The AIG Bailout William K. Sjostrom, Jr.? Abstract On February 28, 2008, American International Group, Inc. , the then largest insurance company in the United States, announced 2007 earnings of $6. 20 billion or $2. 39 per share. Its stock closed that day at $50. 15 per share. Less than seven months later, however, AIG was on the verge of bankruptcy and had to be rescued by the United States government through an $85 billion loan. Government aid has since grown to $182. 5 billion, and AIG’s stock recently traded at less than $1. 00 per share. The Article explains why AIG, a company with $1 trillion in assets and $95. billion in shareholders’ equity, suddenly collapsed. It then details the terms of the government bailout, explores why it was undertaken, and questions its necessity. Finally, the Article describes the regulatory gap exploited by AIG and offers some thoughts on regulatory reform. Table of Contents I. Introduction ………………………………………………………………………. 944 II. AIG’s Operations……………………………………………………………….. 945 A. Overview ……………………………………………………………………. 45 B. Credit Default Swap Primer…………………………………………… 947 C. AIG’s Credit Default Swap Business ……………………………… 952 III. AIG’s Collapse ………………………………………………………………….. 959 A. Credit Default Swaps on Multi-Sector Collateralized Debt Obligations ………………………………………………………….. 959 B. Securities Lending Program…………………………………………… 961 ? Professor of Law, University of Arizona James E. Rogers College of Law.

I would like to thank Professors Steven Davidoff, Michael Guttentag, Lee Harris, Darian Ibrahim, and David Zaring and workshop participants at Salmon P. Chase College of Law, Northern Kentucky University; McGeorge School of Law; and the University of Memphis Cecil C. Humphreys School of Law for helpful comments on earlier versions of this Article. 943 944 66 WASH. & LEE L. REV. 943 (2009) C. Inability to Access Capital Markets and Credit Downgrade …………………………………………………………………. 962 IV. The Bailout ……………………………………………………………………….. 63 A. Initial Bailout ………………………………………………………………. 964 B. Additional Lifelines ……………………………………………………… 968 C. Bailout Restructuring I …………………………………………………. 969 D. Bailout Restructuring II ………………………………………………… 972 E. Grand Total…………………………………………………………………. 974 F. Legal Issues ………………………………………………………………… 976 G. Why the Bailout? ………………………………………………………… 977 V. The (Lack of) Regulation of Credit Default Swaps …………………. 983 A. Regulatory Gap ……………………………………………………………. 983 B. Regulatory Reform ………………………………………………………. 989 VI. Conclusion ………………………………………………………………………… 990 I. Introduction On February 28, 2008, American International Group, Inc. (AIG), then the largest insurance company in the United States,1 announced 2007 earnings of $6. 0 billion or $2. 39 per share. 2 Its stock closed that day at $50. 15 per share. 3 Less than seven months later, however, AIG was on the verge of bankruptcy and had to be rescued by the United States government through an $85 billion 1. Based on net premiums underwritten, AIG was the largest life insurer, the largest health insurer, and the second largest property and casualty insurer in the U. S. American International Group: Examining What Went Wrong, Government Intervention, and Implications for Future Regulation: Hearing Before S. Comm. on Banking, Housing & Urban Affairs, 111th Cong. –2 (2009) (statement of Donald L. Kohn, Vice Chairman, Board of Governors of the Federal Reserve System) [hereinafter Kohn Statement], available at http://banking. senate. gov/ public/_files/KohnStmtMarch52009. pdf. 2. Press Release, American International Group, Inc. , AIG Reports Full Year and Fourth Quarter 2007 Results (Feb. 28, 2008), available at http://idea. sec. gov/Archives/edgar/data/5272 /000095012308002282/y50505exv99w1. htm. 3. Yahoo! Finance, AIG: Historical Prices for American International Group, Inc. , http://finance. yahoo. com/q/hp? s=AIG (last visited Sept. 9, 2009) (on file with the Washington and Lee Law Review). THE AIG BAILOUT 945 loan. 4 Government aid has since grown to $182. 5 billion,5 and as recently as June 2009 AIG’s stock traded at less than $1. 00 per share. 6 AIG’s collapse was caused largely by its $526 billion portfolio of credit default swaps (CDSs), a type of credit derivative widely used by financial institutions but, up until recently, largely unknown by the general public. 7 AIG’s troubles have been covered extensively by the media but are difficult to comprehend fully because of the esoteric financial instruments involved.

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Thus, this Article weaves explanations of CDSs, asset-backed securities, securitization, tranching, and collateralized debt obligations into a detailed and systematic account and analysis of what went wrong at AIG and why the government bailed it out. A thorough understanding of these events is important because of the unprecedented size of the bailout and attendant calls for increased regulation of CDSs. Part II provides a brief overview of AIG’s operations, a primer on CDSs, and analysis of AIG’s CDS activities. Part III explains how AIG’s CDS business pushed it to the brink of bankruptcy by draining it of cash.

Part IV details the terms of the government bailout (including its two restructurings), explores why it was undertaken, and questions its necessity. Part V describes the regulatory gap exploited by AIG and offers some thoughts on regulatory reform. II. AIG’s Operations A. Overview AIG is “a holding company which, through its subsidiaries, is engaged in a broad range of insurance and insurance-related activities in the United States and abroad. “8 It is incorporated in Delaware,9 and its common stock is listed on the New York Stock Exchange. 0 AIG has operations in more than 130 countries with about half of its revenues derived from its foreign operations. 11 4. Infra Parts III & IV. 5. Infra Part IV. E. 6. Yahoo! Finance, supra note 3. 7. Infra Part III. A. 8. AIG, 2007 Annual Report (Form 10-K), at 3 (Feb. 27, 2008) [hereinafter AIG ‘07 Annual Report], available at http://idea. sec. gov/Archives/edgar/data/5272/000095012308 002280/y44393e10vk. htm. 9. Id. 10. Id. at 26. 11. Moody’s Investors Service, Company Profile: American International Group, Inc. 1 946 66 WASH. & LEE L. REV. 943 (2009)

Its principal business units are General Insurance, Life Insurance & Retirement Services, Financial Services, and Asset Management. 12 The General Insurance unit underwrites commercial property, casualty, workers’ compensation, and mortgage guarantee insurance. 13 The Life & Retirement Service unit provides individual and group life, payout annuities, endowment, and accident and health insurance policies. 14 The Financial Services unit engages in aircraft and equipment leasing, capital market transactions (including CDS transactions), consumer finance, and insurance premium finance. 5 The Asset Management unit offers a wide variety of investment-related services and investment products to individuals, pension funds, and institutions. 16 AIG ranked tenth in the 2007 Fortune 50017 and twenty-third in the 2007 Global 500. 18 As of December 31, 2007, AIG had total assets of $1. 06 trillion,19 shareholders’ equity of $95. 8 billion, and a market capitalization of $150. 7 billion. 20 The following table summarizes AIG’s operating performance by unit for the years ended December 31, 2005, 2006, and 2007, and the nine months ended September 30, 2008:21 (Jan. 2008). 12. AIG ‘07 Annual Report, supra note 8, at 3. 13.

