A House of Cards

The Federal Reserve extended $85 billion in new credit to the ailing insurance giant AIG Tuesday night, even as Big Three auto executives were to meet Wednesday with Speaker Nancy Pelosi seeking up to $25 billion in loan guarantees to help them retool to produce more energy efficient vehicles.

The twin events illustrate the continued pressure on government to intercede in the troubled economy after sitting pat just days ago when Lehman Brothers filed for bankruptcy and another Wall Street landmark, Merrill Lynch & Co., was forced into a sale.

In the case of AIG, or American International Group, the Fed appears to have felt more necessity to act because the company’s collapse would impact consumers, outside the protection of state insurance regulators.

While no final decision has been made, proponents of the auto industry loan guarantees are increasingly confident in part because of the impact on Michigan, a major battleground state in November’s elections.

Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke came to the Capitol to brief leading lawmakers Tuesday evening. Hours later came the 9 p.m. announcement that the Federal Reserve Bank of New York had been authorized to lend up to $85 billion to AIG, which has been teetering near collapse.

“This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy,” the Fed said.

The two-year loan would be collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. It’s expected to be repaid from the proceeds of the sale of the firm’s assets and could lead to the liquidation of much of what is AIG today. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders. Fed staff said the 79.9 percent was designed to be just below an 80 percent threshold triggering accounting procedures that would have complicated the transaction.

While the initial reaction among lawmakers to the Paulson-Bernanke briefing was largely supportive, there appeared to be growing concern later as the sheer magnitude of the numbers began to sink in. “These do not increase people's sense of security,” said House Education and Labor Chairman George Miller (D-Calif.). And after backing Paulson in the past, Pelosi herself raised some warning flags.

“The Bush Administration’s eight long years of failed deregulation policies have resulted in our nation’s largest bailout ever, leaving the American taxpayers on the hook potentially for billions of dollars,” the speaker said. “An $85 billion loan is a staggering sum and is just too enormous for the American people to bear the risk; Congress will demand answers to prevent this from happening again.”

In a statement, Senate Banking Committee Chairman Chris Dodd (D-Conn.) said the bailout was a sign that the nation’s financial crisis is getting worse. “Actions that were inconceivable just days ago are now occurring in a manner and at a pace that is certainly cause for concern,” he said.

Added Sen. Chuck Schumer (D-N.Y.): “Hearing of these plans, you have to stop to catch your breath. But upon reflection, the alternatives are much worse."The chief stumbling block for the auto industry loans is the fact that the package has been assigned a 30 percent subsidy rate by the Congressional Budget Office, requiring about $7.5 billion in appropriations to cover the projected risk for the government.

But top Democrats remained sympathetic after a leadership meeting Tuesday; while some adjustments may be needed, proponents were hopeful of action next week on a year- end spending bill.

This so-called “continuing resolution,” which is required to keep agencies funded after the new fiscal year begins Oct. 1, could also be a vehicle for a second, more modest funding request by the Federal Reserve related to the current financial crisis.

But the politics of the auto industry loan guarantees is far richer and testifies to the importance of Michigan as a battleground state in the presidential race between Sens. John McCain and Barack Obama.

“Many factors contribute to legislative successes,” Rep. Dale Kildee (D-Mich.) said, smiling.Pelosi appears to be leaning heavily toward approval.

“The speaker is supportive of having this in the CR,” said Rep. Sander Levin (D- Mich.), a senior member of the House Ways and Means Committee. “It’s going to happen.”The background to the loan guarantees is energy legislation enacted last year by Congress but still dependent on appropriations before the credit can be extended.

Manufacturers can use the loans to re-equip plants or establish new facilities to produce advanced-technology vehicles that are able to meet tougher emissions and fuel economy standards. And as credit has tightened given the current turmoil in financial markets—as well as the auto industry’s own problems—there has been growing pressure to move ahead with the guarantees.

“It’s tough times, and they’re apparently confronting 25 percent interest to upgrade technology,” said House Majority Leader Steny Hoyer (D-Md.), who described himself as sympathetic to the funding. “We want to help,” said Illinois Rep. Rahm Emanuel, chairman of the House Democratic caucus. “We have to figure out how and when.”

“How” became a bigger question after CBO updated its estimates this week to show a 30 per cent subsidy rate to the enterprise. Prior calculations have assumed 15 percent, or about half the cost.But CBO said that “credit conditions for the auto manufacturers have deteriorated markedly — the market interest rates on their outstanding debt, for example, have risen dramatically.”

Another reason the subsidy is so high is a deferment feature of the authorized loan guarantees, as approved last year.Under the program, which would be administered through the Energy Department, borrowers could defer payments of principal and interest for up to five years after putting into operation the new or modified plant funded by the loan.

“CBO assumes that most borrowers would take advantage of the deferment option, and our subsidy estimate reflects the resulting cost to the federal government—taking into account the time-value of money—of delaying loan repayments” CBO said this week.

Democrats are also preparing a new $50 billion economic stimulus bill to which the auto industry loans could be added. But for the industry, going with the CR is the better route since this measure has a much better chance of getting through the Senate and being signed into law.

Democrats have yet to decide how long the stopgap spending measure will run, but as one of the last legislative trains leaving before the elections, it is sure to attract more passengers.

The Federal Reserve request would allow Chairman Ben Bernanke to expedite an initiative under which the Fed pays interest on money held in bank reserves. These payments were not slated to begin until 2011, but Bernanke is now urging a quicker start-up that will also require appropriations in the range of $100 million.

“We have to put ideology aside, and I think the key to the government’s role here is a willingness to support flexible action by the Fed and by the Treasury,” said Sen. Judd Gregg (R-N.H.), a senior member of the Senate Appropriations Committee.

Gregg later praised Paulson and Bernanke’s boldness in dealing with AIG. But the New Hampshire conservative had far less sympathy for a second stimulus bill or the aid to auto industry.But could he block the auto loans? “You never know in an election year,”Gregg said.

“People run scared awful easily.”