Monday, March 23, 2009
AIG and "Payment in Full"
Some press stories note that the Fed is paying holders of AIG credit default swaps full face value. I am not really sure what that means. My understanding of the CDSs is that when issued, they were structured to have a zero value, with the premium being paid just sufficient to cover the insurance liability. If the likelihood of default on the underlying security went up, then there would be a premium paid for that contract. So to say that the Fed (I take this to be the Maiden Lane funds that were set up) is paying full face value is kind of nonsensical. I suspect what is happening is that the Fed is buying a portfolio of underlying securities and the related CDS/insurance for full face value of the underlying security. That makes sense, for a holder of both the security and the CDS would essentially have a guarantee of full payment (so long as the seller of the insurance was going to pay). If this is the case, there is nothing that I see wrong in paying 100% of face value of the underlying security and in fact that makes sense. The transaction eliminates a liability from AIG’s balance sheet and eliminates a need for them to post collateral – and these are the reasons the Fed bailed out AIG in the first place.