Id. at 6. 14. Id. at 10. 15. Id. at 11. 16. Id. 17. See Largest U. S. Corporations, FORTUNE, Apr. 3, 2007, at 210 (showing that in 2006 AIG generated the tenth most revenues among U. S. public companies). 18. World’s Largest Corporations, FORTUNE, July 23, 2007, at 133. This means that in 2006 AIG generated the twenty-third most revenues among all public companies in the world. 19. AIG ‘07 Annual Report, supra note 8, at 28. 20. This number is based on a closing price of $58. 30 per share on December 31, 2007, and outstanding shares of 2,585,000,000. Id. at 13. 21. Id. at 36; see also AIG, Quarterly Report (Form 10-Q), at 12 (Nov. 0, 2008) [hereinafter AIG September ‘08 Quarterly Report], available at http://idea. sec. gov/Archives/ edgar/data/5272/000095012308014821/y72212e10vq (providing part of this data). THE AIG BAILOUT Nine Months Ended 9/30/08 $ 35,854 14,271 (16,016) 658 531 (436) $ 34,862 947 (In Millions) Revenues General Insurance Life Insurance & Retirement Financial Services Asset Management Other Consolidation & Eliminations Total Operating Income (Loss) General Insurance Life Insurance & Retirement Financial Services Asset Management Other Consolidation & Eliminations Total 2007 2006 2005 $ 51,708 53,570 (1,309) 5,625 457 13 $110,064 49,206 50,878 7,777 4,543 483 500 $113,387 $ 45,174 48,020 10,677 4,582 344 (16) $108,781 $ (393) (19,561) (22,880) (2,709) (2,899) 237 $ 10,562 8,186 (9,515) 1,164 (2,140) 722 $ 8,943 $ 10,412 10,121 383 1,538 (1,435) 668 $ 21,687 $ 2,315 8,965 4,424 1,963 (2,765) 311 $ 15,213 $ (48,205) B. Credit Default Swap Primer As is obvious from the above table, AIG had some major problems within its Financial Services unit in 2007 and 2008. The staggering $32. 4 billion in losses the unit racked up from January 2007 through September 2008 stem almost entirely from the unit’s CDS activities.

Because, as discussed in Part III below, these activities are at the heart of AIG’s collapse,22 this section provides a primer on CDSs. A CDS is a privately negotiated contract where one party (the “protection seller”), in exchange for a fee, agrees to compensate another party (the “protection buyer”) if a specified “credit event” (such as bankruptcy or failure 22. See Monica Langley et al. , Bad Bets and Cash Crunch Pushed Ailing AIG to Brink, WALL ST. J. , Sept. 18, 2008, at A1 (noting that “[t]he rot stemmed largely from losses in a unit that sold complex kind of derivative, called a credit-default swap, designed to protect investors against default in an array of assets, including subprime mortgages”). 948 66 WASH. & LEE L. REV. 943 (2009) to pay)23 occurs with respect to a company (the “reference entity”) or debt obligation (the “reference obligation”). 24 CDSs are used for a variety of purposes including hedging, speculation, and arbitrage. 25 For example, if a mutual fund wants to hedge its credit risk exposure on its $100 million of XYZ Inc. (XYZ) bonds that mature in five years, it can do so by entering into a five-year, $100 million CDS with a protection seller.

The CDS would designate XYZ as the reference entity and XYZ’s bonds as the reference obligation. It would define credit event as XYZ’s bankruptcy or payment default on its bonds. In this example, the CDS would have a “notional amount” of $100 million because that is the amount of protection provided by the CDS. 26 In connection with writing the CDS, the protection seller would assess the likelihood of a credit event occurring during the next five years and set its fee for providing the protection accordingly. 27 This fee is referred to as the CDS spread or premium and is expressed in basis points28 per annum on the notional amount of the CDS. 9 The spread is typically payable quarterly. 30 In this example, if the protection seller sets the spread at 100 basis points, the fund 23. U. S. GOV’T ACCOUNTABILITY OFFICE, GAO-07-716, CREDIT DERIVATIVES: CONFIRMATION BACKLOGS INCREASED DEALERS’ OPERATIONAL RISKS, BUT WERE SUCCESSFULLY ADDRESSED AFTER JOINT REGULATORY ACTION 5 n. 6 (2007) [hereinafter GAO REPORT], available at http://www. gao. gov/new. items/d07716. pdf. 24. Nomura Fixed Income Research, Credit Default Swap (CDS) Primer 1, 1, May 12, 2004, [hereinafter CDS Primer], available at http://www. classiccmp. rg/transputer/ finengineer/%5BNomura%5D%20Credit%20Default%20Swap%20(CDS)%20Primer. pdf; see also GAO REPORT, supra note 23, at 5. Other types of CDSs include multi-name, which reference more than one corporate or sovereign entity, and index, which are based on an index of corporate entities. Systemic Risk: Regulatory Oversight and Recent Initiatives to Address Risk Posed by Credit Default Swaps: Hearing Before the Subcomm. on Capital Markets, Insurance, and Government Sponsored Enterprises of the H. Comm. on Financial Servs. , 111th Cong. 4 (2009) (statement of Orice M. Williams, Director, Financial Markets and Community Investment, U.

S. Gov’t Accountability Office) [hereinafter Williams Statement], available at http://www. gao. gov/new. items/d09397t. pdf. 25. See Frank Partnoy & David A. Skeel, Jr. , The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019, 1022 (2007) (listing the uses of CDSs). 26. See Arvind Rajan, A Primer on Credit Default Swaps, in THE STRUCTURED CREDIT HANDBOOK 17, 23 (Arvind Rajan et al. eds. , 2007) (defining notional amount as “the amount of exposure to a particular credit (the reference entity) for which protection is being either bought or sold for a particular period of time”). 27.

See CDS Primer, supra note 24, at 4 (noting that CDS pricing involves assessing “(1) the likelihood of default, (2) the recovery rate when default occurs, and (3) some consideration for liquidity, regulatory, and market sentiment about the credit”). 28. A basis point equals 0. 01% (1/100th of a percent) or 0. 0001 in decimal form. 29. CDS Primer, supra note 24, at 3. 30. See Rajan, supra note 26, at 23 (noting that protection buyers, at least according to U. S. market convention, typically “pay quarterly on an Actual/360 basis”). THE AIG BAILOUT 949 would pay the protection seller $250,000 per quarter during the five-year term of the CDS. 1 If no credit event occurs during the term of a CDS, the protection seller retains the premium payments and the parties go their separate ways. 32 In this example, that means the protection seller would have grossed $5 million from writing the CDS ($250,000 per quarter multiplied by twenty quarters). If a credit event does occur during the CDS term, the protection seller is then obligated to compensate the protection buyer. Compensation occurs through either physical or cash settlement, depending on what the CDS specifies. 33 If the CDS provides for physical ettlement, it will specify types of “deliverable obligations” that the protection seller is required to buy for par (full face value) upon delivery by the protection seller. 34 In this example, assume the CDS provided for physical settlement and designated the XYZ bonds as the deliverable obligation. Following an XYZ credit event, the fund would transfer the $100 million face amount of XYZ bonds to the protection seller. The protection seller would then pay the fund $100 million, and the CDS would terminate. 35 Obviously, XYZ bonds will have dropped in value as a result of the credit event and, therefore, will be worth much less than par.

