The Rescue of American International Group Module B: The Securities Borrowing Facility

On September 16, 2008, the Board of Governors authorized the FRBNY to enter into the $85 billion RCF with AIG. By October 1, AIG had drawn down approximately $62 billion from the RCF, part of which was used to repay counterparties that settled rather than rolled over securities borrowing agreements. In light of this usage and evidence that “AIG was likely to face additional, significant liquidity pressures due to the expected decision by other securities borrowing counterparties to not renew their securities borrowing positions with AIG,” the Board approved a recommendation from the FRBNY to establish the Securities Borrowing Facility (BdofGov 2009, 17). (The facility was then still referred to as a securities lending facility.) The SBF was created as a temporary measure to “reduce the pressure on AIG to liquidate” the RMBS portfolio related to its securities lending program and maintain the value of AIG’s subsidiaries during the portfolio wind down (US COP 2010, 71; BdofGov 2008c, 2-3). The RCF and the Securities Borrowing Facility were part of a large package of assistance established by the government to address AIG’s severe liquidity and capital issues (Massad 2012). In all, AIG-targeted government interventions totaling $182.3 billion would be funded by the FRBNY and Treasury, including loans, asset purchases, and capital investments (Massad 2012).

The Federal Reserve Board authorized the FRBNY to enter into the Securities Borrowing Facility pursuant to Section 13(3) of the Federal Reserve Act, the board’s emergency lending authority. Section 13(3) had three basic requirements: (1) the Board must determine that “unusual and exigent” circumstances exist, by the affirmative vote of at least five members, or if fewer than five members of the Board are available, then by the unanimous vote of such fewer number,  (2) the loans must be secured to the satisfaction of the lending Reserve bank, and (3) the lending Reserve bank “must have obtained evidence that adequate credit was not available from other banking institutions” (Title 12 U.S.C. 343, 112). In determining that exigent and unusual circumstances existed, the Board considered that “as of October 1, AIG had drawn down approximately $62 billion of the RCF,” some of which had been used to repay counterparties returning securities that they had borrowed from AIG (BdofGov 2008c, 2). In addition, the Board noted “the expectation that additional securities borrowing counterparties would decide to not renew their securities borrowing positions with AIG, and the continuing fragile position of the financial markets”^FThe Board minutes reflect the following detail: “The Board members' discussion of the proposed securities lending facility included consideration of (1) the current state of the financial markets, (2) continuing systemic risk to financial markets and possible risk of loss to the Federal Reserve from the disorderly failure of AIG, (3) the likelihood that no incremental losses would be assumed by the Federal Reserve, thanks to the high-quality collateral taken under the proposed facility and the additional protections provided by the terms of the proposed facility, and (4) the need to coordinate with the relevant state insurance authorities for AIG's insurance subsidiaries” (BdofGov 2009, 17). (BdofGov 2008c, 2). This formed the basis for the Board’s determination that exigent and unusual circumstances existed that warranted approval of the Secured Borrowing Facility on the general terms presented before the meeting (BdofGov 2009, 17). It is important to note that state insurance regulators who were responsible for monitoring the insurance subsidiaries involved in the securities lending program also voiced their support (BdofGov 2008c, 2).

Issuance of the loan by the FRBNY also required that the credit could be “secured to the satisfaction” of the lending Reserve Bank (Title 12 U.S.C. 343, 112). The Board minutes observed that: “The advances should be secured by high-quality investment-grade debt obligations that are owned by the insurance subsidiaries of AIG and, thus, were not available as collateral under the current AIG [RCF]” (BdofGov2009, 17). As added comfort, the Fed did not anticipate any losses from the SBF because “advances made under the Secured Borrowing Facility will be with recourse to AIG and fully secured by investment-grade debt obligations” (BdofGov 2008c, 3).

Section 13(3) also requires that the lending Reserve bank “have obtained evidence that adequate credit was not available from other banking institutions.” In authorizing the FRBNY to lend, the FOMC referenced that AIG had thus far borrowed $62 billion under the RCF and had used some of these funds to settle transactions with counterparties returning these third-party securities to AIG under its SecLending Program. (BdofGov 2009, 17)  It also considered the current state of the finance markets and conditioned its authority on the FRBNY  “obtaining evidence that the borrower is unable to secure adequate credit accommodations from other banking institutions.” (BdofGov 2009, 17).  Such evidence was apparently obtained by the FRBNY prior to entering into the Securities Borrowing Facility.

