250,000 pages of 'bail-out oddity'
The House committee on Oversight and Government Reform that headed the Congressional investigation into the more than strange events surrounding the massive AIG bail-out (we remember, some $182 billion in tax cow money were thrown down that swirling drain), has released some 250,000 (!) pages of documents in May (mainly e-mails) relating to the crime, which the NYT has helpfully sifted for a few juicy bits by now. The documents .
AIG / Asian Headquarters, Hong Kong
(flanked by the Bank of China, Photo credit: fmh)
AIG inter alia had to sign that it would, as a condition of its bail-out, relinquish all claims it may have against counterparties 'from the beginning of the world to the termination date of the CDS (although they didn't write 'until judgment day' there, they did mention the term 'forever' quite a few times), including, it appears all 'unknown claims' – this is to say potential claims arising from future information not yet available at the date of AIG's signing away of its rights. 'Claims in AIG's favor that is does not know or even suspect exist at the date of the termination agreement', as it is put in the documents.
As the NYT reports:
|"Mr. Benmosche, steward of an insurer brought to its knees two years ago after making too many risky, outsize financial bets and paying billions of dollars in claims to Goldman and other banks, said he would continue evaluating his legal options. But, in reality, A.I.G. has precious few. When the government began rescuing it from collapse in the fall of 2008 with what has become a $182 billion lifeline, A.I.G. was required to forfeit its right to sue several banks — including Goldman, Société Générale, Deutsche Bank and Merrill Lynch — over any irregularities with most of the mortgage securities it insured in the pre-crisis years."|
In other words, although some of the securities AIG insured via CDS were quite possibly fraudulent, it can no longer pursue any claims it may have against the big banks. Naturally, even blind Freddie could see that the Fed and Treasury used the AIG bankruptcy/bailout situation to arrange a 'back door bailout' for the banksters.
After all, the Fed is the center of the banking cartel and not necessarily in the business of helping out insurers. Incidentally, although at least one bank – namely UBS – offered to accept a 'haircut' in the payout of its CDS claims against AIG (which is quite a normal procedure in bankruptcies, and one might argue that AIG was a de facto, if not de iure bankruptcy – i.e. it was clearly bankrupt absent a bailout), the Fed would not countenance such an idea. Instead the full amount was paid out in every case. Naturally it was not possible to treat the various CDS claimants differently – that would have invited lawsuits for sure – so in order to make sure that, say, Goldman Sachs, got the full amount due to it, no exceptions could be made.
Offers to accept haircuts were thus politely refused by the Fed. Such haircuts were in fact discussed, but most of the banks involved pointed out that since a haircut would mean they would have to bear a loss (duh!), this was not acceptable. The French Banks even insisted that it was 'against the law' for them to accept a haircut, unless AIG actually went bankrupt.
The tax cows were not asked for their opinion. The details of the haircut saga can be found here. The MBS collateral contained in the toxic waste type CDOs that AIG insured was in part transferred to the Fed's balance sheet in 'Maiden Lane III', where it slowly withers away ever since.
As the NYT dryly remarks regarding the Fed's and Treasury's handling of the bailout:
|"As a Congressional commission convenes hearings Wednesday exploring the A.I.G. bailout and Goldman’s relationship with the insurer, analysts say that the documents suggest that regulators were overly punitive toward A.I.G. and overly forgiving of banks during the bailout — signified, they say, by the fact that the legal waiver undermined A.I.G. and its shareholders’ ability to recover damages."|
And further along these lines:
|"About $46 billion of the taxpayer money in the A.I.G. bailout was used to pay to mortgage trading partners like Goldman and Société Générale, a French bank, to make good on their claims. The banks are not expected to return any of that money, leading the Congressional Research Service to say in March that much of the taxpayer money ultimately bailed out the banks, not A.I.G."|
One wonders how this was even possible? Why was it so easy to pressure IAG into reliquishing all claims?
The side letter fraud
Back in 2009, the Insitutional Risk Analyst (IRA) looked at AIG's business and reported on various shady insurance practices that had come to light in the past and appeared oddly similar to what AIG did. Big Picture published the report at the time. This analysis almost immediately disappeared into the memory hole, from whence we are hereby hoping to rescue it. Let's briefly recapitulate the role of debt insurers, such as the mono-lines (ABK, MBIA) in Wall Street's securities production machinery.