If the CDS provides for cash settlement, the parties agree on a market value for the reference obligation. 36 The protection seller then pays the protection buyer the difference between the market value and the par value of the reference obligation. 37 In this example, assume that the market value of the 31. The calculation is as follows: $100 million notional amount multiplied by 1% divided by 4 (number of quarters in a year). 32. See Rajan, supra note 26, at 23 (“If no credit events occur during the term of the default swap, the swap expires unexercised. “). 33. CDS Primer, supra note 24, at 4. 4. Id. at 5. 35. The CDS contract would specify the types and characteristics of XYZ debt that can be used to fulfill the deliverable obligation. See Rajan, supra note 26, at 24 (“[Deliverable obligations] are obligations of the reference entity that may be delivered, per the CDS contract, in connection with physical settlement . . . . [I]n the most common versions of CDS, the deliverable obligation must be pari passu with senior unsecured obligations of the reference entity. “); see also ANTULIO N. BOMFIN, UNDERSTANDING CREDIT DERIVATIVES AND RELATED INSTRUMENTS, at 69 (2005). 36.

See Rajan, supra note 26, at 24 (“If the contract is cash settled, a market value is determined for the reference obligation and the protection seller makes a cash payment to the protection buyer for the implied loss on that obligation. “); see also BOMFIN, supra note 35, at 292 (“The market value of the reference obligation is commonly determined by a dealer poll typically conducted a few days after the credit event. “). 37. See Rajan, supra note 26, at 24 (“[T]he protection seller pays the buyer N ? 100 ? R , where R is the price of the reference security after the credit event (recovery value) and N is the notional amount. ). ( ) 950 66 WASH. & LEE L. REV. 943 (2009) reference obligation dropped to 25% of par following the credit event. The protection seller would then pay the fund $75 million ($100 million par value less the $25 million market value) and the CDS would terminate. 38 In addition to hedging, CDSs can be used to speculate on a change in a company’s credit quality. For example, if a hedge fund believed that XYZ’s credit quality was going to deteriorate within the next two years, it could then buy a three-year $50 million notional amount 200 basis point cash-settled XYZ CDS.

Suppose XYZ suffers a credit event a year later and the CDS reference obligation drops to 20% of par. The hedge fund will have grossed $39 million on the transaction ($40 million cash payment from the protection seller less the $1 million CDS premium the hedge fund paid for the year). Alternatively, if XYZ’s credit quality drops significantly a year later but not to the point where a credit event occurs, the spread that parties would be willing to pay on XYZ CDSs might widen to 700 basis points.

If the hedge fund believes XYZ’s credit quality is likely to improve over the next two years, it could lock in a profit by selling a two-year $50 million notional amount 700 basis point cashsettled XYZ CDS. 39 If, as expected, no credit event occurs during the next two years, the hedge fund will have paid $2 million on the XYZ CDS it bought but will have received $7 million on the CDS it sold, netting $5 million on the two transactions. Further, CDSs can be used for arbitrage. Arbitrage techniques include buying or selling a debt security and simultaneously buying or selling a CDS on the debt security.

The idea is to earn a credit-risk-free return by capturing a temporary mispricing between the debt security and CDS spread. 40 A prominent risk inherent in a CDS faced by a protection buyer, whether engaging in hedging, speculation, or arbitrage, is counterparty credit risk. 41 Counterparty credit risk is the risk that a protection seller will be unable or unwilling to make the payment due under a CDS following a credit event. 42 To address counterparty credit risk, a CDS may require the protection seller to post collateral with the protection buyer equal to a specified percentage of the 38. See id. noting the termination of the swap upon cash settlement). 39. Alternatively, the hedge fund could agree to terminate the CDS in exchange for payment from the protection seller reflecting the change in value or could assign the CDS to a third party in exchange for a fee. BOMFIN, supra note 35, at 70. 40. MOORAD CHOUDHRY, THE CREDIT DEFAULT SWAP BASIS 116 (2006). 41. BOMFIN, supra note 35, at 10. 42. See COUNTERPARTY RISK MGMT. POLICY GROUP II, TOWARD GREATER FINANCIAL STABILITY: A PRIVATE SECTOR PERSPECTIVE 110 (July 27, 2005), available at http://www. crmpolicygroup. org/crmpg2/docs/CRMPG-II. df (discussing counterparty credit risk). Other risks embedded in CDSs include basis risk, legal risk, and operational risk. See id. at 111–14 (discussing these types of risks). THE AIG BAILOUT 951 notional amount of the CDS. 43 If the market spread on the CDS rises above the amount charged by the protection seller, the CDS would typically require the protection seller to post additional collateral as a rising spread indicates a perceived increase in the probability of a credit event occurring. 44 The initial collateral percentage typically varies depending on the protection seller’s credit rating.

The higher its credit rating, the lower the collateral percentage. This is because a higher credit rating indicates higher credit quality and, therefore, a lower chance that a protection seller will default on its obligations under the CDS. The CDS will provide for an automatic increase in the collateral percentage for any downgrades to the protection seller’s credit rating during the term of the CDS. CDSs are transacted over-the-counter (OTC), meaning they are not transacted through an exchange. 45 The CDS market has exploded in size in recent years growing from an estimated $918. billion notional amount at the end 2001 to $54. 6 trillion by mid-year 2008, an increase of approximately 540%. 46 Active players in the market include more than a dozen large, global 43. See id. at 110 (discussing methods of collateral posting); see also Williams Statement, supra note 24, at 13 (discussing collateral posting requirements). 44. See Williams Statement, supra note 24, at 13 (discussing posting requirements and variation in those requirements by party). 45. To Review the Role of Credit Derivatives in the U. S. Economy: Hearing Before the H. Comm. n Agriculture, 110th Cong. 2 (2008) (written testimony of Erik Sirri, Director, Division of Trading and Markets, U. S. Securities and Exchange Commission) [hereinafter Sirri Testimony], available at http://agriculture. house. gov/testimony/110/h81015/Sirri. pdf. 46. International Swaps and Derivatives Association, Inc. (ISDA), Summaries of Market Survey Reports, http://www. isda. org/ (last visited Sept. 29, 2009) (follow Surveys and Market Statistics hyperlink; then follow Summaries of Market Surveys Results) (on file with the Washington and Lee Law Review).

Note that total notional amount is not a good measure of actual market exposure because it does not reflect netting. Netting is best explained through an example. If A buys $100 million in protection on X bonds from B, who buys a $100 million in protection on X bonds from C, who buys $100 million in protection on X bonds from A, then this scenario would result in $300 million gross notional amount of CDSs on X bonds. The net notional amount and actual economic exposure of the three parties to a credit event on X bonds would be zero.

The following explains why the credit exposure is zero: (1) A bought $100 million in protection from B and sold $100 million in protection to C, netting out to zero exposure; (2) B bought $100 million in protection from C and sold $100 million in protection to A, netting out to zero exposure; and (3) C bought $100 million in protection from A and sold $100 million in protection to B, netting out in zero exposure. If there is a credit event with respect to X bonds, A will pay up to $100 million to C, C will pay the same amount to B, and B will pay the same amount to A.

