The Real Story Behind Those Greedy AIG Bankers

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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Numerian

Numerian is a devoted author and poster on The Agonist, specializing in business, finance, the global economy, and politics. In real life he goes by the non-nom de plume of Garrett Glass and hides out in Oak Park, IL, where he spends time writing novels on early Christianity (and an occasional tract on God and religion). You can follow his writing career on his website, jehoshuathebook.com.

56 CommentsLeave a comment

  • There have to be consequences or banks will continue to hold taxpayers hostage. No court would allow taxpayer money to be used to fund the bonuses. It is an outrage that AIG had the gall to list bonuses as a company payroll expense.

    Or nationalize AIG or any bank like them that threatens taxpayers. Additionally, immediately make regulations that excessive leverage won’t ever happen again that threatens world financial markets resulting in the implosion of countries’ economies. Why is everyone so afraid of their power? Totally missing are demands for fair wages for the middle class! If there’s anyone that needs bonuses, it’s them and not the robber barons who created the financial mess. Stop rewarding incompetence!

    Paying these criminals is just delaying the inevitable and making the credit pool larger that taxpayers will take on the responsibility. Make no mistake, there’s only one well to draw from–taxpayers.

  • As the parties have no money, good luck in lawsuits.

    “that employees can sue for double damages – is taken more seriously”

    So contract written in the UK have CT Governing law? Or UK Governing law? If the UK put AIG UK in banjruptcy (which is only recievership). Nothing to sue, no assets.

  • that simple. AIG doesn’t have a leg to stand on. Yep they’re be a lot of international hollering, but there’s no international, economic court that has jurisdiction to take on such cases. If every country did likewise, AIG would soon run out of victims to plunder.

  • do you think they had any idea that any of this would happen when they signed those retention bonus contracts last year?

    I also suspect that the Federal Resource 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.

    did you mean Reserve? or is this a new inside joke?


    albatross

  • AIG was never regulated. It was a financial arm of an insurance company, or as Bernanke said, a hedge fund attached to an insurance company. In the U.S. insurance companies are regulated by the states not the federal government, and worse still, this entity was in London. The central banks stood by either ignoring the peril or wondering just how much this Aaa had built up in its derivatives portfolio, and what would happen if it ever lost its rating.

    So the argument to the employees would be this: welcome to the wonderful world of regulation. We know this is all new to you, but things are done very differently now. Those contracts you signed with previous management when you were a private company are null and void. We want you to stay so we will enter into a new agreement. You will get bonuses, by no means as large as the previous ones, and in pieces as you work the book down. We are going to have you sign new retention contracts with these conditions, and if you don’t sign you will be asked to leave the firm. Any questions?

  • ever be out of resources? Don’t they just go to the resource tree and get more?

    To attempt to answer my own question, wouldn’t that be when our bondholders quit buying more bonds and when the dollar starts tanking? So are those things happening now? Not that I can tell. Well, the Chinese have started to make a few noises along those lines.

  • One of his bookies lost $10 million on the big game by giving 50-1 odds on the favorite. But he says that the Don should keep him or he’ll never know who made the bets. I’m thinking the bookie sleeps with the fishes.

  • but I wasn’t sure if it was intentional or not. I think Federal Resource a great new name for A NEW PUBLICLY OWNED SOURCE OF CURRENCY. sorry to shout, I wasn’t sure if you heard me ;> but what am I and a billion Chinese going to do w/ all these greenbacks and Treasuries?


    albatross

  • … cross-default clauses and bonus payments can be linked. I know that the white paper tries to construct a case where a retention issue could cause a cross default but the example seemed spurious to me.

    This question already generated some discussion at TPM and I would very much like to get to the bottom of it.

  • Cross-default in its broadest sense implies that your counterparty has defaulted in some major way and is heading to bankruptcy court. Any major bank, especially in this environment, would be super cautious about declaring AIG’s swaps in default because it is essentially government owned and you are saying the U.S. government is in default. You’ve got to remember there is no known situation where the U.S. government has failed to make any derivatives payments for AIG and there is complete evidence of the reverse – that the government is going out of its way and paying hundreds of billions of dollars to close out swaps. What lawyer would want to be arguing that AIG is in default under those circumstances?

    We don’t know who the attorneys were who made the White Paper argument, but they were reaching and as is often the case giving a low likelihood event every bit as much emphasis as a high likelihood event. Attorneys don’t like to give odds on their possibilities, and many don’t even think this way.