The size of the loan was determined by the FRBNY to be large enough “to replace all remaining securities borrowing counterparties of AIG,” in the event that all counterparties in the securities lending program demanded their cash collateral back (BdofGov 2008c, 3). According to the filing regarding the creation of the SBF, “As of October 6, 2008, approximately $37.2 billion of securities were subject to loans under AIG’s securities lending program” (AIG 2008c). Therefore, the available size of the loan was set slightly above the amount of cash collateral owed to securities borrowers at the time the SBF was created (BdofGov 2008c, 3).

Section 13(3) required that loans be “secured to the satisfaction of the Federal Reserve” (US COP 2010, 56). The securities that AIG had lent to securities borrowers were high-quality fixed-income securities and easily met the Fed’s discount window criteria. “These securities that counterparties [were] giving back [were] high-quality corporate bonds—the kind of things we lend against,” a Fed official involved in the program told the Financial Crisis Inquiry Commission (FCIC 2011b, 5).

The Congressional Oversight Panel (COP) noted that the quality of the collateral backing the Fed’s $85 billion RCF raised “difficult questions,” since AIG pledged its stakes in insurance companies that were difficult to value at the time and the private sector consortium had only days earlier concluded that AIG didn’t have sufficient assets to back a $75 billion loan (US COP 2010, 227). In contrast, the COP noted that the securities pledged for the SBF were “less risky and more easily valued” than the RCF collateral (US COP 2010, 228). The collateral consisted of high-quality fixed-income securities held by AIG’s insurance subsidiaries and included corporate debt obligations, agency pass-through certificates, collateralized mortgage obligations, and obligations of foreign and local governments (BdofGov 2008c, 3).

According to the Fed’s Section 129 report on the facility: “All advances made under the new facility will be fully collateralized by investment-grade debt obligations that are subject to an appropriate haircut consistent with the Reserve Bank’s usual discount window lending practices” (BdofGov 2008c, 3). Data show the haircut averaged about 14% over the life of the program (BdofGov 2010).

The SBF followed the Fed’s usual practice in offering credit with a term of one day (BdofGov 2008c, 3). The Fed’s discount window loans are typically overnight, although the Fed extended the maturity of discount window loans during the crisis up to 90 days (FCIC 2011a, 252, 363). Prior to the crisis, about 10% of AIG’s securities lending transactions with customers had one-day terms; “substantially all” had terms of three months or less (AIG 2008b, 112).

The Fed stated that it created the SBF with the same maximum duration as the RCF “in order to allow the company to conduct an orderly disposition of certain of its assets” (BdofGov 2008c, 3). While the SBF had a maximum duration of two years, it was wound down just two months later, upon the inception of Maiden Lane II (FRBNY 2008).

Much of the SBF was based on existing programs, such as the discount window and TSLF. For example, the haircuts and one-day term applied to the securities were consistent with conventional discount window calculations (BdofGov 2008c, 3). According to former FRBNY general counsel Thomas Baxter in an interview with YPFS, the FRBNY wanted to utilize some of the features of already standing liquidity programs, in particular the TSLF, and not create new ones from scratch. “At the beginning of October 2008, we had fires burning everywhere and part of the thinking was that we have to solve this new problem, but let's not try to reinvent the wheel” (Baxter 2018, 14). AIG could not draw on the TSLF because it was not a primary dealer; the Fed did not accept its request to become a primary dealer that came the week preceding its rescue (US COP 2010, 105). Since AIG had problems that were similar to those of primary dealers being addressed by the TSLF, Baxter said, it was natural to create a comparable facility, just one that worked for an insurance company like AIG and focused on RMBS portfolios (Baxter 2018, 14).

The FRBNY conducted a daily survey of dealers regarding repo rates on comparable collateral in order to ascertain market rates (BdofGov 2008c, 3). The SBF then charged an interest rate of 100 basis points above the observed repo rates on loans it extended to AIG (BdofGov 2008c, 3).

On October 6, 2008, the Federal Reserve Board unanimously approved the creation of the SBF (BdofGov 2008c, 1; BdofGov 2009, 17). Two days later, the facility was established, and the Fed announced its creation through a press release (BdofGov 2008b,  US COP 2010, 68). In the release, the Fed acknowledged the use of RCF funds to settle securities lending transactions, explaining that the newly created facility would “allow AIG to replenish liquidity used in settling those transactions, while providing enhanced credit protection to the FRBNY and U.S. taxpayers in the form of a security interest in these securities” (Board authorizes FRBNY to borrow securities from . . . AIG 2008). Because of the short duration of the SBF, a little over two months, there was minimal communication from the FRBNY regarding its management. On November 10, 2008, the FRBNY announced the creation ML II and the subsequent termination of the SBF (AIG RMBS LLC Facility: Terms and Conditions).