Federal Reserve in Uncharted, Risky Territory with AIG Investment

March 3, 2009

The U.S. Federal Reserve, by taking an equity stake in American International Group, is moving further into uncharted territory and may be risking potentially large investment losses and its independence.

As part of the latest bailout effort of the troubled insurer, the U.S. central bank will reduce a $60 billion credit facility in exchange for taking a preferred interest in AIG subsidiaries American Life Insurance Company and American International Assurance Company Ltd.

The Fed’s exposure to AIG now totals roughly $93 billion, and could put it on the line for sizeable losses should the value of the stake deteriorate.

“This continues the steady erosion in the Fed’s balance sheet,” said Steven Ricchiuto, chief economist at Mizuho Securities. “They are getting further and further pulled into this crisis.”

“The Fed should be looking to extricate itself from this and put responsibility for this at the Treasury’s doorstep.”

Some regional Federal Reserve Bank presidents agree. Richmond Fed President Jeffrey Lacker and Philadelphia Fed chief Charles Plosser have been vocal in their concerns the central bank’s unorthodox measures could make it vulnerable to political pressure and risk its independence.

“Using the Fed’s balance sheet is at times the path of least resistance, because it allows government lending to circumvent the congressional approval process,” Lacker said Monday. “This risks entangling the Fed in attempts to influence credit allocation, thereby exposing monetary policy to political pressure.”

UNUSUAL TIMES, UNUSUAL MEASURES

The U.S. central bank has taken a number of nontraditional steps to shore up key credit markets, including buying mortgage-backed securities, that have drawn it away from its traditionally safe balance sheet consisting only of U.S. government debt.

The stake in the two AIG units, both of which have large Asian operations, is a further step in that direction.

“Having a large direct equity stake on the Fed balance sheet is sure to make a lot of people justifiably nervous about the central bank getting into the business of running private companies,” said Michael Feroli, economist at JPMorgan.

That, in turn, risks undermining monetary policy, some worry.

Stephen Stanley, chief economist at RBS Greenwich Capital said the conflicts of interests “are pretty obvious.”

“The Fed now essentially owns part of an overseas life insurance business,” he said. “And does it become a consideration when setting monetary policy? Would they want to make sure things are OK with AIG before raising rates, for example?”

“While I don’t think this is a clear and present danger, it has to be asked as the Fed has never gone down this road before,” Stanley said.

The Fed’s path down that road began when it set up a holding company called “Maiden Lane LLC” in March 2008. This company was to hold an asset portfolio JPMorgan said was too risky for it to take on in its fire-sale purchase of investment bank Bear Stearns.

The Fed has reduced the estimated value of the assets held in Maiden Lane LLC by about 12 percent since June 2008, according to the latest available Fed data.

When the Fed and Treasury first rescued AIG in September, the Fed set up two more Maiden Lane facilities.

Some investors and Fed officials worry the central bank has positioned itself to pick winners and losers, rather than focusing on the economy more broadly. Even those who say the Fed had little choice are feeling discomfort.

“At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one,” renowned investor Warren Buffett said in a letter to shareholders this weekend.

Buffett complained that while the credit of his company, Berkshire Hathaway, was “pristine” as one of only seven triple-A rated U.S. companies, “our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing.”

(Additional reporting by Glenn Somerville and Emily Kaiser)

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