    So the bottom line will probably be that this line of argument will be dismissed in the industry.

    What surprises me is that the U.S. government, if it didn’t fall for this argument, at least fell for the argument that there was no choice but to pay out these bonuses. You would think the government with its massive legal resources would know better. It can easily stare down the AIG traders and deal with any lawsuits that erupt.

  • … your missive is the best of many treating this subject. Maybe in the long run, this will prove a small price to pay if the current outrage would hasten the demise of the neo-liberal construct and meaningful reform.

  • So contract written in the UK have CT Governing law? Or UK Governing law?

    Both? UK law applies anyway, but if the contract says that CT law applies too, or there is another reason why CT law applies, then that law is applicable too.

    Is the main registration place of AIG Connecticut?


    –Sell Alaska to China!

  • isn’t blackmail, insider trading illegal? Kevin Drum

    comments are fun:

    Lordy- if we can keep folks
    Submitted by DougMN (not verified) on March 17, 2009 – 7:05am.

    Lordy- if we can keep folks in jail at Gitmo for seven years with no charges, why can we round up these fuckers and put them in jail – and then figure out their criminal acts?


    “Go confidently in the direction of your dreams! Live the life you’ve imagined.” -Henry David Thoreau

  • How come the government did not act earlier in trying to defuse this situation? The obvious explanation of course would be incompetence and lacking staff at the treasury. Hopefully there is nothing more nefarious at play.

    I wonder if Obama has already come to regret his pick for treasury secretary.

  • “The White House … knows the general public and the average Congressman isn’t going to give a damn about cross-default clauses or hedging risks.”

    They got that much right.


  • “Go confidently in the direction of your dreams! Live the life you’ve imagined.” -Henry David Thoreau

    Bowers

    4. Finally, there is a fairly obvious legislative solution that will allow us to get the money back: just pass a law requiring a 100% tax on bonuses paid to employees at companies that have received bailout funds. In fact, Representative Carolyn Maloney is about to introduce a version of said legislation. In the current political environment, where only 14% of the country opposes giving back these bonuses, it probably has about a 99% chance of passing. As such, why do Summers and Geithner keep saying there is no way to get the money back? Clearly, there is a way. Are they lacking in imagination, or are they protecting the executives?

  • It appears the previous administration entered into legal agreements with AIG, upon taking them over, that waived the right of the government to intervene or interfere with certain AIG management decisions such as bonuses and wages. Why Paulson’s team went along with this is unclear but people are going to want to know the answer. Could the Bush administration have been that deferential to business? Even a business on the ropes?

  • A lot of Dem congresscritters are talking about the “tax it all” solution this morning.

    The beauty of it — in addition to helping Obama wiggle out of a tough jam — is that it puts the would-be populist Repugs in a terrible bind: support a tax increase or take the side of the hated bankers?

    And this dynamic could carry over into the larger discussions of tax increases on rich individuals and corporations in general, and especially punative and even confiscatory tax increases on the worst actors. Gotta love it!

  • Congressman Gary Peters (MI-09) proposed just such a tax measure:

    Congressman Peters’ bill would create a 60 percent surtax on bonuses over $10,000 to any company in which the U.S. government has a 79 percent or greater equity stake in the company. Currently, AIG is the only company that meets this threshold. The 60 percent surtax would be added to the normal income tax rate, meaning that bonuses received this year by AIG executives paying the top 35 percent tax rate would be taxed at 95 percent. The remaining 5 percent would likely be paid in state and local taxes, so taxpayers would fully recover any AIG bonuses paid in 2009.

    The full, heartwarming article is over at DKos.

    http://www.dailykos.com/story/2009/3/16/709336/-Freshman-Congressman-Peters-Has-Solution-to-AIG-Bonus-Scam

    Push ’em back, waaaaay back!
    .
    Good times for Smiley! 😀

  • Like Santelli’s rant against miniscule (in the current scheme of things) bailout of J6P mortgage holder, this uproar about $165 million in bonuses is deflecting attention from the bigger issue: who got the $100 billion and why?

    Why does someone like Goldman Sachs get bailout funds from AIG?

  • Biggest problem with this solution is that the worst offenders in the AIG universe are headquartered in London. To the extent that they are not U.S. nationals there is no way to tax them.

  • “Why does someone like Goldman Sachs get bailout funds from AIG?”

