The Rescue of American International Group Module D: Maiden Lane II

Maiden Lane II was one of a set of government interventions assisting AIG in addressing its liquidity and capital problems. It was announced alongside Maiden Lane III (ML III) in November 2008 as a restructuring of government financial support (FRBNY n.d.1). These two SPVs were aimed at removing assets from AIG’s balance sheet to address continuing, significant liquidity drains and to improve its capitalization in the interest of avoiding rating downgrades (Baxter and Dahlgren 2010, 4). Specifically, ML II was the second action taken by the Fed to address the impact of the AIG securities lending program. The first was the establishment of the SBF in October 2008, which allowed the FRBNY to lend up to $37.8 billion on an overnight basis in exchange for fixed-income securities (US COP 2010, 68-69). At that time, it was acknowledged that while the SBF addressed the liquidity issues raised by the securities lending program, the RMBS still posed a problem, as they continued to lose value. Thus, ML II was seen as an ultimate solution (Interview with Sarah Dahlgren 2018). In all, AIG-targeted government interventions totaling $182 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 make a loan of up to $22.5 billion to fund ML II for the purpose of purchasing from AIG a portfolio of RMBS assets (BdofGov 2008; FRBNY n.d.1). This authorization was done pursuant to Section 13(3) of the Federal Reserve Act, the board’s emergency lending authority, which had three basic requirements: (1) the Board must determine that “unusual and exigent” circumstances exist, by the affirmative vote of at least five members, (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). There has been little dispute regarding the first and third criteria.

However, ML II “provides a less straightforward fit with the Federal Reserve’s authority under Section 13(3), and in particular the second criteria cited above, because of its more complicated structure,” compared with the Fed’s use of Section 13(3) for the two previous AIG lending facilities (US COP 2010, 228). Although an SPV is a “person” within the terms of Section 13(3) and thus could be eligible for a loan, the Congressional Oversight Panel (COP)^FNThe Congressional Oversight Panel (COP) was a standing committee established by the US Congress following the implementation of the Troubled Assets Relief Program (TARP) on October 3, 2008 and was dissolved in 2011. The COP’s mandate was to “review the current state of financial markets and the regulatory system.” It was able to hold hearings, review official data, and write reports on actions taken by Treasury and financial institutions and their effect on the economy. noted that “In substance, however, FRBNY was lending money to itself under Section 13(3) and then using the funds to purchase RMBS” (US COP 2010, 229). Despite this structure, undertaken for practical administrative purposes, the Fed Board staff defended the transaction as consistent with Section 13(3) (US COP 2010, 229). It argued that looking through the SPV, the Fed was in essence discounting “each RMBS [which] was itself a promissory note or debt obligation so FRBNY was essentially purchasing a note or debt obligation at a discount (a practice that fits more neatly under its 13(3) lending authority)” (US COP 2010, 229). The Board staff also characterized these transactions as involving a “haircut” because of the difference (almost 50%) between the loan amount (used to purchase the RMBS) and their face value (US COP 2010, 229). The COP did not agree with this characterization, arguing that the loan “did not require a ‘haircut’ in the normal sense of the term” because “securities lending counterparties were not required to take a haircut or make concessions.” Still, COP concluded that because of the great difference in the purchase price and face value of the RMBS, which secured the loan, the FRBNY was justified in finding the loan secured to its satisfaction as required by Section 13(3) (US COP 2010, 229).

There were a number of alternatives that aimed to resolve the RMBS issues facing AIG that were considered in the lead-up to the creation of ML II (GAO 2011, 47). One potential strategy included propping up the insurance subsidiaries and maintaining their credit rating until their sale (GAO 2011, 47). This would have been achieved through “keepwell” agreements and excess-of-loss reinsurance agreements (GAO 2011, 47). The keepwell agreements would have required the Fed to maintain minimum measures for each subsidiary such as capital and net worth, while the excess-of-loss reinsurance would have covered situations when subsidiaries failed to make a payment on a claim, subject to certain limitations (GAO 2011, 47). Although this strategy would have insulated the credit rating of the subsidiaries from the credit rating of their AIG parent company, it ran into legal hurdles (GAO 2011, 48). In particular, there were questions regarding whether the government could protect the value of subsidiaries that were currently acting as collateral for the Revolving Credit Facility (GAO 2011, 48). There were also concerns regarding whether the Fed could prevent the subsidiaries from being seized by state regulators (GAO 2011, 48).

