Republicans and Democrats have so little to agree upon these days, that we must give thanks to AIG for bringing this country together, however briefly. Everyone agrees that paying $165 million in retention bonuses to AIG employees on March 15 is outrageous and shows an appalling lack of appreciation and sensitivity by AIG for all that the U.S. taxpayers have done for them.
To find out just how outrageous these bonuses are, I read the correspondence between AIG executives and the U.S. Treasury, including a White Paper explaining in detail why these payments are considered obligatory. There is, as you can expect, more to this story than the average newspaper reader wants to know, but at the very least it is a cautionary tale about what happens when standard business practices meet up with political realities that are normally not a concern in business.
There is a sub-plot here as well ”“ a second story arc as the TV people would say ”“ involving the U.S. government. Treasury Secretary Geithner didn’t know about these payments until last week, when the Federal Reserve notified him that round two of retention payments was due on the 15th of the month (apparently round one worth $55 million was paid out last December 15th). It appears that the Federal Reserve seems to be heavily involved in the details of what goes on at AIG now that it is effectively owned and managed by the government, even though it is the Treasury that is the actual owner. This is probably due to the fact that the Treasury never, even under the best of circumstances, has the staff to understand and do the necessary oversight work, whereas the Fed does. But it also means that the Treasury, which has a direct link to the White House’s political arm, lacks the direct knowledge necessary to avoid political catastrophes like this one.
So what are AIG’s arguments for making these bonus payments?
1) All 450 employees of AIG in London, where the derivatives contracts were booked and managed, signed retention contracts at the request of management in early 2008. This was at a time when AIG was falling apart but not yet taken over by the U.S. government. The retention contracts called for certain amounts to be paid out of profitability, which now is no longer available, and fixed amounts to be paid regardless. These fixed amounts are the bonuses now under question, and there is more due in 2009.
2) Once AIG was taken over by the U.S. Treasury, the mission changed to winding down the portfolio. There was no real reason why employees would want to stay under such circumstances, so the retention contracts took on added importance. Most of the payments are in the $1,000 to $50,000 range, but seven executives are to receive in excess of $3 million.
3) New AIG management sought advice from outside counsel on whether it could renege on these retention bonuses. Getting outside lawyers to give advice on these matters is standard procedure in banking because it gives cover to the management for difficult decisions. Banking lawyers are peculiar resources, because they are not frequently consulted, but when they are their opinions carry irrefutable weight in decision making
4) The lawyers said breaching the contracts would expose AIG to serious consequences. First, under Connecticut law the parent company could be sued by the employees for willful abrogation of a legal contract. The suits would be easy to win and the penalty is double the amount under dispute. Second, all of AIG’s derivatives contracts around the world have standard cross-default clauses, which say that if AIG fails to make a payment in excess of $25 million, all swaps, options and similar derivatives contracts could be placed in default. Failing to make this bonus payment of $165 million could lead to massive claims of default against AIG on all of its derivatives contracts.
5) AIG management made a third argument. The portfolio has been reduced by 25%, which is probably where all the billions of dollars of Treasury money went when Goldman Sachs, Deutsche Bank and other big players agreed to an early termination and close out of their contracts with AIG. Every closed contract distorts the hedged position of the AIG portfolio, and expert traders are needed therefore to adjust the hedges appropriately. If these traders weren’t kept on staff by AIG, billions of dollars could be lost through inaccurate hedging. Moreover, some of the contracts are ”œbespoke” ”“ Londonese for complex and one-of-a-kind ”“ and only existing AIG traders and support staff understand them enough to be able to close them out.
6) AIG management is working to reduce the contractual retention bonuses due the rest of this year, and they expect to get agreement from the staff on a 30% minimum reduction. Staffing has been reduced from 450 people to 370. All employees have seen their retirement fund wiped out since it was held in AIG stock. Management have agreed to salaries of $1.00. The effect of all these adverse changes is that the current employees are working for far less than they were in 2007 and 2008, and possibly for less than they could achieve in the market.
