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Duh, Hedge Funds Bought AIG Credit Default Swaps Too

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The Wall Street Journal tells us tonight something that is pretty obvious: hedge funds were often buyers of AIG credit default swaps, either directly, or indirectly, by purchasing structured products that had AIG guarantees, such as collateralized debt obligations.

While this report falls in the camp of peeling away yet another layer of AIG’s practices, as opposed to being novel, it does focus attention on the use of CDS to place speculative bets. If the public were to take offense at the idea of government money rewarding successful speculators, it might lead to restrictions on CDS writing in cases where the protection buyer did not own and continue to hold assets of the reference entity. One can only hope.

From the Wall Street Journal:

Some of the billions of dollars that the U.S. government paid to bail out American International Group Inc. stand to benefit hedge funds that bet on a falling housing market, according to people familiar with the matter and documents reviewed by The Wall Street Journal.

The documents show how Wall Street banks were middlemen in trades with hedge funds and AIG that left the giant insurer holding the bag on billions of dollars of assets tied to souring mortgages….

The transactions worked like this: Investment banks such as Goldman Sachs Group Inc. and Deutsche Bank sold financial instruments to hedge funds letting them bet that mortgage defaults would rise. These instruments were credit default swaps, a form of insurance that pays out in the event of a debt default.

Yves here. Note this article is not very well written. Only later does it say the banks laid some of these risks on to AIG. Back to the piece:

Some of the U.S.-government exposure traces back to the hedge funds that spotted problems in the U.S. housing market in 2005. They wanted to “sell short” — or bet against — securities backed by mortgages to questionable borrowers…..

The banks that had sold credit default swaps to the hedge funds wanted to turn around and hedge their own risks. But finding that protection wasn’t easy.

So at Deutsche, the German bank’s securities arm created a handful of offshore companies known as collateralized debt obligations, or CDOs. These companies carried a series of exotic names, according to securities filings, mostly based around the moniker “START,” short for STAtic ResidenTial CDO. They allowed Deutsche to neutralize its exposure to the hedge funds’ bets by buying swaps from START on the same securities its clients were betting against.

START held assets from a hit parade of lenders closely linked to the subprime crisis, including Bear Stearns, Countrywide Financial and New Century Financial, according to documents reviewed by the Journal.

In 2005, Deutsche found a willing taker for a chunk of the mortgage risks held by START: AIG Financial Products. The derivatives arm of AIG agreed to pay out up to $1 billion under two of the START vehicles, if underlying assets deteriorated or the insurer’s own credit rating fell below a certain threshold. AIG stood to earn a fraction of a penny each year for every dollar of protection it sold, according to securities filings, meaning it made less than $10 million annually on the $1 billion in insurance.

Up until AIG exited the market in 2006, “AIG was by far the single largest ultimate taker of risk in the [subprime mortgage] CDO space,” says a senior investment banker whose firm bought credit protection from the insurer.

Yves here. Note the truly awful subprime deals were written starting third quarter 2005 through end of 2006. Even though vintage 2007 deals were even worse, by then the market was under stress, origination volumes were down as defaults had started to rise. The bulk of the bad deal originated were in that 2005-2006 window, and AIG was in the thick of it. Back to the article:

Last fall, after AIG’s credit rating was cut, the insurer paid roughly $800 million to START, according to two people familiar with the matter. Much of the money is being held in escrow and will be used to pay off Deutsche’s swap contracts if mortgage defaults in the portfolio rise above a certain level. Some of that money could go through Deutsche to its hedge-fund clients.

If the housing market improves, AIG could recover some or much of the cash it transferred to START. But that outcome won’t be known for years. The portions of START to which AIG is exposed were originally rated triple-A by Standard & Poor’s. They’ve since been downgraded to “junk” status by the ratings firm.

The START CDOs share some similarities with mortgage pools created by Goldman named “Abacus” and also insured by AIG Financial Products….

Yves here. Do the math. Deal done in 2005. Annual premium $10 million, so AIG has received max $50 million (oh, and since it thought those deals were fine, some of the premiums received in prior years no doubt went out the door in AIGFP bonuses). AIG (actually now the US taxpayer) has had to pony up $800 million. And they have other deals like that.