Ring-fencing subsidiaries by segregating specific assets was considered as well (GAO 2011, 48). However, it was rejected because of time constraints and lack of a legal framework (GAO 2011, 48).

The previous creation of the SBF had alleviated liquidity pressures originating from securities lending counterparties terminating rather than rolling over their contracts. But AIG faced continued exposure to “further declines in the value of the RMBS portfolio (par value approximately $40 billion) purchased with the proceeds of these securities lending transactions” (Section 129 2008, 7). By September 30, 2008, AIG had already suffered approximately $16.5 billion in mark-to-market losses on the RMBS portfolio (Section 129 2008, 7).

In considering how to resolve the problem posed by the RMBS related to AIG’s Securities Lending Program, the FRBNY consulted BlackRock, whose analysts concluded that the securities would return a higher value if held over a longer time period (US COP 2010, 141). Although these RMBS were distressed, they were rated AAA and senior tranche in their respective capital structures (US COP 2010, 35). This increased the likelihood of material interest and principal income over a longer holding period. As a result, the FRBNY decided to purchase the RMBS from AIG, which resulted in the termination of the Securities Borrowing Facility and permanent relief of related liquidity pressures. Unlike AIG or other financial institutions in distress, the FRBNY did not face intense pressures that would necessitate the fire sale of securities (US COP 2010, 141). Thus, it could bear the risk involved in holding the RMBS for a longer period of time, and ideally the market could stabilize.^FNEven following their purchase by and transfer to ML II, the value of the RMBS underlying transactions made by AIG’s insurance subsidiaries kept falling at an alarming rate as real estate prices plummeted and foreclosure numbers soared (McDonald and Paulson 2015, 86, 97-98). Additionally, there was widespread and justifiable anxiety that the assets would continue to suffer losses even after government rescue (US COP 2010, 77). Despite this market pessimism, when the last of the assets were sold in February 2012, the government had realized a net profit of $2.8 billion (FRBNY 2012c).

The RMBS purchased were reviewed and selected by the FRBNY in conjunction with financial adviser BlackRock Financial Management Inc. (FRBNY n.d.1).^FNA tangential issue arose in 2011 when AIG sued Bank of America (acquirer of Countrywide) on claims of fraud relating to the quality of RMBS that AIG had purchased from Countrywide and later were purchased by ML II (Stempel 2013). Bank of America claimed that AIG had lost its right to sue when it sold the assets to ML II, and that any recovery would be double-dipping (McEvoy 2013). A US District Court determined in May 2013 that AIG had not transferred certain of its litigation rights to ML II and could pursue claims against Bank of America, causing AIG to drop a lawsuit against the FRBNY over the issue (Stempel 2013). In addition to limiting AIG’s exposure to the falling values of illiquid RMBS, the creation of ML II allowed the FRBNY to meet its objective of helping AIG avoid further credit rating downgrades, which likely would have triggered new rounds of collateral calls from counterparties to other AIG businesses (US COP 2010, 141; Baxter and Dahlgren 2010, 3-4). The FRBNY senior loan was to be repaid using the cash flows from the RMBS and proceeds from the sale of assets (FRBNY 2008a).

The Fed established ML II as a legally independent entity to facilitate the acquisition of non-agency RMBS from AIG subsidiaries (FRBNY 2008a). On December 12, 2008, ML II, borrowing $19.5 billion from the FRBNY senior loan and utilizing a $1.0 billion cash contribution posted by AIG in the form of a Fixed Deferred Purchase Price (for a total purchase price of $20.5 billion), acquired RMBS with a face value of $39.3 billion from several AIG insurance subsidiaries (FRBNY n.d.1).

