Monday, March 02, 2009
Considering AIG
**WARNING** Long and not funny
See if you follow this and tell me if I have it wrong. I’m know I’m not getting into the details, which are no doubt very important and fascinating, but just think conceptually and see if this makes sense.
The Feds continue to pump money into the empty husk that once was AIG. There is no capital there, it is now just another special purpose vehicle with no assets. It is also shareholder of several regulated insurance companies, but they are prevented by regulators from sending capital up to the parent and so are of limited value unless they can be sold to third parties. (It seems there are still some things that the regulators won’t allow to be looted).
As I understand it, the losses at AIG, the parent, are a result of various credit default swaps made with outside counterparties. At one point these contracts were so out of the money that they probably required tiny premiums to AIG to take the risks (wrapping AAA rated MBS, CDOs etc). The risk of collapse of mortgage markets in particular but also probably other market sectors were perceived as being virtually non-existent. These were contracts where they would pay only in extreme, long-tail events, and the revenues off this book of business were probably pretty small on a per contract basis. Hence, a lot of contracts had to be written to make the business worthwhile, and since the risks were seen as virtually non-existent, this was a management decision in an unregulated entity. Now, we are in the long tail that AIG financial engineers did not foresee, and the contracts have sucked all the capital out of AIG, plus everything the government has given them.
So let’s walk through this. The government pays money to AIG so AIG can continue to honor its contracts. It is making payments under these contracts, to the counterparties on these contracts. The amount of capital given to AIG by the government, most of which AIG has presumably paid out, has reached $180 Billion. That is a lot of money, and is on top of however much capital AIG had before the crisis, which was also sucked out under swap agreements and paid to counter parties.
Isn’t it curious that for all the talk on all the channels all day, all the Paulson speeches, all the hearings with bankers paraded before House panels, no one has mentioned where the huge amounts of money flowing out of AIG are going? They must be going to a number of big institutions. Probably their CEOs stood before Congress only three weeks ago. Some of them are getting AIG money, but they remain silent. The government must know who is getting the money, and they remain silent too. Yet somehow it apparently feels compelled to provide AIG a ceaseless stream of capital to pay to these outside institutions. Will these institutions fail if the AIG contracts stop paying? This must be concern, noting else makes sense other than outright looting.
The government is also giving a lot of capital to a number of institutions through the TARP, the TARF, and the other programs designed to prop up financial institutions. The money that is in a sense being distributed by AIG must be going to some of these same institutions, but is never discussed when we talk about the capital going into institutions. No one says “Bank of Amerillwide is getting another $xx billion, on top of the last $xx billion provided last fall, and of course in addition to the $X billion it received from the Treasury as a result of its contracts with AIG.”
Why is that? What are they afraid to tell us? Which of our various troubled institutions are hanging by a thread but for the money they receive through AIG? And if this is a valid concern and these are important institutions, why not just say who they are and give the money to them directly as part of their other bailout, and close down the SPV that is AIG (letting some of the contracts just default)?
There are only two explanations I can come up with for why this is so. One, the Treasury is just incompetent and like most branches of government, makes everything far more complex than it need be.
The only other explanation I can think of is that there must be some political value in saying we are forking over $180 billion to AIG (as bad as that sounds) compared with the alternative, which would be identifying which institutions are on the other end of the trade and are actually receiving taxpayer money.
A few months ago, all my money would have been on the former, but now I suspect the latter. And my question is why? Is it that much worse than they have told us?
MORE FROM TigerHawk: The NYT has a story that suggests that regulators may be concerned (terrified?) that the collapse of AIG would create a worldwide run on the insurance industry, which is so vast it would take everything down. That does not explain where all the cash is landing, but it may mean that the motive for the bailout and the recipients of the cash are actually unrelated, rather than related.
16 Comments:
By 
TigerHawk, at
Mon Mar 02, 08:15:00 PM:
All good questions. I think you are right, both in your speculations and the implications.
By 
, at
Mon Mar 02, 08:29:00 PM:
other bloggers are guessing "the other end" is basically europe.
By Who Struck John, at
Mon Mar 02, 08:49:00 PM:
That makes sense, silvermine. The European banks were even more heavily leveraged, and the European leadership can't agree on how to deal with their own massive bad loans to eastern Europe. If the other end of these CDS agreements is European banks, and the payments are all that's keeping them out of bank runs, this would be more politically palatable way of funding it than just closing AIG and handing Europe a check for $180 billion. The public is already unhappy with bailing our own bad actors out, let alone foreign ones.
I'd also suspect that a goodly chunk is Asian banks and companies. Telling the people who are buying the T-bills to suck up big losses is not a good way to convince them to keep buying more. It's noteworthy where the Secretary of State went: straight to the Far East ...
By , at
Mon Mar 02, 09:43:00 PM:
A year ago I wouldn't have know a credit default swap from a rebuilt starter. As this aspect of finance moved to the front page, though, I found myself asking who was on the receiving end of these policy benefits. My first thought was domestic banks, like mine.
Chinese, Japanese, and European banks makes a lot of sense though. Being conservative cultures, China and Japan makes a lot of sense, though I don't see any reason to think they are the only ones smart enough to insure.