On a separate topic, we have the lame defense of AIG by Timothy Geithner. I agree, as others have said, the bonus affair seems overdone, but on another level, it makes perfect sense. Intuitively, the public knows the execs and troops of the big financial firms were overpaid in recent years since the earnings were overstated, due to phony accounting and insufficient loss reserves. They can’t get that money back, but the idea of even more going out the door, even amounts small relative to the bailouts, now that the companies are bust, is offensive.

But this truly intelligence-insulting bit from the Treasury secretary is this:

“We will impose on AIG a contractual commitment to pay the Treasury from the operations of the company the amount of retention rewards just paid,” Geithner wrote. “In addition, we will deduct from the $30 billion in assistance an amount equal to the amount of those payments.”

The money at this point is all coming from the government. That is what is so patently foolish. AIG is being treated as if it is a normal company with all the attendant rights thereto, when it from an economic standpoint is nationalized (Uncle Sam has paid multiples of its market cap even in better days); the fictive minority ownership is to avoid consolidating the debt onto the Federal books. But now we are letting accounting contrivances drive substance.

So the US government is haircutting a teeny weenie bit the loans extended to AIG. We said the bonuses were rounding error, and the loan reduction reflects that.

But the American public does not want a penalty imposed on AIG (even if this were a penalty, which it isn’t). It wants one imposed ON THE EXECUTIVES. What about “no” does Tim Geithner not understand?

And what does a $165 million reduction mean, anyhow? If AIG says it needs more money, the government spigot will be opened again, and AIG never asks for less than 11 figure cash injections.

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23 comments

  1. Anonymous

    Yves,

    Another thank you. How do we get the public to stop following the propoganda and lies?

    What continues to grate on my nerves is that is is nothing stopping AIG right now from creating some derivative instrument that they (now the US taxpayers) stand to lose on. Everyone makes processing fees along the way and it is only the taxpayer down the road that has a heart attack.

    I will not be off the edge until I know we are not still digging down….financial instrumently speaking.

    psychohistorian

  2. alex black

    Well, well…. turns out that the two largest Congressional recipients of pliticial contributions from AIG’s Financial Unit were…. Senators Barack Obama and Chris Dodd.

    Interesting….

  3. Greg

    God the press is putrid on this issue. All day, watched the CNBC fools like Kudlow talk about how the taxpayer needs to get repaid all the money we have lent AIG. Hello, earth to Larry et al….we are into them for 160 B. The mkt cap. of the co. is 2 B. You can sell everything and still be 150B short. Fools.

  4. Sukh Hayre

    Why is everybody making such a big deal about this $160 million, when we really should be up in arms about the bonuses that were paid out on fictitous earnings over the past 7 years!

    This is just a big distraction! It’s a circus.

    In the end, much of this $160 million bonuses will be forfeited and the masses will rejoice in the victory for the little guy.

    This will help the masses forget the billions that were paid in bonuses on false profits over the last seven years.

    What a joke.

    This drama is more scripted than professional wrestling.

  5. doc retarded holiday

    Re; “In addition, we will deduct from the $30 billion in assistance an amount equal to the amount of those payments.”

    I hoped someone would shed some light on that retarded stupidity, by Paulson’s Retarded Clone!

    This Crap from Treasury is like a drug addict making shit up on-the-fly, and this treason-like madness is getting closer and closer to criminal negligence! Are there any clear-thinking adults left out there, anywhere (besides Yves)?

    Also see: Ineffective assistance of counsel

    I think Potter also tossed in: “Misappropriation of funds – manipulation – malfeasance … “

  6. Anonymous

    Note the truly awful subprime deals were written starting third quarter 2005 through end of 2006. Even though vintage 2007 deals were even worse, by then the market was under stress, origination volumes were down as defaults had started to rise.

    This would put them after the July 2005 article in the Economist which explained to everyone who was too thick to think for themselves that there was an imminent housing bubble brewing in the U.S., G.B., Ireland, Spain and Australia. It went on to state how on average GDP goes down at least 5%. In other words, there must have been malice-aforethought.

  7. backerman

    Why did AIG have to wind down the cds after the government had come in an kept the company formally out of bankruptcy? Wouldn’t that have been enough to avoid the trigger of default for the cds? I’m really curious to know the answer here. Additionally, if the technical way in which the feds backed AIG didn’t save the cds from default, then shouldn’t there have been a way to take over AIG that wouldn’t have triggered the cds and consequent bailout of counterparties? I’m really curious.