The Federal Reserve did not possess the authority to purchase the RMBS directly off the balance sheets of AIG insurance subsidiaries (Title 12 U.S.C. 342, 111). It was, however, able to facilitate the senior loan to ML II, an SPV and independent legal entity that it created for that purpose (FRBNY 2008a). Holding the RMBS assets in an independent entity made it easier for the FRBNY to isolate and manage the assets, even though they were consolidated onto the Fed’s balance sheet (US COP 2010, 228-229). Although ML II was a separate entity, the FRBNY retained all authority to manage the SPV as long as its loan was outstanding (FRBNY 2008a).

As the controlling party of ML II, the FRBNY was tasked with the day-to-day management of ML II’s assets and engaged a number of vendors based on their expertise, rather than developing internal departments for each need. However, the FRBNY did increase its internal expertise through targeted hiring in order to assist in decision-making and effectively evaluate recommendations from external vendors. The Investment Support Office department, which managed vendor relations, grew from just a few staff members to a sizable business unit once all three SPVs were being managed. The FRBNY chose to retain BlackRock Financial Management Inc., which was “acknowledged as an expert in mortgages, loans, structured finance and risk management” to act as investment manager (Investment Management Agreement 2010, 1; FRBNY n.d.1). Prior to being brought on to work on ML II, BlackRock had already been contracted by the FRBNY to manage ML I^FNMaiden Lane (ML I) was an SPV created in March 2008 to facilitate JPMorgan Chase & Co.’s purchase of Bear Stearns Companies Inc. and ML III assets (Anantharaman 2008).

The FRBNY also hired Bank of New York Mellon as administrator and custodian, Deloitte and Touche as external auditor for annual financial statements, and Ernst & Young to perform closing work (Administration Agreement 2008, 2-7; FRBNY n.d.2; ML II LLC: Financial Statements 2014, 4-5). Although the FRBNY devoted significant attention to the implications of engaging outside vendors, there were a number of potential conflicts of interests that arose between the FRBNY and vendors, which were dealt with on an ad hoc basis (GAO 2011, 122).

The volatile state of the financial markets and the uncertainty surrounding the performance of the RMBS purchased by ML II compelled the Fed to require an equity contribution by AIG to cover the first billion dollars in potential losses (Baxter and Dahlgren 2010, 4-5). The Fixed Deferred Purchase Price would be returned to AIG only after the payment of all costs associated with the creation of ML II and repayment of the principal and interest on the FRBNY’s senior loan (FRBNY 2008a). It was announced on February 28, 2012, that the AIG contribution had been repaid in full, including accrued interest, using proceeds from the sale of remaining ML II securities (FRBNY 2012c).

The interest rates calculated on the FRBNY senior loan and AIG’s Fixed Deferred Purchase Price referenced the one-month LIBOR (FRBNY 2008a). The FRBNY considered a number of factors when deciding how to set rates for its interventions, including risk and characteristics of the assets being purchased (GAO 2011, 90-91). Since ML II held securities that paid monthly interest based on the one-month LIBOR, officials felt this was an appropriate rate to use for the loan (GAO 2011, 90-91).

In order to value the RMBS that ML II was planning on purchasing, BlackRock provided mid-market pricing estimates based on projected cash flows from those RMBS (Asset Purchase Agreement 2008, 9). These estimates used assumptions that were agreed upon by both parties and were the basis for negotiations that took place between ML II and AIG regarding the actual purchase price (Asset Purchase Agreement 2008, 9). It is important to note that the mid-market pricing estimates provided by BlackRock may not have reflected the mark-to-market price, in the case that there was a market for the product, because of the illiquid nature of the RMBS market at the time (Asset Purchase Agreement 2008, 9).

