. collateralized debt obligations credit default swaps confidential treatment request Committee on Uniform Securities Identification Procedures Board of Governors of the Federal Reserve System Federal Home Loan Banking System Federal Reserve Bank of New York Lehman Brothers Holdings, Inc. London Interbank Offered Rate Maiden Lane II Maiden Lane III New York State Insurance Department Office of Thrift Supervision residential mortgage-backed securities Securities and Exchange Commission Special Inspector General for the Troubled Asset Relief Program Troubled Asset Relief Program Department of the Treasury

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