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Monday, March 23. 2009
Fascinating story. From Kimball re AIG bonuses and the CDSs:
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.
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"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."
I would say the target is perfectly centered, just that the timing is wrong. From principal alone I'd let all the sorry bastards find another job... they built the house of cards, let them suffer from its fall. Too bad I'd say for the blackmailing shits and their 'secret' lists. But agree that the prudent choice is not to do so at the present time, unfortunately.
As I wrote on March 20 at MF,
The outrage over $165 million in AIG bonuses is to distract people and the press from the real outrage with AIG.
AIG's financial products group operated under plain view of multiple regulators.
The government has effectively bailed the speculators that wrote CDOs with AIG's financial products group. Tens of billions have gone to speculators!
Why? Because many of the speculators, including Goldman Sachs, are pals with government bureaucrats. Surprised?
Then the political class made a deal to bring in Liddy, who had nothing to do with the mess, to clean up AIG. The political mandarins also approved the compensation scheme.
The people in the financial products group are now working to unravel the complex structures put in place in prior years.
Let me ask this. If these folks are not paid, who will do the job and who has the knowledge base to do the job? Barney Frank and Chris Dodd? Of course not.
Here is the take on the situation by the WSJ.
Luther, I suspect that most of the masters of the universe who originated this witches brew are long gone. It is the portfolio managers and supposed credit people who are working out the portfolio. If we fired all of them, there would be no one with the institutional knowledge that knew where all of the bodies are buried. The portfolio has been worked down from what I understand, but it still remains a major number.
AIG essentially had infinite leverage because it could write any number of CDS deals and collect the premiums without having to post collateral. This is where things came unglued.
And this was done under the noses of the regulators. Who says that regulators are smarter? Who knows if they even understood what was going on.
Okay, Barrett. Perhaps they are gone. Then let's go find and prosecute... or if what they did was not illegal, how about public shaming and some time in the stocks as a substitute?
But the article insinuates that they are still there... that only they held/hold the secrets, the reason for the bonuses. That only their knowledge could help sort out this mess. Which is it? If they've already been replaced then why the extra money. Still sounds like blackmail to me.
Nothing illegal here at all. The regulators and the government OKed the whole process.
In fact, the CDS notion was a seemingly- brilliant innovation of JP Morgan, but the math of it failed with collapsing bubbles.
All that's left at the AIG Financial Products desks are the traders, figuring out how to unload this stuff (for the benefit of us taxpayers).
We need these guys working for us for a while, or we will pick up the whole tab.
"The regulators and the government OKed the whole process."
And isn't that just what we rail against here?
Math... so much mush.
Were it up to me I'd sleep in a cardboard box before giving these assholes another cent.
A crime has been committed.
Assets minus liabilities = net worth.
These people decided to make debt an asset.
Debts minus liabilities = shit.
Accumulate enough shit, I don't care how you package it. It's still shit!
Shit is shit.
We should round up the usual suspects. Build another detention center at Gitmo, and water-board all the bastards.
I'd even throw in Eric Holder.
BD, define "for a while" for me.
BD is right. There was nothing illegal out writing CDSs. It was done right under the noses of multiple regulators.
Was it stupid? Yes! Management and the regulators missed the obvious.
Leverage was infinite. No collateral was required.
What does that mean? This is an oversimplification. Let's say that the FPG wrote a CDS for $100 million for a AAA rated company where the probability of default over the next five years was less than 1%. The insured party had made a $100 million loan that it planned to hold on its books but wanted to to hedge against the probability of default and to free up regulatory capital. Let's say AIG got paid a $1 million premium. No collateral required even though in simplistic terms you could argue that the 1% probability of default should have required $1 million in collateral.
Now 9 speculators come to AIG and say sell us a CDO for $100 million on the same issuer. Each pays $1 million. No collateral is required even though AIG is now theoretically exposed to the tune of $1 billion on one issuer.
Leverage is infinite because AIG can keep writing the same deal or any deal and collect the premium without ever having to put up cash reserves. Any number divided by zero is infinite/undefined.