  8. esb

    Our tax-evading S o T is simply a puta on all fours in front of a small group of plutocrats, licking his lips all the while and liking it more than one can ever know.

    The money and positions that he knows will come to him in the future are his aphrodisiac.

    Is there a single patriot in the room? After all, trillions are being looted.

  9. fresno dan

    I don’t know how many times I asked if Paulson knew how Goldman made money.
    It has now reached the point of asking, “Does Geithner know how AIG ‘loses’ money?”

  10. Anonymous

    It’s my understanding that these contracts usually run for five years. So AIG will be dependent on taxpayer money until 2011 (if they did indeed stop their stupid practices in 2006).

    BTW there’s something that has had me scratching my head lately. A lot of these credit derivatives are essentially speculative insurance. They don’t really hedge anything, they’re just bets placed by third parties with no stake in the underlying credit. Could those kinds of contracts be torn up without much effect on markets? As I see it you only need to pay back the premiums, and that’s that.

  11. ruetheday

    Here’s a plan: Since we now own 79.9% of AIG, we force them to spin off AIG Financial Products into a separate company. Think of it as excising the cancer. This will force the parent holding company into bankruptcy. Fine. We do a forced debt to equity conversion where the government would get paid back on our $112 billion in loans and $40 billion in preferred, first. Our 79.9% share of common stock would be worthless, but that’s ok because we didn’t buy it, we got warrants when the Fed made the loan. The bondholders would now own AIG minus the FP division, and pretty much everyone agrees the core AIG business is a good business. The FP Division is now a separate company and can die a peaceful death. This would cause problems for Goldman Sachs and Bank of America (via Merrill) and a whole host of European banks (DB, SG, BNB Paribas, Barclays) but tough shit, let them come clean and be up front about what they need rather than getting the stealth bailout through AIG, and then we can decide what to do (preferably nationalize them).

  12. M.G.

    @ruetheday: your proposal recall what I proposed for the creation of a “good bank”. I would also proceed by breaking it up and make smaller insurers where appropriation and needed. Let’s see if we can still have “good insurers”. Now that the list of counterparts is know it should be easier to work the details out and see who is taking the haircut and how much. No more systemic risk and uncertainty around…

  13. Anonymous

    it might lead to restrictions on CDS writing in cases where the protection buyer did not own and continue to hold assets of the reference entity. One can only hope.

    You mean require the buyer to have a demonstrated “insurable interest” like, say, purchasers of life insurance? That only applies to the rabble.

    Historical note. When life insurance first started in England it was possible to buy a policy on total strangers. Underwriters soon noticed such insureds were suffering a significantly higher rate of lethal accidents and homicide. When underwriting was restricted to those with a demonstrated lawful interest, viola! The unusual death rates went down.

    Imagine that.

  14. M.G.

    Let’s put it in this way:
    if there was an insurable interest and fair management risk behind each contract fair enough, they need to be honored. If on the contrary we discover that it was pure gambling and betting or fraud, then relevant laws are applicable. I am not sure that gambling is allowed…

  15. gromit stevens

    > http://uk.news.yahoo.com/18/20090318/tpl-us-to-wind-down-aig-in-orderly-way-g-10170b4.html

    there has been no unwind and there will not be soon.

    there are two reasons why AIG financial products is not going to unwind anytime soon.

    first, the size of the portfolio is gargantuan compared to normal market flow. nobody is going to buy this portfolio for a reasonable price. and even if someone was, they would see that there is a large and motivated seller and lower their bids accordingly.

    secondly, a very large part of the staff of AIGFP is going to quit and get cosmetic surgery in the next week or two. many already have. this is one of the largest and most complicated structured credit portfolios on the earth.

    personally, i find the furor over the bonuses misplaced. clearly a massive crime occurred here. the crime occurred while AIGFP was building their portfolio. unfortunately the victims didn't notice it while it was happening. in fact the victims benefited for a while, as the crime subsidized housing and consumer credit in the US.

    i totally understand the anger and i am angry too, but not at the current bonus holders. and i think it is an important distinction, because who we are angry at will determine what our course going forward is.

  16. carol7

    It is troubling that Geithner writes about ¨retention rewards¨: a bonus by any other name stinks as rotten! In addition, 11 of the 73 people who got a million or more, have already left the company.

