by Marla Singer and Geoffrey Batt
Buried in the depths of page 26 of the Office of the Special Inspector General for the Troubled Asset Relief Program's (SIGTARP's) November 17, 2009 report "Factors Affecting Efforts to Limit Payments to AIG Counterparties" hidden in footnotes 33 and 34 is something of a mystery. It might be the beginning of an interconnected financial chain involving Dubai, the Federal Reserve, AIG, Basel I, Eastern Europe and even Switzerland and which, even if it doesn't worry you, probably should. Or it might be nothing at all.
Consider first "footnote 33," that reads as follows:
The first Basel Accord, known as Basel I, was issued in 1988; it focused on the capital adequacy of financial institutions. The capital adequacy risk—the risk that a financial institution will be hurt by an unexpected loss—categorizes the assets of financial institution into five risk categories (0 percent, 10 percent, 20 percent, 50 percent, and 100 percent). Banks that operate internationally are required to have a risk weight of 8 percent or less....
The original paragraph that references the footnote reads thus:
As of September 30, 2009, AIG had $172 billion in exposure to swaps in its foreign regulatory capital portfolio. The portfolio contains swaps purchased by financial institutions, principally in Europe, to provide regulatory capital relief under Basel I. [note 33] AIGFP’s COO informed SIGTARP in July 2009 that they expect that most of these swaps will be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II. Currently, financial institutions are required to hold a certain level of capital against their assets, and one way for a financial institution to reduce the amount of capital is to purchase swap protection on its assets. However, new requirements decrease the level of capital required for such assets and, in most cases, there will be limited capital benefit to holding on to the existing swaps. Nonetheless, AIG warned in a June 29, 2009, SEC filing that if credit markets deteriorate, the company may recognize unrealized losses in AIGFP’s regulatory capital credit default swap portfolio. [note 34] AIG could continue to be at risk if the swaps in its regulatory capital portfolio are not terminated by the end of first quarter 2010 as expected. (Emphasis added).
Taken together we read the thrust of this section to mean that a number of European banks, seeking to limit their regulatory capital requirements under Basel I (read: seeking to increase their leverage) bought swap protection on their assets from AIG. These obligations still sit with AIG and, in the event credit markets sink materially, AIG is likely to take losses on these instruments. Not just that but:
According to an AIG SEC filing, an ongoing concern for AIGFP is whether it will have to post more collateral if credit markets continue to deteriorate. The amount of future collateral postings is partly a function of AIG’s credit ratings, which may be affected by any further decline in AIG’s financial condition. (Emphasis added).
Simply put, AIG might also have to post more collateral. Moreover, though AIG initially expected most of these swaps to "be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II," we see from footnote 34 that:
Subsequent to the June filing, European regulators adjusted the implementation timing of Basel II, potentially affecting the holders of AIGFP’s regulatory capital swaps to hold beyond previously anticipated termination dates.
In other words, AIG is still on the hook- and hadn't planned to be.
This raises a number of questions:
- If the European banks that bought swap protection from AIG are still relying on this protection to meet their capital requirements, and AIG might be unable to make good on the agreements, are these banks actually out of Basel I compliance as we type this?
- Are the banks still able to use swap protection to reduce their collateral requirements because of the implicit or explicit backing of AIG by the Federal Reserve?
- If this situation existed in September-November 2008, as it certainly appears to have, how exactly can the Federal Reserve claim in good faith that it lacked the leverage to negotiate with these banks from a position of strength? (One assumes that many of the same names collecting payment from AIG were also AIG swap protection buyers of the sort mentioned in the SIGTARP report). Failure to back up an insolvent AIG would have resulted in near-immediate Basel I non-compliance as the protection offered by these swaps, and on which these banks depended for their reduced capital requirements, evaporated- a near death sentence.
- Or had these banks somehow, and in the middle of the credit crisis, managed to boost their capital to levels that made the swaps unimportant?
- If so, why keep them on the books now, instead of unwinding them?
- Since it doesn't seem likely that a teetering AIG could make good on these agreements without substantial assistance is the Fed is currently the ultimate backstop for AIG?
- Does this mean that the Fed is effectively underwriting these swap agreements?
- Will the Fed post collateral if deteriorating credit conditions at AIG (today's -$11 billion news suddenly seems especially daunting if the potential insurance shortfall has an effect on credit ratings) or general credit market issues require it? Or are we missing something significant? By September 30, 2008 AIG had already posted $974 million in collateral for its "Foreign Regulatory Capital" portfolio.
- What if European banks are hit with more losses from, oh, we don't know, say... Dubai? Deleveraging, risk reduction and credit tightening would have an effect on LIBOR, the Eurobond market and, of course, Eastern Europe. Might not that sort of contagion easily spread to, say, Switzerland, which enjoyed the other side of the carry trade for years by lending Swiss Franc like mad to any Eastern European mortgage borrower who could sign documents?
- Could it be that the Fed, once again, might have to bail out the world?
Or maybe we are just missing something obvious.