ISDA estimates actual exposure of CDS counterparties at 1% to 2% of notional amount. See Jonathan R. Laing, Defusing the CDS Bomb, BARRONS 44 (Nov. 17, 2008) (noting that “the peak value would have been $622 million to $1. 24 billion”); see also GAO REPORT, supra note 23, at 1 n. 2 (noting that notional value is an indicator of the market’s value but does not necessarily represent the credit and market risks to which counterparties are exposed from their credit derivative contracts). 952 66 WASH. & LEE L. REV. 943 (2009) banks which serve as CDS dealers. 7 CDS dealers try to profit by capturing the equivalent of the bid/ask spreads between buying and selling protection and, therefore, constantly buy and sell CDSs on the same reference entities and obligations. 48 Other players include hedge funds, investment companies, and insurance companies (for example, AIG). 49 C. AIG’s Credit Default Swap Business AIG operates its CDS business through its subsidiaries, AIG Financial Products Corp. and AIG Trading Group, Inc. , and their respective subsidiaries (collectively, AIGFP). 0 AIG contractually guarantees “all present and future payment obligations and liabilities of AIGFP arising from transactions entered into by AIGFP. “51 The following is a description of AIGFP’s CDS business based on publicly available information (SEC filings, documents available on AIG’s website, and congressional hearing testimony). The information is incomplete in some respects and, therefore, portions of the description reflect an educated guess as to what actually occurred. AIGFP’s CDS business consisted largely of selling protection on “super senior risk tranches of diversified pools of loans and debt securities. 52 Deciphering what exactly this means requires a basic understanding not only of CDSs but also of asset-backed securities. Asset-backed securities “are securities that are backed by a discrete pool of self-liquidating financial assets. “53 The financial assets could be commercial loans, residential mortgage 47. Sirri Testimony, supra note 45, at 2; see also GAO REPORT, supra note 23, at 6 (“The top five dealers in 2005, ranked by total trading volumes as estimated by Fitch Ratings, were Morgan Stanley, Deutsche Bank, Goldman Sachs, JP Morgan Chase, and UBS. ). 48. See Editorial, The Meltdown That Wasn’t, WALL ST. J. , Nov. 15, 2008, at A10 (noting that “large dealers generally make their money facilitating trades for customers, not betting one way or another on corporate defaults”). 49. See Sirri Testimony, supra note 45, at 2; GAO REPORT, supra note 23, at 6 n. 8 (“The top five end-users of credit derivatives are banks and broker-dealers (44 percent), hedge funds (32 percent), insurers (17 percent), pension funds (4 percent), and mutual funds (3 percent). “). 50.

See AIG ‘07 Annual Report, supra note 8, at 11 (outlining operations of AIGFP). 51. AIG September ‘08 Quarterly Report, supra note 21, at 36. 52. AIG ‘07 Annual Report, supra note 8, at 11. 53. Asset-Backed Securities, Securities Act Release No. 8518, Exchange Act Release No. 50,905, 84 SEC Docket 1624 (Dec. 22, 2004) [hereinafter Asset-Backed Securities Release], available at 2004 WL 2964659, at *4. Note that the phrase “asset-backed securities” is sometimes used in a narrower sense to mean securities backed by nonmortgage debt, such as auto loans and credit card receivables.

Under that scheme, securities backed by mortgage debt are referred to as mortgage-backed securities (either residential or commercial depending on the borrower). See Ratul Roy & Glen McDermott, ABS CDOs, in THE STRUCTURED CREDIT THE AIG BAILOUT 953 loans, credit card receivables, student loans, and similar assets. 54 Asset-backed securities are created through the process of securitization. 55 The typical securitization process for residential mortgage loans is as follows: It starts with a borrower applying to a lender (either directly or through a broker) for a mortgage loan to purchase a home or refinance an existing loan. 6 Assuming the application is approved, the lender funds the loan as part of the purchase or refinancing closing. 57 Then, the lender sells the loan to an institution called an arranger or issuer. 58 The arranger then sells the loans—and oftentimes similar loans it has purchased from other lenders—to a newly formed special purpose vehicle (SPV). 59 The SPV funds the purchase of the loans by selling investors debt obligations representing claims to the cash flows from the pool of residential mortgage loans owned by the SPV. 0 These obligations are referred to as asset-backed securities because they are “backed” or supported by a financial asset (the mortgage loans). 61 The SPV uses the cash flows from the pool of mortgage loans (primarily monthly loan payments) to service the debt it issued investors to buy the loans. 62 Often, the SPV divides the debt securities it issues into different tranches reflecting different levels of seniority or payment priority. 63 For example, the SPV could issue three different classes of debt securities: a senior class, a mezzanine class, and a junior class.

The SPV’s indenture (the document that HANDBOOK, supra note 26, at 335, 336–37 (describing residential mortgage-backed securities, commercial mortgage-backed securities, and asset-backed securities as three different categories of structured finance securities). 54. Asset-Backed Securities Release, supra note 53, at *5. 55. See id. at *4 (listing steps needed to achieve securitization). 56. See id. at *5 (describing the loan origination process). 57. Id. 58. Id. 59. See id. (“The sponsor then sells the financial assets . . . to a specially created investment vehicle. “). 0. Id. ; see also U. S. Securities and Exchange Commission, Mortgage-Backed Securities, http://www. sec. gov/answers/mortgagesecurities. htm (last visited Sept. 29, 2009) [hereinafter Mortgage-Backed Securities Release] (“Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans. “) (on file with the Washington and Lee Law Review). 61. Asset-Backed Securities Release, supra note 53, at *4. 62. See Mortgage-Backed Securities Release, supra note 60 (describing payment process for mortgage-backed securities). 3. See COMMITTEE ON THE GLOBAL FINANCIAL SYSTEM, THE ROLE OF RATINGS IN STRUCTURED FINANCE: ISSUES AND IMPLICATIONS 4 (2005), available at http://www. bis. org/publ/cgfs23. pdf (“Typically, several classes (or ‘tranches’) of securities are issued. “). 954 66 WASH. & LEE L. REV. 943 (2009) specifies the terms of the debt securities) would then provide that obligations (interest and principal) owed to the senior class are to be paid first, followed by those owed to the mezzanine class, with the junior class to be paid last. 4 If all amounts owed on the loans or other financial assets owned by the SPV are paid timely, the SPV will have sufficient funds to meet its obligations with respect to all three classes. If funds are insufficient, the junior class is the first to not get paid, followed by the mezzanine class. 65 The senior class would only not get paid if the SPV’s shortfall exceeds amounts owed to the junior class and the mezzanine class. 66 Typically, the SPV will have all but the most junior tranche rated by one or more of the credit rating agencies.

As part of the rating process, the SPV will seek input from the rating agencies regarding how the securities need to be tranched for the most senior tranche to receive a rating of AAA (the highest possible rating). 67 The senior tranche can receive AAA, even if there are no AAA assets in the SPV’s pool, because it is the first to be paid and thus the last to suffer a loss. 68 Its creditworthiness is enhanced because junior tranches insulate it from some level of losses from the SPV’s underlying pool of assets. 69 The higher the credit rating, the lower the interest rate the SPV will need to offer on a particular tranche and vice versa.

Thus, tranching provides investors with different risk/reward profiles. The basic idea is to convert a pool of financial assets with a single rating into various debt securities with ratings at, above, and below the pool’s rating. 70 This is desirable because demand for fixed income securities is bifurcated between investors seeking the presumed safety of highly rated (AAA or AA) debt securities and investors seeking the high returns offered by lower rated securities, with demand for highly rated 64. See id. (describing various tranches built into mortgage-backed securities). 65.

