Maggie's Farm

Fascinating story. From Kimball re AIG bonuses and the CDSs:

...Epstein explains, for more than a decade some 400 traders in a London-based subsidiary of AIG have managed $1.6 trillion in derivative contracts for the company. It’s an interesting story:

In 1998, this tiny group got into the newly-created credit default swap business when JP Morgan Chase came to it with a proposition to transform debt on its books into security packages that could be sold off its books. To make these bank debt packages salable to other institutions, they needed credible insurance against default to get Triple-A rating. So the AIG financial product group, seeing no risk of default, sold it in the form of credit default swaps. Soon afterwards, with the support of Treasury Secretary Lawrence Summers (now President’s Obama’s economic advisor), the Commodity Futures Modernization Act was passed, which excluded credit default swaps from being considered a “security” under the jurisdiction of the SEC or any other government agency. This act allowed these swaps to be deployed on a massive scale to convert all kinds of debt, including even subprime mortgages and car loans, into triple A securities and turned AIG’s arm, now headed by Joseph J. Cassano, an aggressive Brooklyn-born alumni of Drexel’s back office operations, into a multi-billion dollar profit center for the insurance behemoth. Even though the unit’s 400 or so traders constituted less than one-third of one percent of AIG’s loyal employees, it produced close to twenty percent of its total operating profits. While Cassano kept the list of his counterparties in the credit default swaps a closely held secret, he bragged at a conference in 2007 that they included a global swath of “investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.” By 2006, his group was raking in nearly $4 billion in profits, and, as is the tradition in the derivative game, he and his traders got a rich cut of the loot, which on average amounted to roughly $1.1 million a trader.

So far, so good, right? No complaints then. These guys were coining money and a lot of people got rich, spent their money, and made a lot of people happy.

But into every life a little rain must fall. Epstein continues:

With the collapse in 2008 of the debt AIG was insuring, came such massive losses that Cassano resigned, and AIG, unable to post collateral, faced bankruptcy. At this point in September 2008, the US government rescued AIG, pouring in $173 billion of tax payers’ money. Even so, there remained a $1.6 trillion in potential liabilities that could be triggered by thousands of the credit default swap contracts, many of which would not expire until 2012. To prevent hundreds of billions of losses, these custom-designed contracts had to be continually watched, and, if necessary hedged, by traders who understood each one’s particular vulnerability.

So what would you do if you were Obama, Maxine Waters, or some other moralistic scold? Deplore the bonuses? Easy to do, but at what cost?

All those complex contracts: who was going to deal with them?

To perform this critical task, the remaining 370 or so remaining traders in the group wanted the same sort of guaranteed compensation in the form of retention bonuses as had in their two year contracts. The situation for AIG, and the US government that now owned 80 percent of it, was not unlike the one in Mario Puzo’s Godfather in which an offer is made that cannot be refused. In this case, even without a bloody horse head under the blankets, AIG and its federal overseers could not risk falling into a $1.6 trillion black hole by turning down the demands of the traders in the financial product group. It was not that these traders had such unique skills in managing derivative contracts that they could not be replaced by other people but that they knew the business’ crucial secrets, including the identities of he counterparties to the credit default swaps and the vulnerabilities in their positions. The implicit threat: they could use the secrets to which they were privy to trade against AIG’s positions as it attempted to unload its $1.6 trillion dollar portfolio.

Maybe, all things considered, AIG did the right thing, the prudent thing, the fiscally responsible thing?

Under these circumstances, rather than risking immense losses from having their secret book compromised, AIG paid to keep its traders from defecting. Their compensation, when approved by the Fed and Treasury, would amount to about $500,000 a trader a year ( less than half what they had been getting in 2008.) The staff at the NY Fed, while Timothy Geithner was still its head, in fact helped negotiate the terms for these retention bonuses. When Geithner moved on to become Treasury Secretary in January 2009, he presumably understood how financially dangerous it could be to do otherwise, since he intervened with the Senate Banking Committee Chairman in February to get a provision dropped from a bill that would have prevented AIG (and other recipients of federal money) from paying such huge bonuses. In fairness to Geithner, the alternative to making these pay-offs might have proven a thousand times more costly to AIG, and its defacto owner, the US Government.

Moralistic outrage can be a delicious emotion. But it is worth making sure that you have the right target before going to town with it.

So this London group sold the insurance (CDS) based on a low-risk prediction, predicted wrong, and left us looking at such vast and disruptive counterparty risk that something had to be done. The bankruptcy of AIG was not a reasonable or responsible option. Apparently making CDSs "non-securities" made the whole mess possible, but I understand why the Clinton admin did that at the time: they did not anticipate that it would make it possible to put lipstick on pigs, and that one could run out of lipstick.

It's all about the unintended and unexpected consequences of financial legislation. Even the smart Larry Summers was the biggest supporter of CDSs, and tons of supposedly savvy folks wanted to get into the CDS market for speculation, hedging, or arbitrage. Wiki has a good description of the CDS markets.