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.