Not all the details have been released, so I will update this as new things come forth.
Bottom line, the government is going to offer American International Group (AIG) a bridge loan. The amount of the loan will be to the tune of $85 billion. In return, from what we know now, AIG will begin to sell assets ASAP to serve as collateral for the loan. Also, the company will grant the government Warrants.
If this is the case, here's what this means. For the uninitiated, bridge loans are short term loans lasting between two weeks to about 3 years. The "bridge" term comes in as these transactions are interim financing until a business concern can find a longer-term loan solution. Bridge loans are rarely issued by banks and other financial solutions because the highly speculative nature of the loan. Because of this high risk, bridge loans often demand a much larger interest rate, and other necessities like equity in the company. For example, say you owned a shop that makes money regularly but you needed cash fast, the banks are saying they can't help you sooner than you need. So you go to a friend or an investor or financier, they say OK we'll give you the money, but we want 10% interest and 10% ownership of the company; in addition the loan is due in a month. All right, not the world's greatest example, but I am trying to give you an idea here of what's going on.
Now Warrants are security instruments that allow someone to buy the shares of a company at a specific price until a certain time. In a sense, they area derivative. The difference between a Warrant and a Call Option is that the latter are traded by exchanges (though some warrants are traded as well), warrants are issued by the company whereas options are created by an exchange, and the life of a warrant can be in years whereas a Call option often is in months.
So what's this all mean for the tax payer, AIG's shareholders, AIG's bond holders, and the US government? Well for starters, assuming no deal is finalized, tomorrow morning AIG would declare bankruptcy. Still, this deal is no panacea either. If this goes through, the tax payer will be putting up that $85 billion. AIG's shareholders will see their stock dilhuted to the point that it's worth nothing. AIG's bond holders will see a similar fate, as they will be put in the back of the line (along with the company's shareholders) of creditors.
The US government will now be first in line to get money. Unlike, say the Fannie and Freddie deal, the tax payer stands to make a substantial amount of money. As the company begins to unload assets and build up reserves, the tax payer will get it's loan repaid. Secondly, as the financial health of the company improve, and it will, the value of the warrants held by the government will increase in value.
But we need to be realists, and see that there is also a downside. What if AIG is unable to sell off assets? What if the counter-parties to the Credit Default Obligations and Swaps say no dice, we won't do more business with you?
Luckily, because the government is now offering the cash, under the way these swaps and derivatives are designed, AIG won't be deemed in default. You see, they need to maintain a certain credit rating to keep going on business. The infusion of cash helps make the case, and many on the Street are saying they are in agreement in such. At the end of the day, AIG will be able to stand behind it's obligations.
Folks, the crisis isn't over in the financial world, but we're finally plugging in some of the holes. Right now, watching CNBC, the most irate people have been Larry Kudlow and gang. They are now demanding that the government return the Warrants. These people want the government to allow AIG to fall, regardless of the ramification.
UPDATE: It's official, despite some dismay by Treasury Sec, Hank Paulson who originally objected, the deal is now official!
UPDATE 2: Here's the nitty gritty from the Wall Street Journal, just put out.
The U.S. negotiators drove a hard bargain. Under terms hammered out Tuesday night, the Fed will lend up to $85 billion to AIG, and the U.S. government will effectively get a 79.9% equity stake in the insurer in the form of warrants called equity participation notes. The two-year loan will carry an interest rate of Libor plus 8.5 percentage points. (Libor, the London interbank offered rate, is a common short-term lending benchmark.)
The loan is secured by AIG's assets, including its profitable insurance businesses, giving the Fed some protection even if markets continue to sink. And if AIG rebounds, taxpayers could reap a big profit through the government's equity stake.
"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 Fed said in a statement.
It puts the government in control of a private insurer -- a historic development, particularly considering that AIG isn't directly regulated by the federal government. The Fed took the highly unusual step using legal authority granted in the Federal Reserve Act, which allows it to lend to nonbanks under "unusual and exigent" circumstances, something it invoked when Bear Stearns Cos. was rescued in March.
As part of the deal, Treasury Secretary Henry Paulson insisted that AIG's chief executive, Robert Willumstad, step aside. Mr. Paulson personally told Mr. Willumstad the news in a phone call on Tuesday, according to a person familiar with the call.
- excerpt from "U.S. to Take Over AIG in $85 Billion Bailout", WSJ,com, 2008