The terms of the loan to ML II specify that the senior loan was intended to be repaid from interest and principal payments received from assets if held to maturity, or the proceeds from their sale (FRBNY 2008a). As previously mentioned, the analysts at BlackRock concluded that the securities would realize more value if held for a longer period of time. This alleviated the risk of potential losses to the public by undertaking a buy-and-hold strategy (US COP 2010, 141). If it was determined that liquidation was not the profit-maximizing option, ML II would be able to hold these assets to maturity, as the hold-to-maturity proceeds were predicted to be greater than the FRBNY’s senior loan (Baxter and Dahlgren 2010, 6). The FRBNY announced its intention to begin liquidating the ML II portfolio on March 30, 2011, citing improved market conditions and investor interest. At this time, it also opted against outlining a fixed timeline for completing the sale. Rather, it allowed for flexibility in order to maximize return: “There will be no fixed timeframe for the sales and at each stage the Federal Reserve will only transact if the best available bid represents good value for the public” (FRBNY 2011a). Sales were completed when the remainder of the assets held by ML II were liquidated on February 28, 2012 (FRBNY 2012c).

On March 30, 2011, it was announced that the FRBNY rejected AIG’s initial offer to buy back all of the ML II assets (FRBNY 2011a). Instead, the FRBNY pursued a strategy of selling ML II securities “individually and in segments rather than as a single block,” which would “give a larger set of investors opportunity to bid for the assets [and] maximize sale proceeds while also reducing the likelihood that any one institution ends up with concentrated exposure to the assets” (FRBNY 2011a). In the event, the result was that, while $9.96 billion was sold in a broad competitive bidding process to 22 bidders, the overwhelming majority of the assets were sold in large blocks to major broker-dealers, resulting in some concentrated exposure to the portfolio (see Figure 2: Sales of Maiden Lane II Assets in Competitive Auction Over Time). The FRBNY discovered that after an initial positive reaction to individual auctions, the market quickly grew weary of this protracted process. Demand was significantly greater if investors had assurances that they could access larger segments of the portfolio. Therefore, the second set of auctions consisted of large blocks, which remained open and competitive but resulted in greater efficiency and better relative pricing.

The FRBNY finished selling the assets in February 2012, realizing a total residual profit of $2.8 billion for the US government once ML II was terminated on November 12, 2014 (FRBNY 2012c; FRBNY n.d.1).

Knowing that AIG was due to report a substantial loss for the third quarter on November 10, 2008, the FRBNY made the decision to announce its financial support restructuring on the same day (US COP 2010, 138; GAO 2011, 53). Credit agencies had notified the FRBNY that they would likely downgrade AIG in the wake of the disappointing earnings announcement, and the potential for ensuing market turmoil led the FRBNY to communicate its plans earlier than it might have otherwise (GAO 2011, 53). At 6:00 a.m. EST on November 10, 2008, the Federal Reserve Board of Governors and Treasury Department issued a press release that outlined a restructuring of financial support to AIG (BdofGov 2008). This restructuring included purchasing $40 billion of preferred shares in AIG using Troubled Assets Relief Program (TARP) funds, changes to the terms of the Revolving Credit Facility, and the introduction of ML II and ML III (BdofGov 2008). The release describes these measures as an attempt to “establish a more durable capital structure, resolve liquidity issues, facilitate AIG’s execution of its plan to sell certain of its businesses in an orderly manner, promote market stability, and protect the interests of the U.S. government and taxpayers.” (BdofGov 2008). Announcement of the restructuring preceded its actual implementation by weeks.

In general, the FRBNY took a stance of transparency regarding ML II. It announced developments and progress regularly and provided extensive detail on the assets held. For example, in November 2008, it announced the intent to form ML II and purchase the RMBS from AIG, and on March 30, 2011, it announced its intent to begin selling the assets over time (BdofGov 2008; FRBNY 2011a). Included in that announcement was a commitment to transparency and to providing information “as soon as is practicable,” as well as a detailed communication plan (FRBNY 2011a):

“The New York Fed already publishes on its website a list of all the securities in its portfolio. In order to allow the public to track progress on asset dispositions, the New York Fed will provide monthly updates on portfolio holdings and a list of the securities sold within the prior month. In addition, it will provide quarterly updates on total proceeds from sales, and the total amount purchased by each counterparty. Finally, the New York Fed will provide further details regarding these transactions, including an account showing the acquirer and the price paid for each individual security three months after the last asset is sold, ensuring timely accountability without jeopardizing the ability to generate maximum sale proceeds for the public.”^FNThis reported data can be found at  FRBNY n.d.1.