AIG's house of cards

[Puppycow]

Everyone should read this article about what AIG was doing.

Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion, which will affirm, yet again, A.I.G.’s sorry status as the most crippled of all the nation’s wounded financial institutions. The recent quarterly losses suffered by Merrill Lynch and Citigroup — “only” $15.4 billion and $8.3 billion, respectively — pale by comparison.
. . .
More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin.

“They were the worst of them all,” said Frank Partnoy, a law professor at the University of San Diego and a derivatives expert. Mr. Vickrey of Gradient Analytics said, “It was extreme hubris, fueled by greed.” Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet — and this is the part that should make your blood boil — the company is being kept alive precisely because it behaved so badly.

 

[kevinquinnyo]

It is pretty infuriating. Doesn't it make you think they should let these companies fail?

What bothers me, is that the companies receiving bailout money are companies that AIG 'insured' against default. So, if they let one of the companies fail, but the amount necessary to keep it afloat is say 50 billion, it could be that the claim to hedge funds and pension funds and whoever else bought this insurance comes to a combined total of like 500 billion, right?

Who knows? It's mind-blowing. I have a hard time wrapping my head around the numbers.

But overall, what it teaches future entrepreneurs is, if you're going to take excessive risk, with insufficient capital reserves, just make sure you're embedded enough in the financial system, and you'll get bailed out.

 

[kevinquinnyo]

And you know what's actually unfair?

If you purchased a CDS from AIG on a company that is being bailed out and/or nationalized.

Anyone know if that is considered a credit event? I mean in terms of getting filing your 'claim?'

Like if I paid 5B to AIG for a 100B CDS on citibank, do I get paid or not?

 

[oggiesnr]

It is pretty infuriating. Doesn't it make you think they should let these companies fail?

Much as it irks me to say so.... if AIG fails then the shockwaves of failure is going to be huge. Now I am lucky, I actually make things so if the system collapses I may be able to barter my way through

The insurance offered by AIG was the cornerstone of turning turds into gold. The problem is that everyone now sees them as turds and is looking to AIG to reimurse them the balance. Yet again "air cash" is going to be converted to "real cash" at our expense and I don't see an alternative other than collapsing the whole system.

Steve

 

[kevinquinnyo]

Can anyone answer my question about CDSs?

Do the purchasers of CDSs get payment on claims, if the swap was purchased on a company that is bailed out?

Is that considered a credit event?

 

[Random]

The insurance offered by AIG was the cornerstone of turning turds into gold.

It was rising houses prices that did most of the heavy lifting in creating this crisis. The assumption that the value of an asset (housing) was going to up at 5-10 percent a year forever made absolutely silly deals ($250k mortgage to a man making $35k a year) seem rational. The system would still have operated more or less the same with or without AIG and their credit default swaps, AIG simply made it all look better to investors.

Everyone in the process was making the same bet. Home owners, banks, investors, and insurers were all betting that housing prices were going to go up, and then they didn't. The only people who didn't care were the mortgage brokers, whose only problem was not getting the next sale. Once the papers were signed, they were out of the process.

Not sure if it has been posted before, but this is probably the best, most informative explanatory video on the mess IMO. The credit default swaps are barely mentioned, but the only function they served was making the CDO look like a better investment then they actually were. The Crisis of Credit Visualized

eta: just noticed kevinquinnyo posted a link to the same video on youtube earlier.

 

[Puppycow]

Can anyone answer my question about CDSs?

Do the purchasers of CDSs get payment on claims, if the swap was purchased on a company that is bailed out?

Is that considered a credit event?

Based on what I've heard, ususally the specific trigger for a CDS would be if the company can't pay its bonds. So if it gets a bailout and as a result is able to make good on its bonds, the CDS would not be triggered.

One of the problems is that people were using these instruments not to insure their bonds, but simply as bets. They didn't own the bonds, they were just speculating that the company wouldn't be able to pay them. It was like having 100 different $100 K insurance policies on one $100 K house. People who didn't even own the house were buying insurance policies on it as bets.

 

[geni]

$61.7 billion. The estimate wasn't far off.

 

[Free Thinkr]

Ah, thank you, FIRE sector of the economy. You're fake wealth generation and real wealth destruction are truly appreciated.

 

[Paul C. Anagnostopoulos]

$61.7 billion. That's some actual money. They ended up losing $99 billion in 2008, after making $9.3 billion in 2007. That's just surreal.

~~ Paul

 

[macdoc]

It was all bubble money - no real wealth involved Welcome to the big squeeze

 

[geni]

$61.7 billion. That's some actual money. They ended up losing $99 billion in 2008, after making $9.3 billion in 2007. That's just surreal.

~~ Paul

Massive swings for insurence companies are not unknown. However historicaly they've either been small enough to allow to go to the wall or big enough to absorb the impact. Lloyds had rather a lot of it's names wiped out at one point.

 

[oggiesnr]

It was all bubble money - no real wealth involved Welcome to the big squeeze

Fine. The problem is that the taxpayer is being landed with the bill for turning "squeeze money" into bankables readies.

