AIG CDS We Don’t Hear About

In all the newly-discovered outrage at AIG’s payoffs to its CDS counterparties, we had a typical public humiliation session today.

Uninformed partisan hacks all lined up with their rotten vegetables to throw at (Tiny) Tim Geithner and Hank (Elmer Fudd) Paulson while they were locked in the stocks in the Town Green.

The Republicans lined up on the right with their tomatoes, and the Democrats lined up on the left with their cabbages.  I’m sure Timmy and Hank didn’t see much difference between the organic matter hurled at them, and just thanked their lucky stars for the time limit on the punishment.

I watched the Congressional questioners try to “get to the bottom” of the events that led to tens of billions of taxpayer dollars going in the front door at AIG and out the back door 30 seconds later to a chosen few banks and Wall Street firms.

What I didn’t see was discussion of the second round of CDS payments an AIG event of default would have triggered.

I can’t be the only observer that heard Goldman’s Blankfein say quite plainly that even if AIG had failed, they would not have taken a loss.  Any guesses as to why?

Here’s why:  in the hidden world of 100-1 (and higher) leverage from undisclosed and unregulated CDS, Goldman had bought additional insurance against AIG’s default.  I know that AIG was considered so strong, almost until the end, that CDS on AIG’s credit were really, really cheap.  Think a dozen or fewer basis points per annum.

For easy back-of-the-envelope estimation, let’s assume 12 basis points was the price paid by some enterprising speculator (or Wall Street firm seeking hedge protection) in  late 2006.  That’s 1 basis point per month (see what I mean by easy estimation?), or $100 per month for a million dollars of credit insurance.

By September of 2008, AIG was getting stripped bare of all its cash by margin calls on its CDS, mostly written to protect counterparties on AAA-rated CDO’s structured and sold by those same counterparties.

Any realistic attempt to get the counterparties to accept discounted payoffs on their contracts would have involved threatening default or filing bankruptcy.

Why weren’t the questioners asking where else the trail led?  What banks or insurance companies would have been on the hook to pay off on CDS written on AIG’s own credit?  Obviously not AIG.

As we have seen in a number of actual events of default, CDS often far exceed the amount of debt outstanding.  In the settlement of the Fannie Mae CDS at under 10 cents on the dollar, the amount lost on the $400 billion of Fannie CDS  exceeded even the credit losses to every bondholder for every subprime mortgage bond ever issued.

My skeptic mind says maybe Citibank, or some big state pension funds, or Merrill (now BankAmerica), or maybe some other huge institutions like JP Morgan or the international banks were the counterparties on even more CDS against AIG’s name than the clowns at AIGFP had written against the CDO’s.

After all, at its peak, the Bank for International Settlements reported over $60 trillion in CDS outstanding at the major banks they deal with.  That’s a lot more than all the investment grade debt in the world at the time, and actually a little larger than the world GDP.

What if AIG CDS totaled trillions of dollars?  Could the system survive payment of that many dollars of losses from bet losers to the bet winners?

Of course not.

That’s what happens when you let the side bets in the casino go undocumented and uncapitalized, and let those side bets outweigh all the chips in the casino money cage.

These turkeys actually let the side bets on credit grow larger than the world economy, and called it “innovation.”  Then “The Maestro” Alan Greenspan insisted that every player in a massive complicated game like that was always going to get it right, so there was no need for regulation, or even disclosure.

Maybe Geithner, Paulson, et al would rather take their hits on the AIG taxpayer ripoff/cover-up than admit their alternative was to hand every dollar in the civilized world to a few dozen tax-avoiding speculators.

It’s been hundreds of years since human beings decided serfdom and feudal lords wasn’t an appropriate way to organize society.  Maybe that was the real alternative if they had let the rest of the dominoes fall.



2 Responses to AIG CDS We Don’t Hear About

  1. Tom D says:

    We agree.

    I know you’ve read Mark Twain’s discriptions of Congress and Congressmen in the 19th century. One of his career jobs was staffer to a Nevada senator. Congress hasn’t changed a bit since it is chosen by the little and mostly ignorant people who don’t change.

    Central bankers don’t change either as Kindleberger established and as Reinhart and Rogoff more recently document.

    When Congressmen and central bankers are staring into the abyss is when they actually do protect the public as a byproduct of saving the system they serve and which rewards them. The hearings are attempt to fine tune the blame and reward aspects of the nearly complete failure had AIG been allowed to fail like Lehman did.

    In the end, the system works! 😉

  2. Julie N says:

    Hi Howard, hope you’re doing well. I was just thinking about you the other day so I thought I’d pop over and leave you a comment. Keep up the interesting commentary here. It makes for good work conversation. 🙂

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