See Ingo Fender & Janet Mitchell, Structured Finance: Complexity, Risk and the Use of Ratings, BIS Q. REV. 69 (June 2005), available at http://www. bis. org/publ/qtrpdf/ r_qt0506f. pdf (describing process of tranching claims to distribute losses to different levels of mortgage-backed securities). 66. Id. 67. See id. at 73 (“[S]tructured finance tranches are usually tailored by arrangers with target ratings in mind. This, in turn, requires the rating agencies to take part in the deal’s structuring process, with deal origination implicitly involving obtaining structuring opinions from the rating agencies. ). 68. See id. at 69 (explaining that the senior tranche is insulated from losses by the junior tranches). 69. Id. 70. See Introduction: A Roadmap of the New World of Structured Credit, in THE STRUCTURED CREDIT HANDBOOK, supra note 26, at 1, 2 (describing how “the CDO tranching process creates both higher and lower credit quality financial instruments from the original portfolio”). THE AIG BAILOUT 955 securities the greatest. 71 Through tranching, an SPV can take a pool of assets that falls in between these two points and create securities sought by both types of investors. 2 In fact, the securities can be tranched easily so that the senior tranche is by far the largest tranche, aligning with the greater demand for highly rated securities. 73 Notwithstanding the highly rated nature of the top tranche of an SPV’s debt securities, there is demand for credit protection on these securities. As noted above, the bulk of AIGFP’s CDS portfolio is comprised of protection it wrote on what it refers to as the “super senior” tranche of various types of assetbacked securities.

AIG defines the “super senior” tranche “as the layer of credit risk senior to a risk layer that has been rated AAA by the credit rating agencies, or if the transaction is not rated, equivalent thereto. “74 As of December 31, 2007, AIGFP had the following net notional amount of protection outstanding on the super senior tranche of securities backed by the specified types of financial assets:75 Net Notional Amount (in billions) $ 230 149 70 $ $ 78 527 Corporate loans Prime residential mortgages Corporate debt/Collateralized loan obligations Multi-sector collateralized debt obligations Total 1. See id. (“[T]he demand for assets is split between money seeking absolute safety of principal and money seeking high returns. “). 72. See id. (describing how structured credit technology has evolved to meet the demands of these investors). 73. See id. (noting that a BBB-rated corporate bond portfolio could be tranched so that 90% of the debt securities would be rated AAA). 74. AIG ‘07 Annual Report, supra note 8, at 122. It is not clear whether the SPV’s are issuing a “super senior” class of securities r that the protection is triggered only after a certain level of losses is incurred on the AAA class. AIG states in its 2007 Annual Report that “AIGFP provides . . . credit protection on a ‘second loss’ basis, under which AIGFP’s payment obligations arise only after credit losses in the designated portfolio exceed a specified threshold amount or level of ‘first losses,’” which seems to indicate the latter. Id. at 121. 75. See id. at 122 (listing asset values). As of September 30, 2008, the net notional amount of the portfolio had decreased to $377. billion. AIG September ‘08 Quarterly Report, supra note 21, at 114. 956 66 WASH. & LEE L. REV. 943 (2009) Approximately $379 billion of AIGFP’s portfolio (the corporate loans and prime residential mortgages CDSs) were written to provide various European financial institutions “regulatory capital relief. “76 While AIG’s filings do not explain exactly what this means, presumably these institutions were able to reduce the amount of capital they are required to maintain against asset-backed securities they hold by purchasing CDSs on the securities.

As a recent Business Week article explained: Under international regulations known as the Basel Accords, European lenders have to set aside a certain amount of money to cover potential losses. By owning credit default swaps, banks could make it appear as if they had off-loaded most of the risk of a loan to AIG or another firm, thereby reducing their capital needs. The perfectly legal ploy allowed banks across the Continent to free up money to make more loans. 77 Most likely, such an institution would buy a CDS in this context only if its expected return from the resulting regulatory capital relief exceeded the cost of the credit default swap.

AIG indicated that, as of December 31, 2007, it “expects that the majority of these transactions will be terminated within the next 12 to 18 months by AIGFP’s counterparties as they implement models compliant with the new Basel II Accord. “78 The balance of AIGFP’s CDS portfolio (the remaining $148 billion) was arbitrage motivated. 79 AIG does not explain what this means but presumably the counterparties bought the protection as part of some type of arbitrage trading strategy.

The following diagram, which appears in AIG’s quarterly report for the third quarter of 2008, depicts “a typical structure of a transaction including the super senior risk layer. “80 76. See AIG September ‘08 Quarterly Report, supra note 21, at 118 (disclosing that certain CDSs were written to provide regulatory capital relief). 77. David Henry et al. , A Lethal Loophole at Europe’s Banks, BUS. WK. , Oct. 27, 2008, at 32; see also BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS: A REVISED FRAMEWORK 126–30 (2006), available at http://www. is. org/publ/bcbs128. pdf (explaining risk treatment for CDSs); BOMFIN, supra note 35, at 299–303 (explaining the treatment of CDSs under Basel I and Basel II). 78. AIG ‘07 Annual Report, supra note 8, at 33. 79. See AIG, Quarterly Report (Form 10-Q) 50 (June 30, 2008), available at http://media. corporate-ir. net/media-files/irol/76115/reports/Q210Q. pdf (listing Multi-sector CDOs and Corporate debt/CLOs under the heading “Arbitrage”). 80. AIG September ‘08 Quarterly Report, supra note 21, at 115. THE AIG BAILOUT 957 Obviously, AIGFP sold protection to make money.

