Why Does AIG Need So Much Cash From the Fed? (Update)

Updated from Thursday, Oct. 9

It took AIG (AIG Quote) less than a month to burn through more than $70 billion of the $85 billion bridge loan that the Federal Reserve provided it last month.

The insurance giant has drawn down $70.3 billion of that rescue facility, with much of the cash being used to cover credit default swaps, says Joe Norton, director of public relations at AIG. However, because the company is no longer able to obtain cash from the usual market sources due to the credit freeze affecting business all over the U.S., the Fed late Wednesday agreed to back up to $37.8 billion more.

This latest Federal support will back a $37.2 billion securities lending program that AIG operates to provide working capital. Under this agreement, the Fed will act as a counterparty, or lender of last resort, to a maximum amount of $37.8 billion, just slightly more than the size of the securities-lending program. Norton says AIG now has the ability to access the cash, which will be provided by the Federal Reserve Bank of New York and secured against investment-grade fixed securities provided by its domestic life insurance companies.

This program, which has a similar asset value as it did at the end of the second quarter, lost $22.9 billion in the first six months of the year mainly due to other than temporary impairments, but with the markets in the middle of a freefall, the value of the assets will be significantly marked down again for the third-quarter financial filings. This has no immediate cash effect other than the asset value representing the amount of cash that can be obtained from lending out the securities, leading to the conclusion that AIG has to act now to sell off assets and raise cash.

Norton was unable to confirm whether any of this new facility has been used as of Friday morning. Norton did confirm that the last new derivatives written were $5.4 billion in the second quarter and that this was as a result of contractual obligations that have now been satisfied and there are no new commitments. He emphasized that AIG is no longer writing credit default swaps.

Without this cash availability, AIG would be unable to continue to operate normally and would almost certainly have been forced to return, cap in hand, to Treasury Secretary Henry Paulson for an increase to the original $85 billion it was loaned in mid-September. The cash advance is being provided under "normal" commercial terms and conditions that were unknown to Norton. He confirmed that as of Oct. 9, AIG has only $37.2 billion in securities-lending obligations.

Pressure is now on AIG to liquidate the assets that Chairman and CEO Edward Liddy announced are no longer part of the aim to refocus "on our traditional strengths in property and casualty underwriting." This means that the life insurance companies involved in the junkets Congress complained about this week are not part of the long term plans for the strategic direction of AIG and will be sold. Balancing the cash requirements of the group and completing the sale of the companies whose assets are being used in the AIG securities lending program is not going to be easy.

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