    Because they’re on the upside of a bet that AIG made. AIG is (or was) imploding because it owed money, when the government bailed out AIG, it bailed out the people that AIG owed money to. AIG owed money to GS.

    When GM gets bailed out, people aren’t complaining about Delphi (a parts manufacturer) getting a bailout as well. IMHO the salient issue is that GS might be double-dipping on bailouts.

  • And so they cannot be let go? Perhaps it has nothing to do with expertise per se.

    “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.”

  • Huge dif. GS makes nothing of real value in its deal with AIG. Delphi does with GM, however.

    I think you have it completely backwards here. Everybody was screaming bloody murder that the auto companies were going to get a few billion, on loan. “Let ’em fail!!,” they said. By definition that meant Delphi and a whole slew of others would tumble as well.

    Damn straight I wasn’t complaining about downstream biz benefiting from an auto bailout. That was the whole point. No one has really made an argument for why need GS at all. Do we?

  • are these responses what you intended? if so, damn , you are good. the peasants will be tearing down the walls in no time. but you haven’t answered my question.
    What will China do in the event that the political pressure becomes so great that the US does not, or is not able to, honor its Treasury obligations? Who is sold out first, the SS Boomers or the Chinese?


    albatross

  • The US can always pay back its debt because it is dollar denominated. If the dollar devalues, that’s China’s problem. Of course, with a weak dollar the US will not be able to import as much from China, unless China forces the yuan down in tandem with the dollar (a distinct possibility).

    China could sell its bonds now rather than wait until maturity when the dollar might be weaker. But first, what are they going to buy? Euros? There aren’t as many of these around as there are Treasuries, and the devaluation risk might even be greater. European banks are weaker than even the US banks, and half of Europe has a worse financial situation than the US. That leaves Swiss, Canadian, UK, Japan, etc., but those bond markets are tiny in comparison.

    China could buy stuff rather than paper, but it is already doing that and look what it has done to their economy. Over supplies exist in steel, copper, concrete, scrap iron, aluminum – you name it. And this doesn’t count overcapacity in every single industry China has built up. Even if they did buy stuff, the Chinese people have little money to purchase it. Unless, of course, the Chinese lent them the money to buy things.

    But isn’t that how the US got into this mess in the first place?

  • GS was “made whole”, as they say, and sat in on all the government deliberations to decide who survived, who failed, and who would be made whole. And Geithner was there every step of the way, so he’s not going to be talking unless under a subpoena.

    One of the causes of these bonuses is something very basic that no one has talked about: habit. The investment banking industry was in the habit of rewarding people at the top with $5 million plus every year, and scaled down all the way to the clerks. Goldman Sachs average payout was in excess of $100,000, including the clerks. When things were blowing up in 2008, everyone continued to operate under the standards and norms for bonuses. They were entitlements. AIG management thought it was perfectly normal to execute these retention agreements with the usual payouts, and in fact management had to do so in order to justify in their own minds the amounts they were routinely receiving. It was the system, and even the crises of 2008 didn’t change that mindset.

    We haven’t even finished three months of 2009 and there is a definite sea change underway that must be shocking the industry to the core. You mean I can’t ever get $5 million as a bonus? Even if my business is profitable? Just because some idiots over on another trading desk screwed up and now we’re stuck holding this government bailout?

    Goldman has been hit so hard by this that they are lending money to their employees so they can pay the money right back to Goldman as margin collateral due on the employee investment pool. They are bailing out their own managers, many of whom spent their entire bonuses, plus borrowed against the profits in the investment pool (which have now disappeared).

    I have to repeat it again. The gravy train is over once and for all, and it is just now beginning to sink in. The public reaction to the AIG bonuses (which are relatively small in industry terms) must terrify a lot of investment bankers. There will be ripple affects as well with the lawyers, hedge funds, equity funds, buyout specialists and others expected to make millions every year. How will they ever survive?

    The coup de grace to this whole system will be elimination of mark to market. It will take away the up-fronting of revenue that provided the bonuses and made the Ponzi finance merry-go-round operate. For a lot of reasons I am opposed to eliminating mark to market, but if it does happen the industry is really cooked. No wonder Goldman Sachs is petrified about this change.

    This scandal might also mean that AIG receives no more federal money. If so, how do they close out the remaining 75% of their portfolio?

  • The Obama administration should make very clear how much of this goes back to Paulson. It is in there best self interest to attach the blame there. If this doesn’t happen over the next couple of days – and in a well supported manner – I will remain highly skeptical of Geithner and Summers.