A former AIGFP senior executive characterized writing CDSs as “gold” and “free money” because AIGFP’s risk models indicated that the underlying securities would never go into default. 81 Thus, the CDSs would expire untriggered, and AIGFP would pocket the premiums. 82 Basically, AIGFP speculated against a drop in credit quality with respect to innumerable asset-backed securities. After the fact, as discussed below, the strategy was a disaster, but not necessarily irrational or reckless before the fact. 83 Because almost all of 81. Carrick Mollenkamp et al. Behind AIG’s Fall, Risk Models Failed to Pass RealWorld Test, WALL ST. J. , Nov. 3, 2008, at A1; see also Gretchen Morgenson, Behind Biggest Insurer’s Crisis, Blind Eye to a Web of Risk, N. Y. TIMES, Sept. 28, 2008, at A1 (quoting statement from head of AIGFP that “[i]t is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [CDS] transactions’’); AIG, 2006 Annual Report (Form 10-K) 94 (Mar. 1, 2007) [hereinafter AIG ‘06 Annual Report], available at http://idea. sec. gov/Archives/edgar/data/5272/000 095012307003026/y27490e10vk. tm (“[T]he likelihood of any payment obligation by AIGFP under each [CDS] transaction is remote, even in severe recessionary market scenarios. “). 82. See AIG ‘06 Annual Report, supra note 81, at 94–95 (explaining CDS transactions and why they are likely to have positive results for AIG). 83. But see David Stout & Brian Knowlton, Fed Chief Says Insurance Giant Acted Irresponsibly, N. Y. TIMES, Mar. 3, 2009, available at http://www. nytimes. com/2009/ 03/04/business/economy/04webecon. html (citing Federal Reserve Chairman Ben Bernanke’s characterization of AIG as a “quasi-hedge fund” that “made irresponsible bets and took huge losses”). 58 66 WASH. & LEE L. REV. 943 (2009) AIGFP’s CDSs were written on super senior tranches and losses are allocated sequentially starting with the equity tranche, a pool of loans backing the SPV’s securities could suffer substantial defaults before any losses would be incurred by the super senior tranche. 84 If lower rated tranches absorb all the losses, meaning no losses have to be allocated to the super senior tranche, there will be no “credit event” with respect to the super senior tranche and, therefore, no payment obligation under the CDS AIGFP wrote on the tranche. 5 The weighted average attachment points at which the securities underlying different categories of AIGFP’s CDSs ranged from 12. 9% to 22. 9%. 86 “Attachment point” essentially means the percentage of loans in the pool that would have to be in default for any losses to be allocated to the super senior tranche. AIGFP’s historical models indicated that these levels of default would never occur. 87 Through its CDS business, AIG was leveraging further its then-AAA credit rating and trillion dollar balance sheet. 8 Counterparties were presumably willing to pay AIGFP a higher premium for protection because of AIG’s guarantee than they would pay for the same protection from a seller with a lower credit rating, lesser balance sheet, or less-favorable guarantee. 89 Further, as AIG noted in a May 2008 conference call presentation, its CDS business was very similar to its excess casualty insurance business, a business in which it had been profitably engaging for years. 90 84. See supra notes 63–73 and accompanying text (describing different tranches of securities). 5. See supra note 64–66 and accompanying text (explaining why no losses would accrue to the super-senior tranche). 86. AIG, Conference Call Credit Presentation 12 (May 9, 2008), http://media. corporateir. net/media_files/irol/76/76115/ConferenceCallCreditPresentation_05_09_08. pdf (last visited Sept. 29, 2009) (on file with the Washington and Lee Law Review). 87. See id. at 6 (noting that “[t]he attachment point for the ‘Super Senior’ portion of each portfolio is modeled as a minimum threshold above which there is no expected loss to AIGFP”).

AIG also noted that “[t]he final attachment point is negotiated to exceed the modeled attachment point, giving AIGFP an additional cushion of subordination to its risk position. ” Id. 88. See Kohn Statement, supra note 1, at 2 (“Financial Products . . . was able to take on substantial risk using the credit rating that AIG received. “). 89. See BOMFIN, supra note 35, at 10 (“[O]ther things being equal, the higher the credit quality of a given protection seller relative to other protection sellers, the more it can charge for the protection it provides. “). 90. Id. at 41. THE AIG BAILOUT III.

AIG’s Collapse 959 This Part explains why a company with $1 trillion in assets and $95. 8 billion in shareholders’ equity suddenly collapsed. The answer is that AIG ran out of cash largely as a result of the CDSs AIGFP wrote on multi-sector collateralized debt obligations. A. Credit Default Swaps on Multi-Sector Collateralized Debt Obligations A collateralized debt obligation (CDO) is a type of asset-backed security whose underlying pool of assets consists of tranches of other asset-backed securities (for example, mortgage-backed securities) and other debt obligations. 1 Just like the asset-backed securities structure described above, a CDO is typically tranched into different classes of debt securities reflecting different levels of seniority and, therefore, a range of credit ratings (from AAA to BB). 92 A multi-sector CDO is one whose underlying assets consist of tranches of asset-backed securities with underlying pools of assets from multiple sectors such as residential mortgage loans, commercial mortgage loans, auto loans, credit card receivables, and other similar assets. AIG wrote protection on super senior tranches of these CDOs as well as “high grade” and mezzanine tranches. 3 Unfortunately for AIG and its shareholders, $61. 4 billion in net notional amount of AIGFP’s CDS portfolio was written on multi-sector CDOs with underlying residential mortgage-backed securities whose asset pools included subprime mortgage loans. 94 As AIG noted in its 2007 annual report, “[i]n mid2007, the U. S. residential mortgage market began to experience serious disruption due to credit quality deterioration in a significant portion of loans originated, particularly to non-prime and subprime borrowers . . . .”95 Defaults 91. See Douglas J.

Lucas et al. , Collateralized Debt Obligations and Credit Risk Transfer 1 (Yale ICF Working Paper No. 07-06, 2007), available at http://papers. ssrn. com/ sol3/papers. cfm? abstract_id=997276 (noting that a CDO might contain corporate loans or mortgage-backed securities). 92. See id. at 2 (describing seniority structure of CDOs). 93. AIG September ‘08 Quarterly Report, supra note 21, at 115. “High grade” refers to CDO securities with underlying collateral credit ratings on a stand-alone basis of predominantly AA or higher at origination. Id. Mezzanine” refers to CDO securities in which the underlying collateral credit ratings on a stand-alone basis were predominantly A or lower at origination. Id. 94. See AIG ‘07 Annual Report, supra note 8, at 122 (“Approximately $61. 4 billion in notional amount of the multi-sector CDO pools include some exposure to U. S. subprime mortgages. “). 95. Id. at 30. 960 66 WASH. & LEE L. REV. 943 (2009) by these borrowers rippled through the chain, ultimately leading to massive write-downs in AIGFP’s CDS portfolio totaling $11. 2 billion in 200796 and $19. billion for the first nine months of 2008. 97 Specifically, (1) the defaults negatively impacted the cash flow of the SPVs who issued debt securities backed by the loans, which (2) negatively impacted the credit quality of the SPVs and their securities, which (3) negatively impacted the credit quality of the multi-sector CDOs which purchased some of the SPVs’ securities, and which (4) caused the estimated spread on the CDSs written on the CDOs’ securities to widen resulting in unrealized losses on AIGFP’s CDO CDS portfolio.

While these write-downs certainly contributed to AIG’s cash woes, they were not the main culprit given they were unrealized and, therefore, did not actually directly impact AIG’s cash flow. 98 The principal cause of AIG’s cash woes was the collateral posting obligations in AIGFP’s multi-sector CDO CDSs. 99 As discussed above, these provisions are a common feature of CDSs designed to reduce the counterparty credit risk assumed by a CDS protection buyer. 100 The amount of collateral that AIGFP is required to post depends on the terms of the provisions. 101 These terms are subject to negotiation and thus vary across AIGFP’s portfolio. 02 Some CDSs require AIGFP to post collateral equal to the difference between the estimated cost to replace the applicable CDS and the collateral posted to date (subject to certain thresholds) with the calculation performed daily, weekly, or at some other interval as provided in the CDS. 103 The large majority of AIGFP’s multi-sector CDO CDSs base collateral posting requirements on the difference between the notional amount of the particular CDS and the market value of the underlying CDO security. 104 Accordingly, as CDO values tanked, AIG was obligated to post more and more cash collateral.

For example, from July 1, 2008, to August 31, 2008, declines in the CDO securities on which 96. See id. at 122 (showing table listing loss). 97. See AIG September ‘08 Quarterly Report, supra note 21, at 114 (showing table). 98. The write-downs had an indirect impact on AIG’s cash flow because they made it difficult for AIG to access the capital markets for additional cash. Infra Part III. C. 99. See AIG September ‘08 Quarterly Report, supra note 21, at 118 (discussing the collateral posting requirements). 100. See supra note 43 and accompanying text (describing posting obligations). 101.