Enter the credit crisis. Let's say that the issuer has landed on hard times and has been downgraded to CCC - true junk-junk status. The probability of default is now 90%.
Now people are concerned about whether AIG can cough up $1 billion if the issuer defaults. Remember, AIG has only collected $10 million in premiums. No investor is good enough to turn $10 million into a billion in almost no time (except if you are Hillary Clinton, remarkable woman that she is, trading futures contracts).
Multiply this many times over. AIG had all kinds of counterparties from commercial banks to investment banks to insurance companies to hedge funds.
AIG had bet many times its capital base and many counterparties were relying on AIG to make good if there were defaults. Here comes the black swan event and no one knew who was exposed to AIG and what an AIG default would mean in terms of impairing the capital base of the counterparties. Instant systemic risk.
The first outrage here is that AIG was allowed by management and regulators to write CDOs, collect premiums and never post collateral even when the probability of a claim increased.
The second outrage is that tens of billions of dollars went to pay off speculators, which is the majority of the CDO marketplace as I understand it.
Although I understand the populist feeling, the bonuses are a side show. The risk needs to be unwound and $165 million is peanuts relative to the exposure of what could happen if everyone walked out the door. Yes, the situation stinks.
Barrett, please explain something to me.
There was only ONE actual loan for $100M in your example, namely the first instance for which the CDS was issued by AIG. The other 9 instances by speculators do not involve loans for which AIG offered to act as guarantor, right? So, what would be the consequence of AIG paying out on the first contract but defaulting on the remaining CDS contracts with the 9 speculators? AIG is then on the hook for just one defaulted loan of $100 M, and the speculators who gambled all lose their $1M premiums if AIG defaults on those 9 other CDS contracts they wrote. Why, I ask, is there any obligation for the US to bail out those 9 speculators? As long as AIG covers the original $100M loan, it seems to me there is minimal economic damage if the speculators are stiffed.
That is a great question and gets to the heart of the matter.
It raises the issue of the rule of law (i.e. contract law) as does the idea that judges can unilaterally modify mortgage contracts. The bailing out of speculators is the real outrage here for me.
I understand why the government did it - because the web of counterparties that included the financials was unfathomable and given the notional amount the government did not know if there would be a chain reaction of bankrupticies bringing down the financial system.
CDSs were also just a part of more complicated hedging and trading strategies. Having said that, you are correct that in theory, and perhaps in practice, "stiffing" the speculators would have been the least expensive way out.
It raises the issues of regulation, the purpose of CDSs and OTC (non-transparent) versus exchange traded contracts.
Collateral requirements, exchange based trading (provides price discovery, transparency and settlement guarantees) and proof of holding the underlying exposure (e.g. the loan or bond) would eliminate essentially all of the issues. For example, collateral requirements would prevent the AIGs of the world from betting multiples of their capital base and would have forced pricing to reflect risk.
Barrett, I would never pig pile on BD : ) He, and you are correct. I'm not arguing that point. To me this is the crime of the century,and so far there seems to be no consequences.
I want someone to start naming names, maybe Bernie will sing, but I doubt it. Didn't these people learn any thing after junk bond king Michael Millikin.
If we can hold hearings for steroids in baseball, then we can have hearings to investigate Wall St. They were all in on the gig. Congress, the SEC, Standards, Moody's, regulator's Board of Directors, and Public Accounting firms.
We are all going to reap what these bastards sowed.
We get to pay , and they get to walk. I got out of school in 78. Can you see me trying to explain to my professor's what a SDO, CDS, Derivative Contract and anything sold OTC is . They would of thought that I was crazy.
To me they also tried to rewrite the rules of economics. Something that just can't be done. I think I'll spend the rest of my day making a water-board.
I share your sentiment because the consequence is one where the responsible people pay for the actions of poor management and clueless regulators. In that sense, it is the "crime" of the last 100 years.