    Obama needs to get this right. If my worst fear plays out and Geithner and Summers turn out to be just another flavor of corporate toadies we’re all sold down the river.

  • … they were corporate toadies all along. Once a toadie always a toadie. The corporate culture needs to be shocked and awed into submission first before a drastic change in direction can take hold. Whether Geithner and Summers are the right change agents I’ll leave for the professionals to decide.


    Tolerating prostitution is tolerating abuse and torture of women and children.

  • 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.

    This is plausible but we still don’t KNOW if the right people were kept on. According to the NYT, at least 11 who are no longer with AIG have received bonus payments.

    Conservatives are not necessarily stupid, but most stupid people are conservatives.

    – John Stuart Mill
    English economist & philosopher (1806 – 1873)

  • Is AIG management saying they lost +/- $200 billion on hedged positions? Is that even possible? And what the f**k are these AIG guys doing closing out “hedged” contracts early – hedging is suppose to limit losses on positions. These would seem to the last contracts AIG would want to settle early. First guess is the AIGFP guys are blowing smoke up AIG management’s dumb ass and AIG management is just passing it on.

  • Is AIG management saying they lost +/- $200 billion on hedged positions? Is that even possible? And what the f**k are these AIG guys doing closing out “hedged” contracts early – hedging is suppose to limit losses on positions. These would seem to the last contracts AIG would want to settle early. First guess is the AIGFP guys are blowing smoke up AIG management’s dumb ass and AIG management is just passing it on.

  • of course, if these “best and brightest” that screwed up the economy actually were fired, i guess thy wouldn’t be getting bonuses, would they?

  • AIG never anticipated paying out on its insurance policies since the risk of problems in the mortgage market were remote. Their modeling showed home values steadily increasing across the country, which was also shown at all other banks and at Moody’s and S&P. When sub-prime mortgages began to deteriorate in 2007, the model couldn’t cope and had to be replaced with a new model that allowed for more “stochastic” freedom – greater potential statistical outcomes.

    What AIG saw was that a certain number of their Collateralized Default Swaps were performing badly. The transactions which they insured were bleeding cash, suggesting that AIG might have to pay the issuer of that bond an amount to cover the lost cash. This is similar to saying that sub-prime home owners were defaulting on their mortgages, and AIG’s insurance was kicking in so that it had to make up the difference to the bond holders who held the mortgages.

    This was “current reality.” AIG also began doing stress tests to figure out how bad things could get. Once you realize housing values can go down in the US, all your modeling changes. These stress tests showed that many more insurance contracts (Super Senior CDSs in AIG’ parlance) could be called upon by the beneficiaries, and billions of dollars might be needed to satisfy these claims. Suddenly the cash position of AIG overall looked threatened with such massive claims down the road.

    So that was step one and two: what is our current claim payout situation, and how bad could it get? Step three was altogether different. All of AIG’s contracts called for the company to post collateral in support of its potential claims payouts if AIG’s credit rating deteriorated. When the market entered into these CDSs, that was unthinkable. AIG was one of the few Aaa’s in the market and had never paid collateral to anyone – they received collateral from the market because everyone was a weaker credit risk to them. Since AIG couldn’t meet this demand for cash, it wound up in the hands of the federal government.

    What we see now is the government frantically trying to reduce the AIG portfolio and attendant risks by forcing the market to accept buyouts. AIG approaches Goldman Sachs and says I have 500 contracts I want to abrogate. What do you think they are worth today, less any of the collateral I’ve already given you and which you can keep as part of the close-out. GS puts out a number, which seems to always be 100% par value (as if the loans in the swaps transaction are all going to perform to maturity with no defaults). AIG agrees, and gets the Treasury to pony up $8 billion more, in Goldman’s case, to pay them 100 cents on the dollar to close out these contracts.

    This is a long and arduous process requiring constant rejiggering of the swap portfolio and its hedges. If the portfolio is properly hedged throughout, AIG faces the three risks above: payout on existing and potential insurance claims, and collateral posting as AIGs credit deteriorates. If during any part of this process the hedges on the portfolio get out of whack and cease to serve as effective hedges, AIG could experience billions more in losses or gains, depending on market conditions. So there’s a fourth risk with the portfolio.

    I hope that clear things up a bit. This describes the process. It doesn’t give you any actual numbers with counterparty names because the government is keeping all that secret.

