Sunday, March 1, 2009

NYT: AIG (AIG) - Propping Up a House of Cards

Joe Nocera is one of the best business writers out there - a long time writer at Fortune he moved over to the New York Times a few years ago; he writes about 1 article a week but they are excellent, informative reads. Below is a background on what happened to the clusterstock that is AIG in layman's terms - and why we are not near done bailing it out. And essentially how the "financial innovation" of one branch of the business is killing the entire body. Please feel free to print it for your neighbor's who can't be bothered with all this "sophisticated money stuff". Or read it to your children at bedtime - after all it's their paychecks that will be siphoned off for the next 40+ years. It's a grand story of wizards and magic (you'll see)

It also reinforces the thesis that all we are doing by bailing out "AIG" is funneling US taxpayer dollars directly into the banks of Western civilization. [Oct 17: Your Tax Money Paid to Investment Banks and Hedge Funds via AIG] Who knew insurance could be so exciting? Then again who knew auditing could be so exciting, right Arthur Anderson?

Via New York Times
  • 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.
  • At the same time A.I.G. reveals its loss, the federal government is also likely to announce — yet again! — a new plan to save A.I.G., the third since September. So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat. It has softened the terms it set for the original $85 billion loan it made back in September. To ease the pressure even more, the Federal Reserve actually runs a facility that buys toxic assets that A.I.G. had insured. A.I.G. effectively has been nationalized, with the government owning a hair under 80 percent of the stock. (remember our big secret - shhhh... stuff on the Federal Reserve balance sheet is "safe" - it's a magical place called Bentopia where all toxic assets turn into beautiful butterflies - and we'll make a profit off the butterflies someday too)
  • Donn Vickrey, who runs the independent research firm Gradient Analytics, predicts that A.I.G. is going to cost taxpayers at least $100 billion more before it finally stabilizes, by which time the company will almost surely have been broken into pieces, with the government owning large chunks of it.
  • A quarter of a trillion dollars, if it comes to that, is an astounding amount of money to hand over to one company to prevent it from going bust. Yet the government feels it has no choice: because of A.I.G.’s dubious business practices during the housing bubble it pretty much has the world’s financial system by the throat.
So why is AIG - a single insurance company THAT important? I mean... there are plenty of insurance companies out there.... why is AIG "the chosen"?
  • If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system. (ah so it's Lehman Brothers on steroids - "too connected to fail")
  • But that doesn’t mean we should feel resigned about what is happening at A.I.G. In fact, we should be furious. 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. “It was extreme hubris, fueled by greed.” (hey watch how you talk - I call it financial innovation fueled by the free market self regulation - worked like a charm! Until it didn't)
So what the heck were they DOING?
  • When you start asking around about how A.I.G. made money during the housing bubble, you hear the same two phrases again and again: “regulatory arbitrage” and “ratings arbitrage.” (you had me at arbitrage)
  • The word “arbitrage” usually means taking advantage of a price differential between two securities — a bond and stock of the same company, for instance — that are related in some way. When the word is used to describe A.I.G.’s actions, however, it means something entirely different. It means taking advantage of a loophole in the rules. A less polite but perhaps more accurate term would be “scam.” (oh, sort of like a Ponzi scheme... well that's not a problem - our regulators would snif that out in a jiffy!)
So a company with shady practices probably would look at least a bit suspicious eh?
  • As a huge multinational insurance company, with a storied history and a reputation for being extremely well run, A.I.G. had one of the most precious prizes in all of business: an AAA rating,held by no more than a dozen or so companies in the United States. That meant ratings agencies believed its chance of defaulting was just about zero. It also meant it could borrow more cheaply than other companies with lower ratings.
Ok - not so much. Score another for the rating agencies! (who still rate the U.S. AAA too! now you see how useful *that* rating is)
  • To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. (Its insurance divisions remain profitable today.)
  • But one division, its “financial practices” unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities.
Ooooh! Wizards! Tell me more - Lord of The Rings: The Return of the Loophole Scam Artists
  • Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.
  • These exotic instruments acted as a form of insurance for the securities.
  • In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too.
Aaaahhh... that's the magic the wizards had. Bundle 1000 subprime mortgages together, and sprinkle the special AIG sauce... and you get magic! AAA! Sort of like what is on the Federal Reserve Balance sheet? Headed by Warlock in Chief Uncle Ben. When securities go from the Wizards balance sheet (AIG) to the Warlocks balance sheet (Fed) it turns into pretty butterflies of AAAAAAA rating. Safe & Sound! No staggering losses coming for US taxpayer here - nope! I love these stories! Are hobbits involved? Dragons??
  • Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to A.I.G., and the AAA rating made the securities much easier to market. What was in it for A.I.G.? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up.
  • Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets — housing — could only go up in price. (I love fiction!)
Tell me more - fairies? elves? please!
  • That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, (regulation is evil and just slows down the American capital system! Phil Gramm - another wizard - told me so) and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. (why should they? home prices never go down! The Realtors Association told me!)
  • AIG's leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.
  • Second, in many of its derivative contracts, A.I.G. included a provision that has since come back to haunt it. It agreed to something called “collateral triggers,” meaning that if certain events took place, like a ratings downgrade for either A.I.G. or the securities it was insuring, it would have to put up collateral against those securities.
Why would they do a stooopid (sic) thing like that?
  • Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them.
  • Those collateral triggers have since cost A.I.G. many, many billions of dollars. Or, rather, they’ve cost American taxpayers billions. (I got your back AIG - just wondering do I get to stay in the homes of the executives or "wizards" who banked all the coin from this division? do I get to clawback their art? or salaries? or bonuses from that magical era? no? .... Ok so I get all the downside with none of the upside? I'm cool with that! Back to American Idol reruns)
So what kind of money we talkin'?
  • At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do.
Sorry I asked.

But seriously where were the flipping regulators (realizing regulation is evil and it kills innovation)
  • It’s not as if this was some Enron-esque secret, either. Everybody knew the capital requirements were being gamed, including the regulators. Indeed, A.I.G. openly labeled that part of the business as “regulatory capital.”
Bugger! Can you just give me the upshot?
  • Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. (indeed - isn't that just full circle) Indeed, that may be the single most important reason it can’t let A.I.G. fail. 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. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful.
Now this might get all you angry (unless you are reading this from AIG's UK Office of Wizardry) ... but really as the politicians and executives say - it is not a time to point fingers in the past (i.e. attempt a clawback on salaries or start charging the regulators with gross neglect) It is best we hold hands, sing Kumbaya and think of common solutions (rip off your grandkids) for an uncommon problem. They'll be time some day (never) to study how we got here (think Katrina) and make sure it never happens again (until lobbyists start up in earnest in about 4 years to slowly relax all regulations again as it is stifling American ingenuity. And wizardy. UK wizardy as well) Got it? We're in this together! (except the wizards)

And just remember - don't say it's nationalization. We don't do nationalization. Only loser countries do! (hi UK) We're USA! USA! USA!

[Feb 24, 2009: CNBC - AIG May Post $60 Billion Loss - Seeking More Taxpayer Help]
[Nov 9, 2008: AIG Needing More of Your Grandkids Money]
[Sep 16, 2008: Federal Reserve Considering Loan Package to AIG]

[Nov 11: AIG Executives Caught Again]
[Oct 8: AIG Executives Party it Up Post-Bailout]

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