    Apparently, the contracts were negotiated in April 2008, i.e. after the collapse of Bear Stearn, i.e. after the obvious troubling times ahead for AIG. This notwithstanding, the contracts stated that the 2008 bonuses would be at least equal to bonuses for 2007, which was a completely over the top record bonus year. Obviously, these contracts should never have been made this way, and obviously could have been renegotiated, if only the administration had tried.
    In addition, all US contracts contain a clause, exempting ¨acts of God, government actions, ….¨. Clearly, the government could have acted….

    The stimulus bills allows the Treasury to negotiate the rewards of the top-20 executives. This AIGFP bonus outrage shows how ridiculously low this number is: 73 people got more than 1 million! Was this low number (20) put in just as a smoke screen?

    All these tax law proposals currently circulating on the hill to try to stem the population´s rage are also smoke screens as Wall Street firms are in the process of reducing bonuses while at the same time increasing salaries.

    Sukh Hayre, you are right that a much bigger issue are the bonuses over the fake, artifial profits of the last years. But these bonuses are an important issue as they finally open peoples´ eyes.
    The subdued reaction of the US taxpayers till now has been amazing. Only a few knowledgeable blogs — thanks Yves! Apparently, the concept of fiat money, fractional reserve system with overleverage, naked CDS, derivatives to the tune of 600 trillion, i.e. more than 10 x Gross Earth Product, the intricacies of market manipulation, have all been too complicated. These bonuses are easy to understand, and finally lay bare AIG and other Wall Street players for what they are: supergreeds, who with financial weapons of mass destructions gambled with the world economy.

    At Anonymous 8:05 ¨A lot of these credit derivatives are essentially speculative insurance…. Could those kinds of contracts be torn up without much effect on markets? As I see it you only need to pay back the premiums,..¨
    +
    At M.G. ¨ then relevant laws are applicable. I am not sure that gambling is allowed…

    NY AG Cuomo estimates that 80% of CDS are speculative, not speculative insurance, but plainly speculative. Gambling is not allowed, but Congress explicitely exempted CDS!!!
    Still, those bets can easily be declared null and void, without much effect on the markets. And no, you do not need to pay back the premiums. Not declaring these bets null and void will in the end result in a huge disastreous effect on the markets.

  17. Guttersnipe

    The gubmint simply cannot bail out everyone. Someone is going to have to lose (besides the US taxpayers). I wonder who the losers will be and how they will be determined.

  18. MyLessThanPrimeBeef

    No one is too big to fail. It doesn’t matter if you are the United Nations, IMF, the World Bank, Great Britain, Germany, China, Japan or Mars. Water here today, gone tomorrow.

    So, we have to be careful about protecting what can be protected and let go of what can’t be saved. And it looks like Always Insatiable Greed, i.e. AIG, is a goner or should be.

    It may not be too early to worry about the survival of the species, not that we are so great, but only to ensure the next mutation, preferably with a smaller and simpler to use brain (Why? Because that’s the trend with all gadgets.) and maybe involving asexual reproduction (the benefits are self-evident, as they said back in the colonial days), has a chance to occur. And if this involves declaring the financial industry a federal disaster area, or the whole country a disaster area, so be it.

  19. geo1952

    Thank you Ives, I would be even more ignorant about all this without you and your regulars.
    Today’s news and folks reactions to it leave me speechless. All I want is a couple stiff drinks and a bed with covers to pull over my head. Maybe my view of this colossal failure on so many levels will improve tomorrow. Right now I just want to run away. Now where did I place those rose colored specs?

  20. rd

    Theoretically, the buyers of the CDS’s for speculative purposes would be “sophisticated.” Wouldn’t we expect the sophisticated investor to do due diligence on whether or not an insuring party would have the wherewithal to payout on a bet? The difference between a casino and the financial markets is that casinos have rules and have to hold collateral against the bets on the floor. The hedge fund managers should know this.

    Other than the sheer magnitude, I don’t understand the difference between this and Madoff. Why aren’t we just paying off to the extent that we need to cover financial institutions who may have bought CDS for pruposes to insure holdings to meet regulatory purposes? The rest of them we can just give them their premiums back and tell them to do their gambling at the race track where the track is actually holding the money made to place all of the bets.

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