See AIG September ‘08 Quarterly Report, supra note 21, at 118 (“These provisions differ among counterparties and asset classes. “). 102. See id. (noting that posting requirements vary). 103. See id. (explaining mechanism for determining amount to be posted). 104. See id. at 119 (“[T]he exposure amount [is] determined pursuant to an agreed formula that is based on the difference between the net notional amount of such transaction and the market value of the relevant [CDO]. “). THE AIG BAILOUT 961 AIGFP wrote protection, together with rating downgrades on these securities, resulted in AIGFP posting or agreeing to post $6. billion in collateral, representing approximately 34% of the $17. 6 billion in cash and cash equivalents AIG had available on July 1, 2008, to meet the cash needs of its operations. 105 B. Securities Lending Program Adding to AIG’s cash struggles was its securities lending program, a program managed by AIG Investments, AIG’s institutional asset management unit. 106 Under the program, AIG Investments loaned securities from the investment portfolios of AIG’s insurance companies to various financial institutions (the typical reason an institution borrows securities is to sell them short) in exchange for cash collateral posted by the borrower. 07 AIG Investments would then invest the collateral in debt securities to earn a return which would serve as compensation for lending securities. 108 At one point, AIG investment had loaned $76 billion in securities to U. S. companies. 109 As borrowers received news about AIG’s massive write-downs and collateral posting obligations, they became concerned about the safety of the cash collateral they had posted with AIG Investments. Thus, many of them decided to return lent securities and get their collateral back. 110 Unfortunately, AIG Investments had invested a significant portion of the cash in residential ortgage-backed securities which had plummeted in value and liquidity. 111 As 105. See id. at 49 (noting amount of loss and level of cash on hand). 106. See id. at 143 (noting that the program was run for the benefit of AIG’s insurance companies). 107. See id. (describing program). Short selling is a technique used to profit from a drop in value of a security. The short seller borrows a security and immediately sells it with the hope that the price of the security will drop allowing the short seller to buy it back at a lower price and then return it to the lender. 08. See id. (“Cash collateral is received and invested . . . to receive a net spread. “). 109. See American International Group: Examining What Went Wrong, Government Intervention, and Implications for Future Regulation: Hearing Before S. Comm. on Banking, Housing & Urban Affairs, 111th Cong. 5 (2009) (written testimony of Eric Dinallo, Superintendent of Insurance, New York State Insurance Department) [hereinafter Dinallo Testimony], available at http://banking. senate. gov/public/_files/DinalloTestimonyAIG3509. pdf (“At its height, the U.

S. pool had about $76 billion. “). 110. See AIG September ‘08 Quarterly Report, supra note 21, at 144 (“Counterparties began curtailing their participation in the program by returning securities. “); Dinallo Testimony, supra note 109, at 6 (noting that crisis at AIGFP “caused the equivalent of a run on AIG securities lending”). 111. AIG September ‘08 Quarterly Report, supra note 21, at 144. 962 66 WASH. & LEE L. REV. 943 (2009) a result, the program lacked sufficient funds to satisfy collateral-return obligations. 12 Accordingly, AIG was forced to transfer billions in cash to the program, cash which was immediately paid out to these borrowers. 113 Through August 31, 2008, AIG had transferred $3. 3 billion in cash to the program. 114 C. Inability to Access Capital Markets and Credit Downgrade By early September 2008, AIG realized its cash situation was dire and, therefore, accelerated its ongoing efforts to raise additional capital. 115 It held discussions with private equity firms, sovereign wealth funds, and other investors but was unable to strike a deal. 16 In more bad news, several of AIG’s subsidiaries were unable to roll over their commercial paper financing,117 meaning AIG was essentially shut out of the commercial paper market. After considering the massive write-downs on AIGFP’s CDS portfolio, the billions of dollars of collateral posting obligations, AIG’s inability to access the capital markets, and its insurance company investment portfolio losses, the credit rating agencies downgraded AIG’s long-term debt rating on September 15, 2008—S&P by three notches and Moody’s and Fitch by two notches. 18 These downgrades triggered in excess of $20 billion in additional collateral calls because the collateral posting provisions contained in many of AIGFP’s CDSs also took into account the credit rating of AIG, with a credit downgrade triggering additional posting obligations. 119 112. See id. (noting that AIG did not have sufficient liquidity to pay). 113. See id. at 49 (noting that AIG paid $6 billion); see also Kohn Statement, supra note 1, at 7 (noting that decline in RMBS values caused a strain on AIG’s finances). 114. AIG September ‘08 Quarterly Report, supra note 21, at 49. 115. See id. describing AIG’s efforts to raise capital, including hiring J. P. Morgan). 116. See id. at 50 (noting that AIG discussed raising capital with multiple parties but could not reach agreement). 117. See id. (noting that AIG had to give $2. 2 billion to its subsidiaries to make payments). 118. S&P’s rationale for the downgrade was “the combination of reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgage-related losses. ” Standard & Poor’s, Research Update: American International Group Rating Lowered and Kept on Credit Watch Negative, 2 (Sept. 5, 2008). Moody’s rationale was “the continuing deterioration in the US housing market and the consequent impact on [AIG]’s liquidity and capital position due to its related investment and derivative exposure. ” Moody’s Investors Service, Moody’s Downgrades AIG (senior to A2); LT and ST ratings under review, 1 (Sept. 15, 2008). Fitch’s rationale was “that AIG’s financial flexibility and ability to raise holding company cash is extremely limited due to recent declines in the company’s stock price, widening credit spreads, and difficult capital market conditions. Fitch Ratings, Fitch Downgrades AIG to ‘A’; Remains on Rating Watch Negative, 1 (Sept. 15, 2008). 119. See AIG September ‘08 Quarterly Report, supra note 21, at 50 (“Subsequently, in a THE AIG BAILOUT 963 The day after the downgrade, AIG made a last ditch effort to raise additional financing. Among other things, AIG management met with representatives of Goldman, Sachs & Co. , J. P. Morgan, and the Federal Reserve Bank of New York (NY Fed) to discuss putting together a $75 billion secured lending facility syndicated among various financial institutions. 20 By the early afternoon, however, it was apparent that no private sector lending facility was forthcoming121 and that AIG “had an immediate need for cash in excess of its available liquid resources. “122 As a result, the government decided to intercede. IV. The Bailout At 9:00 p. m. EDT on September 16, 2008, the Federal Reserve Board (Fed) announced, with the support of the U. S. Department of the Treasury (Treasury), that it had authorized the NY Fed to bail out AIG through an $85 billion revolving credit facility (Fed Credit Facility). 23 The intent of the loan was to “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. “124 This Part discusses the initial bailout and subsequent restructurings, analyzes some legal issues associated with the bailout, and probes why the government stepped in. period of approximately [fifteen] days following the rating actions, AIGFP was required to fund approximately $32 billion, reflecting not only the effect of the rating actions but also changes in market levels and other factors. ). 120. See id. (noting that AIG met with those firms to try to arrange a loan). 121. See id. (stating that private firms could not organize a facility). The banks advising AIG determined that “it would be all but impossible to organize a loan of that size. ” Matthew Karnitschnig et al. , U. S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up; Emergency Loan Effectively Gives Government Control of Insurer; Historic Move Would Cap 10 Days that Reshaped U. S. Finance, WALL ST. J. , Sept. 7, 2008, at A1; see also Kohn Statement, supra note 1, at 4 (commenting that the private sector effort “was unsuccessful in a deteriorating economic and financial environment in which firms were not willing to expose themselves to risks—a risk aversion that greatly increased following the collapse of Lehman Brothers on September 15”). 122. AIG September ‘08 Quarterly Report, supra note 21, at 50. 123. See Press Release, The Federal Reserve Board (Sept. 16, 2008) [hereinafter 9/16/08 Fed Press Release], available at http://www. federalreserve. ov/newsevents/press/other/ 20080916a. htm (announcing bailout and explaining that failure of AIG would damage markets). 124. Id. 964 66 WASH. & LEE L. REV. 943 (2009) A. Initial Bailout As initially struck, the Fed Credit Facility provided for a line of credit of up to $85 billion in principal amount, had a two-year term expiring on September 22, 2010,125 and bore interest at the greater of 3. 5% per annum and 3-month LIBOR,126 plus 8. 5% per annum (meaning a minimum interest rate of 12%). 127 AIG was required to pay an initial gross commitment fee of $1. billion128 and an ongoing commitment fee of 8. 5% per annum on undrawn amounts. 129 As described below, these terms have been revised but the other terms of the original agreement remain in place. 130 The Fed Credit Facility requires AIG to pay interest and commitment fees through increases to the outstanding principal balance under the facility,131 although AIG has the option to pay them in cash. 132 AIG may use borrowings under the facility for general corporate purposes, including as a source of liquidity. 33 Additionally, AIG is required to use any net cash proceeds from the sale of certain assets or the issuances of equity or debt securities to pay down the outstanding balance on the Fed Credit Facility. 134 The amount available for borrowing under the Fed Credit Facility is reduced permanently by the amount of any such payments. 135 The Fed Credit Facility required AIG to issue 100,000 shares of preferred stock (Series C Preferred) to AIG Credit Facility Trust (Trust),136 “a new trust 125. See Credit Agreement Between American International Group, Inc. and Federal Reserve Bank of New York § 4. 12 (Sept. 2, 2008) [hereinafter Credit Agreement], available at http://www. sec. gov/Archives/edgar/data/5272/000095012308011496/y71452exv99w1. htm (defining terms of agreement, including the $85 billion commitment and the September 22, 2010 maturity date). 126. LIBOR stands for London Inter-Bank Offer Rate. It is the rate of interest at which banks lend money to one another in the London wholesale money markets. 127. See Credit Agreement, supra note 125, § 2. 06(a) (defining terms of loan and giving Applicable Margin as 8. 5%). 128. See id. § 4. 02(e) (requiring AIG to pay 2% of total $85 billion on closing date). 29. See id. § 2. 05(a) (describing exact terms of available commitment fee). 130. See infra Parts IV. C–D (noting that revised terms are less harsh for AIG). 131. See Credit Agreement, supra note 125, § 2. 06(b) (discussing loan payment mechanism). 132. See id. § 2. 11(c) (requiring two days notice of AIG cash payment). 133. See id. § 5. 07 (referencing preamble’s list of acceptable uses for money). 134. See id. § 2. 10 (listing events triggering AIG payment obligation). 135. See id. § 2. 10(h) (stating that loan commitment reduced simultaneously with any prepayment by AIG). 36. AIG’s initial Form 8-K filed with the SEC with respect to the Fed Credit Facility stated: THE AIG BAILOUT 965 established for the benefit of the United States Treasury. “137 AIG issued the shares to the Trust in March 2009. Following the requisite vote of AIG stockholders to amend AIG’s certificate of incorporation to increase the number of authorized shares of common stock to 19 billion and reduce their par value from $2. 50 to $0. 000001 per share, the Series C Preferred will be convertible at the Trust’s option into a number of shares of common stock equal to 77. % of AIG’s then outstanding shares of common stock plus the maximum number of shares reserved for issuance with respect to the equity units AIG sold in a May 2008 offering. 138 The Series C Preferred will vote with the common stock on AIG issued a warrant to the Board of Governors of the Federal Reserve (“Federal Reserve”) that permits the Federal Reserve, subject to shareholder approval, to obtain up to 79. 9% of the outstanding common stock of AIG (after taking into account the exercise of the warrant). AIG anticipates calling a special meeting for such purpose as promptly as practicable.