You are also right that all of the players you cite plus corporate boards, line managers, risk managers and even investors were complicit. There are multiple failures here. Government and big business are too close and the revolving door always heightens my skepticism and cynicism.
Asking Congress to hold hearings will propbably be done. It will be a circus. There will be more regulation and 99% of it will be to create jobs for more government bureaucrats and be completely ineffective.
The reforms I noted in my earlier post to Agent Cooper are not complicated, but they would be effective.
Sarbanes-Oxley has added a mountain of cost and done virtually nothing to protect investors. The SEC misses Madoff and Sanford. S&P and Moody's are worthless as tits on a bull. Caveat emptor can never be escaped. I often disagree with Buffet, but he is right when says if you don't understand it don't buy it.
Financial innovation does not have to be a bad thing. In fact, the economy has benefitted from lower costs and greater access to capital as a result of financial innovation. However, financial innovation has risks and if those risks are ignored (as is the case here) and the market is large enough, then the consequences can be catastrophic - a black swan event.
This could have been avoided just like the mortgage mess could have been avoided. It stinks and the only thing we can try to do about it is to take government back.
Barrett. I'd like to thank you for your time and the effort expended in explaining in simple terms what has transpired with AIG. I appreciate it.
I'd like to clarify one thing though... I'm not looking at the matter from a populist perspective. More an idealistic naivety. I have no issues with anyone being rewarded for assuming financial risk. And as you and Jappy have covered much of what I was going to say here I will just add that it is the lack of personal integrity that bothers me most about the situation. All those involved appear to have had none.
My particular profession is based on integrity, on a man's word. Honesty, trust... all those old fashioned values that have seemingly disappeared from public discourse. My comment about public shaming was made in the sense that shame and the concomitant embarrassment might again well serve the public good. In other words the "moralistic outrage' that started this discussion.
If, as BD states, it was all legal and above board then what other recourse is available for the lack of foresight shown by this "seemingly- brilliant innovation".? Avarice, greed and a lack of responsible thinking shouldn't be dismissed without sanction.
You have placed your finger on the reason for the decline in our society and the West. Everyone's reputation and business depends on honesty and integrity.
Our values have been compromised by political correctness and multi-culturalism. You can't call someone a liar and a thief anymore, even if they are. You can't call a person's performance into question without being questioned for discrimination of some kind (making the subject of merit almost moot). Bankruptcy used to carry social stigma. Now it is a financial engineering tool.
Public outrage and shaming! From whom? Barney Frank, Chris Dodd and Obama, who have all been gorging themselves at the tables of AIG, Fannie, Freddie, the banks and the like while undermining the public trust? From the completely dishonest press? The NYT or MSNBC (Olberman, Matthews)?
Until we take back government from the central planners, moral relativists and anti-Constitutional lawyers, America will continue to fade away.
I am fed up. So are you and many others here at MF and elsewhere. I am taking the action I can, including influencing those around me. I hope you do the same.
A bunch of these guys have now quit AIG. Are they going to use their knowledge to trade against AIG's positions, and make even more money than the lost bonuses. I certainly hope so!
Well, Bob, you could hire them to manage your finances. What are the odds that this will happen again?
Talking about letting AIG fail is useless, for months now.
Since it became a ward of the state it is ours to live with and the desire to punish the successful amongst them is a childish reflex that yall's cheerleader, Mudboy Hussein delights to tease.
AIG is underwriting Sharia law with it's luanch in 2006 of AIG Takaful - Enaya; Sharia compliant insurance solutions at its best!
US tax dollars are used by AIG to promote Islam and Shariah law and it's war against the USA.
I wager, Mudboy won't be out raising rabbler's for that obamination.
In fact, in reply to a lawsuit filed by former US Marine, Kevin J. Murray and Thomas More Law Center on this issue the Hussein Administration claims it doesn't control AIG and isn't responsible for the what amounts to Sharia war waged by BHO on the USA.
Now, that is something legitimately pissin' this fella off.
Yall need to focus on the real enemy.