AIG watch

Treasury is setting up a special vehicle to buy up (face value) $70 billion in "troubled" CDOs insured by AIG CDS. At 50 cents on the dollar they intend to spend $30 billion in taxpayer dollars and $5 billion of AIG's money. This should reduce the collateral calls on AIG, although it's not clear that all the entities holding AIG CDS actually own the referenced CDO. Who at Treasury did the calculation to confirm that the ultimate value of the CDOs in question is over 50 percent of face value? If I'm holding the CDO and corresponding CDS contract, and I'm confident that the government is behind AIG, why should I sell at a 50 percent loss?

Kashkari remarks on TARP.

WSJ: ...The government's initial intervention was driven by concern that AIG's failure to meet it obligations in the credit default swap market would create a global financial meltdown. ...

Under the revised deal, AIG is expected to transfer the troubled holdings into two separate entities.

The first such vehicle is to be capitalized with $30 billion from the government and $5 billion from AIG. That money will be used to acquire the underlying securities with a face value of $70 billion that AIG agreed to insure with the credit default swaps. These securities, known as collateralized debt obligations, are thinly traded investments that include pools of loans. The vehicle will seek to acquire the securities from their trading partners on the CDS contracts for about 50 cents on the dollar.

The securities in question don't account for all of AIG's credit default swap exposure but are connected to the most troubled assets. The government may be betting that its involvement will encourage AIG's trading partners to sell the securities tied to the CDS contracts to the new entity.

Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted to back the contracts. The total collateral at stake is about $30 billion.

It may also have some unintended consequences across the markets. For the plan to work, AIG's trading partners -- the banks and financial institutions that are on the other side of its credit-default-swap contracts -- may have to agree to any changes in the terms of their agreements with AIG.