AIG, Current Report (Form 8-K) 1 (Sept. 18, 2008). AIG filed an amended Form 8-K the next day indicating that AIG did not in fact issue a warrant but will be issuing a 79. 9% equity interest. AIG, Amended Current Report (Form 8-K/A) 1 (Sept. 19, 2008). 137. Credit Agreement, supra note 125, § 5. 11, Exhibit D, at 1. Presumably, because the government had, and continues to have, many fires to put out, the trust was not actually created until January 16, 2009. AIG Credit Facility Trust Agreement Among Federal Reserve Bank of New York et al. (Jan. 6, 2009), available at http://www. newyorkfed. org/ newsevents/news/markets/2009/AIGCFTAgreement. pdf. A NY Fed press release describes the trust as follows: Pursuant to the terms of the Trust Agreement, the trustees will have absolute discretion and control over the AIG stock, subject only to the terms of the Trust Agreement, and will exercise all rights, powers and privileges of a shareholder of AIG. The trustees will not sit on the board of directors of AIG. Day-to-day management of AIG will remain with the persons charged with such management.

To avoid possible conflicts with the New York Fed’s supervisory and monetary policy functions, the Trust has been structured so that the New York Fed cannot exercise any discretion or control over the voting and consent rights associated with the equity interest in AIG. The New York Fed will, however, continue to monitor closely the financial operations of AIG in connection with its role as lender. Press Release, The Federal Reserve Bank of New York, Statement Regarding Establishment of the AIG Credit Facility Trust (Jan. 16, 2009), available at http://www. ewyorkfed. org/newsevents/news/markets/2009/an090116. html. The trust agreement provides for three initial trustees: Jill M. Considine, former chairman of the Depository Trust & Clearing Corporation; Chester B. Feldberg, former chairman of Barclays Americas; and Douglas L. Foshee, president and chief executive officer of El Paso Corporation. Id. For speculation as to why the shares are held in trust as opposed to directly by the U. S. Treasury or Fed, see Steven M. Davidoff & David T. Zaring, Big Deal: The Government’s Response to the Financial Crisis 32 (Nov. 4, 2008), available at http://ssrn. com/abstract=1306342. 138. Credit Agreement, supra note 125, Exhibit D, at 1–2. For a description of the May 2008 offering of equity units, see AIG September ‘08 Quarterly Report, supra note 21, at 26. As of September 30, 2008, AIG had five billion authorized shares of common stock and nearly three billion shares outstanding. Id. at 2. Thus, it needs to increase its authorized shares of common stock so that it has sufficient authorized but unissued shares to issue upon conversion 966 66 WASH. & LEE L. REV. 943 (2009) ll matters submitted to AIG’s stockholders and will be entitled to one vote per share into which the Series C Preferred is then convertible, not to exceed 77. 9% of the aggregate voting power. 139 The Series C Preferred is entitled to participate on an as-converted basis in any dividends paid on the common stock, not to exceed 77. 9% of the aggregated divid