The Fed's Risky Backdoor Bailouts

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Disentangling AIG from Wall Street has proved difficult, though, and the aid package has been expanded from $85 billion to more than $150 billion.

To stabilize the banking system, the Fed decided to quarantine some of AIG's riskiest holdings. Especially worrisome: the tens of billions of dollars' worth of insurance AIG had sold to banks on toxic mortgage securities. If those mortgage securities continued to fall in value and AIG couldn't pay out on the insurance, known as credit default swaps, the banks would lose desperately needed capital.

So the Fed created Maiden Lane III, an entity named after the location of the central bank's New York branch, to buy the assets from the banks and cancel the insurance. The Fed put in $15 billion of its own capital and took an additional $5 billion from AIG, which had received the money from Treasury. Maiden Lane used the $20 billion to purchase so-called collateralized debt obligations—the toxic mortgage securities that AIG had insured for banks—with a face value of $46 billion, paying 43¢ on the dollar. AIG also paid the banks $26 billion in insurance payouts on the CDOs.

"a good deal"

The result: The banks were paid in full for securities that were virtually impossible to sell in the marketplace. That strengthened their balance sheets, helping them to better weather the financial crisis in recent weeks. "It certainly seems like it was a good deal for the [banks]," Maurice R. "Hank" Greenberg, former chairman and current major shareholder of AIG, wrote in a letter to AIG management. AIG and the banks declined to comment.

But beyond the basic framework, little is public about Maiden Lane III. Société, Deutsche Bank, and Goldman Sachs received money, but the Fed didn't disclose how much each got. And the list of recipients is likely longer than those three banks. Nor does the Fed offer any clue about the composition of the 100 or so CDOs it now owns. An exhibit in a Dec. 2 regulatory filing by AIG provides most of the specifics, but AIG only makes public a heavily redacted version.

The few known details about Maiden Lane III raise questions about the Fed's risk-taking. The central bank usually makes short-term loans that the borrower must repay within a few months. In this case, the Fed will recoup its capital on the CDOs only if the securities pay off or can be sold to outside investors. That's a dicey bet. Merrill Lynch (MER) sold similar securities last summer for just 22¢ on the dollar. Since then, the housing market on which they're based has deteriorated even further.

The anxiety could grow if the central bank remains silent. "If the Fed doesn't want to give us the specifics, they should tell us something that makes us comfortable that they are properly capitalized and not presenting an undue risk to the financial system," says veteran Fed watcher Jim Bianco of Bianco Research. "The integrity of the Fed is in play here."

With Robert Berner in Las Vegas