    But then the unthinkable did happen. The ratings agencies didn’t like what they saw developing at AIG and eventually removed the Aaa rating. All hell broke loose, literally. Tens of billions of Treasury securities were suddenly needed to be posted with around 100 of the largest financial firms in the world, to protect them in case AIG went bankupt and was unable to its payments under its swaps.

  • When a company is worth something like $200 billion based on its legitimate business and then gambles with $450 billion in unregulated, promissory “insurance” commitments that it knows very well it does not have sufficient reserves to honor (unlike its legitimate insurance), is this not fraud in itself?

  • “The coup de grace to this whole system will be elimination of mark to market. It will take away the up-fronting of revenue that provided the bonuses and made the Ponzi finance merry-go-round operate.”

    I am not sure how this follows. Could you explain?

  • is too big to exist. Congress, Geithner, and Obama need to get clear and determined on this RIGHT NOW. But I won’t hold my breath: too big to fail is quite the powerful weapon, eh?

  • At the beginning of last month, Ian Welsh explained why the credit default swaps are fraudulent, and noted that it is an established legal principle that fraudulent contracts should not be enforced by governments.

    http://firedoglake.com/2009/02/01/cutting-the-gordian-knot-of-bad-contracts-to-save-the-economy/

    If the AIG CDSs were declared fraudulent, then AIG’s counterparties would be forced to take them off there books, right? That in turn would free up reserves, right? How does that NOT solve the problem of bank insolvencies? Alternatively, if AIG’s counterparties have these CDSs on their books as assets, then the reserve problem is intensified. In that case, regulators could temporarily lower or even suspend reserve requirements. Adjusting reserve requirements does not cost taxpayers a dime.

    But, what if the AIG CDSs were off-book? In that case, I don’t see how a system-wide invalidation of CDSs as fraudulent can impact the financial position of an AIG counter-party.

    Your thoughts?

  • not the receiver. So simple is that.

    But it might be that the politicians do not want to introduce anything functional, just some show for the peasants.


    –Sell Alaska to China!

  • In a normal 5 year deal, let us suppose the profit is $100,000 and may be taken into income once a year for $20,000 each year.

    If this deal were marked to market, the entire $100,000 can be taken here and now, with several adjustments. First, it has to be present valued at the five year interest rate. That means you take in $85,000 today and $15,000 spread out over the remaining four years. In addition, out of your $85,000 you have to carve out some reserves for the cost of carrying the hedge for five years, plus potential liquidity problems in the future. Here is where the industry has gotten lax and taken maybe $5,000 in reserves. If nothing happens, they get this money back at the end of the deal. What should have been happening is something like $40,000 should have been taken out to protect against bad market conditions, but no bank had the foresight or courage to do that.

    Anyway, the gist of the matter is that $85,000 comes in up front, rather than $20,000 in the old days. Of course, for years 2 – 5, you can only get more income by doing more such deals, hence the pressure to build up volume.

  • In a normal 5 year deal, let us suppose the profit is $100,000 and may be taken into income once a year for $20,000 each year.

    If this deal were marked to market, the entire $100,000 can be taken here and now, with several adjustments. First, it has to be present valued at the five year interest rate. That means you take in $85,000 today and $15,000 spread out over the remaining four years. In addition, out of your $85,000 you have to carve out some reserves for the cost of carrying the hedge for five years, plus potential liquidity problems in the future. Here is where the industry has gotten lax and taken maybe $5,000 in reserves. If nothing happens, they get this money back at the end of the deal. What should have been happening is something like $40,000 should have been taken out to protect against bad market conditions, but no bank had the foresight or courage to do that.

    Anyway, the gist of the matter is that $85,000 comes in up front, rather than $20,000 in the old days. Of course, for years 2 – 5, you can only get more income by doing more such deals, hence the pressure to build up volume.

  • The standard CDO and CDS agreement is supported by an ISDA master agreement for the product, and this has been produced by dozens of industry lawyers with help from regulators, outside counsel, and various trade agencies. As long as you stick to this agreement, plus any technical amendments you make for a particular deal, you should not be liable to any claims of fraudulent behavior.

    This does not belie the suggestion that all such contracts should be removed from the books. I’ve been suggesting for some time that the central banks get all the biggest players in one room and determine the maximum number of contracts that among that group could be abrogated.

    In a sense, it looks like that is what is going on with AIG, since the government has been able to reduce the portfolio by 25%.

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