Topic: Economic Policy
AIG, Truth and Consequence. The bigger they are, the harder they fall, unless you have the strong arms of the Federal Government to break your fall!by Gene DeNardo
(libertarian)
Friday, March 20, 2009
"Just the facts, Ma'am!" Sergeant Friday interviewing AIG's widow the Federal Government.
It seems the fall of AIG has been widely misunderstood. It has been attributed to secret government conspiracies, your neighbor's home foreclosure or a black cat and a ladder. Well, it isn't that simple, but there definitely is a trail of cause and effect!
AIG was under the self impression that if it was insurable, they could insure it. The world's largest insurance firm, they had pretty much made their case. But it was this idea, this outlook that everything was insurance and all risk could be defined that took them down.
The Credit Default Swap is an odd piece of quasi insurance. It is a contract where one party [the insurer or backer] agrees to eliminate the risk that a bond will default. If the bond defaults, the insured party receives payment, if not; the insurer has collected some hefty premiums. The insured party, interestingly, doesn't have to be the actual bond holder. In this sense, it can also be a wager.
AIG got way into CDSs.Way big! There are no reserve requirements for these derivatives and it is obvious now they never much considered reserves at all. Their investment division expressed many times how profitable the CDSs were and what a foolproof and safe investment they were. A fool requires no proof!
One thing that AIG never did that was common in the industry, was to CDS their CDSs! That is, provide the insurance and then take out insurance on the insurance. In this way, if you had to pay out, you would also get paid.
AIG also had a big portfolio of Mortgage Backed Securities. When the value of these began to slide downward, the value of AIG's capital reserves went along for the ride.
CDSs have collateral requirements. The higher rating the insurer has, the lower the collateral needed to secure the contract, down to zero at the highest rating. AIG was making out big on these contracts for precisely this reason, they had little if any actual cash put out and the premiums were pouring in. When their capital reserves began to decline, all that changed. That's when Moody's stepped in!
They were downgraded from triple-A to single a. The collateral calls then came in at @ $100 billion and they had nothing even close to that. Total CDS contracts were @ $450 billion, and most at the time were still sound, so you can see from a backing standpoint, they were winging it.
Government to the rescue!
An interesting problem with these contracts, and they are contracts, is the priority of payout. With the collateral clauses, the CDSs take precedent over all other credit and in AIGs case, policies. Big buck corporate financiers get their money and mom and pop's burnt house is left in ashes! The company may go down but the gamblers win big!
So AIG is quite experienced in fulfilling their contractual obligations, at least with big daddy Fed propping them up. There is no risk that is too big for AIG and Uncle Sam to take on together! So whether it is raising collateral or paying out bonuses, AIG is a company of their word, as long as they stay in bed with the Fed.
Personally I don't believe there is any regulation that would have prevented this or that caused this to happen. Illogical blame is firmly entrenched in the muddy cries of the right and left, but this is a bloated corporation that made bad decision after bad decision. A contract is law and if you enter into a contract[s] that you can't fulfill you have entered into that contract fraudulently. AIG's Investment Division did this countless times, reaped the enormous temporary rewards and then skated on the final judgment call.
Every entity around AIG involved in these transactions is a "limited liability" corporation. They should understand their own nature. And they do, and that is why they are so dependent upon the government and the Fed. Limited liability is just that, when the chips fall the wrong direction, it's time to pick up what you have left and get out quick. It is only the government, we the citizen taxpayer, that will be stuck with the tab. Profits will be taken whenever possible but if it seriously goes the other direction we get social liability. And what are the alternatives we are presented with?
Three Choices:
1. Massive Corporate Profit Taking
2. Economic Collapse
3. Socialized Bailout
The name of the game is Capitalism and AIG was one of the best ever when it came to profit taking. They forgot about the namesake of the game though, the ism; Capital. When you don't keep enough real capital around, you lose.
And the reality of the system is Corporate Capitalism. This isn't an Austrian fairy tale where each transaction spreads liberty and justice, this is the real deal Colonial Derivative Corporatism. And when those privileged with "limited liability" exceed their limits, there is little suffering in their crowd. Instead all of us with our run of the mill "unlimited liability" are left mopping up the mess in the dining room before getting back into the kitchen to prepare the next trillion dollar feast. Perhaps another round of Choice Papier Asset Value smothered in delectable Subsidy Sauce?
And this enormous transfer of liability from the limited to the unlimited when things get rough, this is a textbook display of another "ism", that would be Socialism.
The views expressed in this
article are those of Gene DeNardo only and do not represent
the views of Nolan Chart, LLC or its affiliates. Gene DeNardo is
solely responsible for the contents of this article and is not an
employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.
Posted By: Jahfre Fire Eater
Date: 2009-03-21 11:12:53
Hi Gene,
Good description. The direct impact this had on the average American was that insurance via CDS allowed banks to show less risk so they could borrow / lend more which was the engine of the mortgage bubble.
All AIG did was to find the most productive use for its competive advantage; its AAA rating. In doing so they invented a new market in which they were overwhelmingly dominant and not constrained by the short-sighted intervention of the US government.
They soon believed they had created a perpetual wealth producing scheme. They failed to recognize it as the same scheme devised by John Law and by ignorant central bankers every few generations since the Great Mississippi Bubble.
Hi Jahre, very true! They weaved their expansive web, it got too big and broke and then they ask us to fix it!
One aspect I don't understand is why the collateral calls necessarily have preference over the calls of other creditors? Perhaps law should define "productive credit" [credit engaged in production rather than speculation] as priority or companies that buy risk should clarify the priority of client's risk to their clients which would determine what the premium level would be?
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