Category: counterparty risk

AIG: America’s Insolvent Guarantor

Since the Fall of 2008 the US government has committed over $11 trillion in new credit and or credit backstops to prevent the collapse of our modern day banking system. Closer examination of various TARP and other bailout recipients reveal the extraordinary demands of American International Group (AIG) which after Monday surpassed the $173 billion level. Hard to imagine when AIG had assured shareholders just one year ago that “excess capital was $14.5-19.5 billion”. At the same time we were commenting on how credit default swaps would follow sub prime lending as disaster du jour with AIG leading the charge. Of course as a taxpayer and reluctant current shareholder of AIG I have to ask how did we get here and how high does this bailout number get over the next several years?

If we rewind the tape back to the Summer of 2007 most market participants envied AIG, the world’s largest insurance company. How could you not after hearing statements like this from one of their top brass:

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

~ Joseph J. Cassano, a former A.I.G. executive, August 2007

Just 12 months later the shadow banking system was imploding and former Treasury secretary Hank Paulson called Goldman CEO Lloyd Blankfein and several other counterparties to discuss implications of AIG’s swap exposure. Unbeknown to many at the time was Goldman’s counterparty importance to AIG, specifically both credit default and interest rate swap exposure. Unfortunately 70% of the derivative market trades under-the-counter so specifics on CDS and interest rate swaps is difficult to decipher, until now. After reporting a quarterly loss of $61 billion last week, the largest quarterly loss in U.S. history, AIG’s largest shareholders demanded details on where the bailout money was dispersed. The list of culprits comes as no surprise.

Goldman Sachs Group Inc and a parade of European banks were the major beneficiaries of $93 billion in payments from AIG — more than half of the U.S. taxpayer money spent to rescue the massive insurer. Revelations that billions of U.S. taxpayer dollars were funneled through AIG to Goldman Sachs — one of Wall Street’s most politically connected firms — and to European banks including Deutsche Bank, France’s Societe Generale and the UK’s Barclays could stoke further outrage at the entire U.S. bank bailout.

It doesn’t to me seem fair that the American taxpayer has got to bear the 100 percent of the downside,” said Campbell Harvey, a finance professor at Duke University. “A hedge is not a hedge if you did not factor in the counterparty risk. And the U.S. taxpayer should not be obligated to make people whole for hedges that were not properly executed.”

My Comments: In a little over 12 months the largest insurer in the world has now become part of the zombie gang joining other former leveraged high fliers such as Citigroup, Fannie Mae and Freddie Mac. Latest disclosure documents from AIG put potential CDS exposure north of $500 billion. When adding interest rate swap exposure to the mix the total derivative book exceeded $1.5 trillion! Are derivatives becoming a problem now that the asset inflation game has come to a grinding halt? Citibank, Bank of America , HSBC Bank USA , Wells Fargo Bank and J.P. Morgan Chase reported that their “current” net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31, 2008 . Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days.

As the shell game continues we get closer to the real players in this collapsing fraud, primarily the insolvent TARP recipients who require yet another open ended capital conduit. Is it any surprise that the AIG bailout money flows through to politically connected zombies such as Goldman, Merrill (now Bank of America) and Deutsche Bank? Or that Bernanke makes a 60 Minutes infomercial Sunday night assuring the American people that money center banks will not fail based on his “new”reflation experiment?

Finally, we look at the Obama administration where Turbo Tax Timmy Geithner is assigned to the AIG bonus scandal hoping the distraction preoccupies most of main street. Unfortunately this too shall backfire since many of these potential bonus recipients know where all of the counterparty skeletons reside in this open ended bailout sham. Note to the administration: Be careful what you wish for.

End of bubble behavior

As the greatest bubble in history continues to unwind we now see the various fiduciaries turning on one another. Several weeks ago the monolines floated a trial balloon involving a split into two divisions, one municipal insurance and the other insuring defaults on structured finance. Today, the derivative plot thickens as hedge funds file lawsuits against Citigroup and Wachovia over credit default swap contracts.

In separate lawsuits filed in a New York federal court, a $58-million-asset hedge fund alleges that Citigroup and Wachovia Corp., respectively, improperly required the fund to pay out more money from insurance derivatives contracts known as “credit default swaps” amid a steep decline in the value of mortgage-backed bonds. The hedge-fund manager says he didn’t view the insurance-related trades as particularly risky and now says he feels “suckered.” Citigroup and Wachovia each say the fund’s claims are “without merit.”

Meantime, other financial players say they have been stiff-armed by trading partners when they’ve tried to cash out on profits from such insurance-related transactions. In one instance, a hedge-fund manager says he was blocked from selling out of a swap position, unless he made another credit-default swap (CDS) trade.

Of course the subject of counter party risk moves front and center while the results are somewhat discomforting.

The problem with banks and brokers buying credit protection from hedge funds is that you just don’t know when they are going to go dark, turn out the lights and say this is now the brokers’ problem,” says David Lippman, a managing director of Metropolitan West Asset Management, a bond manager in Los Angeles.

Unlike most other big players in the swaps market, hedge funds aren’t subject to heavy oversight by regulators or capital requirements. Financial firms usually guard against the risk of their hedge-fund trading partners being unable to pay by requiring they put up cash or collateral for their swap trades.

So are banks forcing hedge funds to over collateralize the CDS contracts?

One suit, filed Feb. 14, outlines a credit-default-swap agreement in which Ctigroup bought $10 million of protection against a security backed by subprime-mortgage assets from a small Florida hedge fund with just $58 million in capital. The security was a “collateralized debt obligation,” known as a CDO, or a thinly traded investment that packages pools of loans.

The fund — VCG Special Opportunities Master Fund Ltd., which is owned by an investment firm that also owns a Puerto Rican investment bank — alleges that Citigroup breached its contract after the bank demanded the fund post additional collateral. By this January, the hedge fund says, the collateral Citi sought from it nearly equaled the $10 million “notional,” or underlying, amount of the swap.

More importantly, is there really a secondary market for CDS? Some other hedge-fund managers say they’ve been bullied by securities firms when they’ve tried to cash out on profits from such positions. When one hedge-fund manager considered selling out of a credit-default swap — in which his fund bought protection on $10 million of bonds of Countrywide Financial Corp. — he says there was a condition attached by two securities firms. He says the firms — Bear Stearns Cos., which sold him the swap, and Morgan Stanley — told him they would cash him out of his profitable position, only if he would simultaneously enter into another swap-selling insurance protection on the bonds equal to his fund’s $3 million profit. Eventually, he says, his fund sold the position through Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc., allowing him to book the $3 million profit.

My comments: It appears the shadow banking system is dealing with the mother of all margin calls. One creating a viscous chain reaction whereby brokers, insurers and speculators are turning on one another in order to survive the perfect financial storm.

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