If we accept the idea that some information exists which should not get a public airing, (say matters related to national security as one example) would this qualify?
Sometimes it's a fine line between thinking the general public is to thick, and our political leaders are too thick. In this case I don't know how to call it.
I tend to think that the public is able, by and large, to responsibly weigh matters and arguments which are more complex than they are thought able to manage. I also think that our politicians are fearful of candor as it may lead to a loss of control.
Just sayin'.
M.E.
By Viking Kaj, at
Mon Mar 02, 09:51:00 PM:
AIG is a major insurer on the secondary market for most of the credit default swaps purchased by European banks. From what I understand what is driving the bail out is the need to shore up reserves to deal with the possibility of several large European banks calling in those policies at the same time, which is a distinct possibility.
By , at
Mon Mar 02, 10:16:00 PM:
If we are talking about major European and Asian counterparties, they bought protection (or whatever they bought) thinking that AIG was was as good as the full faith and credit of the US Treasury. Default, or threat thereof, would cause a run against Treasuries and the dollar like we would hate to see
By Viking Kaj, at
Mon Mar 02, 10:37:00 PM:
I think Europe more than Asia but I could be wrong. I saw some coverage today that mentioned that the US government was getting a stake in two AIG subs in Asia, both of which continue to be profitable, in exchange for its $ 30 billion.
I think what they are trying to do is to prevent massive bank failures over in Europe via AIG rather than direct US intervention.
BTW, my source for this was NPR's Maketplace evening broadcast, so I don't think this is a big secret even if Obama doesn't really want you to know what they are doing.
By , at
Mon Mar 02, 10:39:00 PM:
Like you, I've been wondering about this same question for awhile and the only explanation I can suggest is spending $180 billion (with more to come) is less bad than not spending it. We must be avoiding even greater losses, and the willingness to readily renegotiate with AIG on their demand suggests it's not even a close call. How many CDS agreements were there, and who were the counterparties? One has to assume the effort is to prevent a cascading series of bank and insurer defaults that would impoverish large numbers of average Americans, so the counterparties must have been banks and insurance companies holding vast savings and retirement accounts. AIG must be the front lines of the battle.
By Viking Kaj, at
Mon Mar 02, 10:49:00 PM:
Remember that what touched this whole thing off was Merill, Lehman and AIG all needing a bailout at the same time.
At the time Geithner was the head of the New York fed and he had to choose. They brokered a shot gun wedding for Merill and let Lehman fail, so the only one they really felt like they had to bail out was AIG.
Now I think we have a better idea why they felt that way.
IMO, letting Lehman fail was a huge mistake, but then what do I know? I was over in Europe at the time, and was wondering why Deutsche Bank was issuing warnings that the failure of Lehman had nothing to do with the safety of German deposits, which struck me as odd at the time. Now maybe not so odd, they were probably refering to garantees made via AIG.
By , at
Mon Mar 02, 11:03:00 PM:
There's not a lot of support for giving money to foreign banks. Wars start as a result of economic problems like this. I hope we dodge that bullet.
By Viking Kaj, at
Mon Mar 02, 11:25:00 PM:
Yes, but if the European banks go then ours do too these days.
Or is the plan to have a lot of gold under the floorboards and lots of guns to defend it?
By Viking Kaj, at
Tue Mar 03, 10:17:00 AM:
I heard something else pertinent to this discussion this morning. Apparently someone, I think it was the Hungarians, have threatend that Western Europe will be facing a huge wave of unemployed immigrants if it does not continue to bail out bad loans in the east.
Also, apparently there has been no effort whatsoever on the part of AIG to try to renegotiate the terms of the reinsurance contracts. So they are still paying at face value.
Interesting eh? I wonder how happy most people would be if they knew that most of the AIG money is a bailout for the former communist countries of eastern europe funded by US taxpayers on money we ourselves are borrowing and will have to pay back ?
By Muddy Waters, at
Tue Mar 03, 12:23:00 PM:
Did anyone else catch this question posed to Bernanke this morning? The senator from Oregon asked and Bernanke dodged.
By , at
Tue Mar 03, 11:41:00 PM:
How much of this comes back to the government? Aren't profits on derivatives (which is what CDS are) taxable income? Not that this alters the essential craziness of what they're doing, but it would be nice to know.
By MTF, at
Wed Mar 04, 09:38:00 AM:
I don't think this comes back to "the government". These contracts were more in the nature of insurance I bleieve (I haven't read one), since AIG was effectively insuring the credit of companies, municipalities and other borrowers. They were lending out their AAA rating, in effect, allowing lesser credits to borrow more cheaply. They exploited our archaic system of rating public credits, thinking the risk would never actually come back to haunt them.
By MTF, at
Thu Mar 05, 04:34:00 PM:
As a reference in future discussions, the NYS insurance regulator has quantified (I haven't seen this elsewhere) the nominal value of CDS contracts AIG wrote. He says "the unit had written some $440 billion in credit default swaps and should have been subject to more and better regulation."
Nah, you think?