Buried in all these arguments is one in particular that AIG must have known is the Achilles heel of the Fed and the Treasury, and that is the claim that cross-default clauses will be triggered around the world if AIG fails to make these bonus payments on March 15th. Remember that it is a lawyer making these claims, not AIG, so they must therefore be serious and credible arguments. And what we have seen consistently from the U.S. throughout this financial crisis is avoidance at all costs of the possibility of massive derivatives contract defaults, which presumably would drag down one bank after another into receivership. Whether or not AIG management knew that this argument would be like poking at an abscessed tooth, the U.S. responded predictably ”“ give these people what they want, and make the possibility of massive derivatives defaults go away.
The derivatives blogosphere is filling up with experts opining on the validity of this argument, and not a few lawyers are challenging the assumption. Cross-default clauses are assumed to be triggered if AIG failed to make a payment due under a swap or option contract. Other obligations, such as employee bonuses, are not considered by most lawyers to be the sort that would trigger a cross-default clause. But of course, no one knows for sure. Nothing like this has ever occurred before, and what you really wind up with is a guess as to how a bankruptcy court would adjudicate such a matter.
I suspect that common sense would prevail. A bankruptcy judge would rule that AIG is still performing under all of its derivatives, it is still actively engaged in closing them out and making gargantuan payments to the market in so doing, and that therefore these retention bonuses are remote and unrelated. The defendant, AIG, wins. I also suspect that the Federal Reserve is too nervous to ever want to find out, and simply doesn’t need hundreds of lawsuits being filed against AIG, even if the legal basis is specious.
The second legal claim from outside counsel ”“ that employees can sue for double damages – is taken more seriously. Here too, though, most of these employees are U.K. citizens whose standing in a Connecticut court could be challenged, and who might not personally have the means to pursue an expensive lawsuit against the U.S. government.
The third argument is also a serious one ”“ that AIG employees are needed to wind down the book. People are calling this the blackmail argument. ”œI created such complex instruments that only I can get rid of them.” It does seem that AIG management are engaging in a little bit of extortion, because certainly in this market there are loads of experienced traders in London looking for work. The problem isn’t really the uniqueness of the expertise at AIG, but the familiarity of AIG traders and back office personnel with the book and the systems supporting it. If there were a mass exodus of traders and operations personnel, payments could be disrupted even to the point that AIG could be in technical default. It would take months for any new team of employees to get used to the book and systems to right the ship, and in the meantime the market would have to be patient waiting for its money.
With all these arguments, there is no assured answer as to what would happen. More than likely, cross-default clauses would not be triggered, London employees wouldn’t really file suit for their retention bonuses, and the staff wouldn’t quit en masse, because there is no place to go. But the Federal Reserve in particular doesn’t want to operate AIG under ”œmore than likely” circumstances. For the amount at stake in the market ”“ including an enormous systemic crisis ”“ the Fed wants continuity, stability, and competence at AIG. It must look at $165 million as a small amount to pay for these qualities.
The White House ”“ including now President Obama ”“ is looking at a public relations disaster that is political and non-partisan. It knows the general public and the average Congressman isn’t going to give a damn about cross-default clauses or hedging risks. Politically, it must be very attractive for the White House and Congress to dare these ungrateful AIG employees to sue. Make my day, as it were.
It may be too late for President Obama and Timothy Geitner. It appears as if the bonuses were paid out – though no one is yet confirming this – and the White House is now talking about options to claw back the money. This is going to introduce some nastiness in the courts, and certainly the morale at AIG London must be almost non-existent. Few employees there can have an expectation that the remaining retention bonuses for 2009 will be paid, contract or no contract. Those who can leave, probably will, and even if it is a small minority who can get a new job, you wouldn’t want any of these to be in critical risk management jobs.
I have thought all along that someday the strains of trying to manage the banking business via government are going to be too much, because the objectives are too dissimilar and occasionally the parties are in diametrical opposition. This is one of those occasions. We have also learned throughout this financial crisis that things which seem very unlikely to happen do occur. It seems unlikely that many AIG employees will be leaving, or that massive default claims against AIG and the U.S. will occur, but stranger things have happened in a financial system that is hypersensitive and hanging together by a thread.
The global financial system is therefore capable of blowing up at any time, beyond anything we have seen or imagined so far. As is often the case, it only takes what appears to be an inconsequential event to light the match.
Is this that event?
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