There is BBC Radio4 radio comedy called "Old Harry's Game" Old Harry being the Devil and concerning the goings on in Hell. In the first episode of the new series he's considering what to do with two bankers. The exchange went somethinf as follows...

OH " It's simple, you've done something wrong so you suffer for it"

Bankers "You don't understand, we're Bankers. We never suffer. Someone else does"

Fred Goodwin spring to mind?

Steve

 

[bignickel]

"If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses."

While they may not want to let the banks eat these losses, and I can understand the reasons why... surely, we don't have to let the idiots who had nothing to do with the mortages, but bought CDS on them anyways get away with ill-gotten gain?

In fact, if we do, it looks the we're helping them complete their scam for them. Let those who bought CDS on mortgages that they never possessed be twisting in the wind. For those already got paid off: their assets should be frozen, and they should be investigated by grand jury.

 

[kevinquinnyo]

Based on what I've heard, ususally the specific trigger for a CDS would be if the company can't pay its bonds. So if it gets a bailout and as a result is able to make good on its bonds, the CDS would not be triggered.

One of the problems is that people were using these instruments not to insure their bonds, but simply as bets. They didn't own the bonds, they were just speculating that the company wouldn't be able to pay them. It was like having 100 different $100 K insurance policies on one $100 K house. People who didn't even own the house were buying insurance policies on it as bets.

Thanks for the answer.

Yeah they were totally used as bets, no question about it. It's like taking out a life insurance plan on someone else that you think might die.

And I realize these are totally unsecured, but it seems like if I bought a CDS for Citibank or something, and then they got nationalized and rescued, I would be furious, because my bet should have paid off, but it didn't, because they were bailed out.

Pretty messed up.

 

[Puppycow]

Thanks for the answer.

Yeah they were totally used as bets, no question about it. It's like taking out a life insurance plan on someone else that you think might die.

And I realize these are totally unsecured, but it seems like if I bought a CDS for Citibank or something, and then they got nationalized and rescued, I would be furious, because my bet should have paid off, but it didn't, because they were bailed out.

Pretty messed up.

Speculators are supposed to consider all possibilities including the possibility of a bailout or a takeover by another, healthy company. The bet is specifically on whether or not the bond will be paid, so if it is paid, they lost their bet fair and square.

And, there's also a counterparty risk: If their counterparty for the CDS is AIG, and AIG is insolvent, then in a certain sense they should not expect to be paid even if the conditions did come true, because they didn't accurately assess counterparty risk. AIG did have a AAA credit rating though, which doesn't reflect well on the credit-rating agencies.

 

[Francesca R]

If you purchased a CDS from AIG on a company that is being bailed out and/or nationalized. [ . . . ] Like if I paid 5B to AIG for a 100B CDS on citibank, do I get paid or not?

No I don't think so, but you shouldn't want to be because Citi is still servicing its bonds. And if it didn't, you would.

Yeah they were totally used as bets, no question about it. It's like taking out a life insurance plan on someone else that you think might die.

You have just described insurance though. It is not necessarily "all bets". But some of it is (that is--people taking risk rather than trying to hedge it) and that seems to work fine per se.

And I realize these are totally unsecured

Eh? CDS exposures are almost all covered by collateral so they are secured. if they weren't then the counterparty risk would be a great deal bigger. (However the collateral has left a lot to be desired in some cases)

but it seems like if I bought a CDS for Citibank or something, and then they got nationalized and rescued, I would be furious, because my bet should have paid off, but it didn't, because they were bailed out.

That would be your miscalculation that it would not be supported though. Like if you bet that your Auntie Sue was going to die but then medical science came to the rescue. Perhaps temper your fury

 

[Francesca R]

And, there's also a counterparty risk: If their counterparty for the CDS is AIG, and AIG is insolvent, then in a certain sense they should not expect to be paid even if the conditions did come true, because they didn't accurately assess counterparty risk. AIG did have a AAA credit rating though, which doesn't reflect well on the credit-rating agencies.

The actual problem was that the collateral calls on AIG to cover its unrealised losses on CDSs are what threatened to break it. When you transact a CDS and then you lose money, you normally have to post high-enough quality assets over which the other party has a legal charge. The legalese is agreed up front, usually by means of an ISDA master agreement and a "credit support annex" (pardon the jargon)

 

[kevinquinnyo]

Ohhhhh.

Well, then, I guess all of that answers that.

And I guess that's right about taking all things into consideration (government bailout included) when making a bet. (or insurance)


It makes me wonder if there could be a conspiracy!!

Maybe someone had an incentive to not bail out bear-stearns, or whoever.

I'll write the screenplay and send it to Nicolas Cage. He likes a good conspiracy.

 

[Francesca R]

I assume you're not actually trading in CDSs, but to correct a possible misapprehension, they are not "binary payoffs" that either cough up loadsa lolly or remain worthless. Like swap contracts generally, the standard is to exchange (swap, that is) a floating short term interest rate for the expected return on something else, such as a Citi bond. If market expectations on the return from Citi's bonds goes bad (because of an expected default probability and a less than full recovery rate) then the CDS makes money and could be sold in the market at a profit at that point.