The main role of such guarantees was not really to 'guarantee' anything, since it was clear (or should have been clear) to all concerned that in extremis, these insurers could never ever be expected to survive paying all the potential claims. 'In extremis' describing the situation that finally became reality in 2007-2008, namely the long overdue implosion of the credit bubble.
If you insure a number of different debt securities during an economic boom, everybody naturally assumes that at worst, you may have to pay claims on just a handful of them. In a mild downturn, there may be a few more claims, but nothing that is likely to deplete the capital of the insurer, or so the thinking went. Well, since we recall numerous people warning about the dangers inherent in the credit insurance business as far back as 1999 (for instance), we can well imagine that the people in charge at big sophisticated financial institutions must have been able to assess the growing risks as well, or at least have had some inkling that things might one day go wrong.
However, the post Nasdaq bubble recession once again showed that the Fed's money spigot stood ready pump money and credit into the economy and reignite the credit bubble in a reasonably short time. The repeated example of credit booms being reignited in the wake of crises may well have lowered many peoples' guard.
These guarantees were of course extremely convenient for the Wall Street sales machinery – after all, even shoddy credits could be transformed into highly rated securities that way. The credit insurance business took off well before credit default swaps became the preferred instrument of insuring debt against default risk, going from the rather mundane business of providing insurance for municipal debt to insuring an ever wider range of debt securities.
Finally, in the blow-off phase of the housing bubble and the invention of CDOs and ever more complex varieties of securities – all of which were on purpose designed to actually hide risk – credit insurers seemed to have (re-)discovered the proverbial 'free lunch'. Rating agencies, Wall Street banks and insurers worked hand in hand to churn out an ever larger pile of 'AAA' rated securities that were in reality complete junk.
The buyers of these securities – mainly institutional investors that were 'hungry for yield' but were forced by their statutes to eschew debt securities below a certain rating threshold – happily, and stupidly snapped such securities up. After all, the rating agencies had given their placet and were not at all reluctant to slap high ratings on the senior tranches of mortgage backed CDOs and many other insurance-enhanced debt securities.
Their models allegedly proved that the likelihood of default was very small – except, of course, in extremis. Curiously, few people seemed disturbed by the inherent conflicts of interest attending the debt rating business. The fact that a state-sanctioned cartel gets paid by the issuers of debt to rate it, should have been a major red flag for every thinking person. We notice by the way that even today, many analysts look at the economy and markets solely through the lens of of the post war experience, which consists largely of a single huge credit bubble that grew into a veritable monster.
Similar to the ratings agencies whose models of default probabilities regarded only this era, they make the cardinal mistake of not considering the last time when a major credit bubble burst. But we digress.
AIG as a large insurance company felt compelled to enter this business, a decision which the IRA found rather odd.
From the report:
|"For some time now, we have been trying to reconcile the apparent paradox of American International Group (NYSE:AIG) walking away from the highly profitable, double-digit RAROC business of underwriting property and casualty (P&C) risk and diving into the rancid cesspool of credit default swaps (“CDS”) contracts and other types of “high beta” risks, business lines that are highly correlated with the financial markets."|
Well, we happen to think that CDS actually have a valuable function, so we would not necessarily generalize about them in this manner ('rancid cesspool'). However, we do acknowledge that it seems odd that AIG went into this business – a business it evidently poorly understood.
At this point, let us recall what AIG said in early 2008 when its CDS contracts began to go sour. In essence AIG's management stated on earnings calls 'we cannot properly estimate the size of the loss or exposure'. Why could they not? Were the contracts that obscure and difficult to understand? Their counterparties sure had an opinion regarding the size of the collateral they wanted posted after all (i.e. AIG got a margin call).
The IRA analysis continues:
|"We also learned from [Robert] Arvanitis, who worked for AIG during much of the relevant period, that the decision by Hank Greenberg and the AIG board to enter the CDS market was, at best, chasing revenue. No rational examination of the business opportunity, assuming that Greenberg and his directors were acting based on a reasoned analysis, could have resulted in a favorable decision to pursue CDS and other “high beta” risks, at least from our perspective."|
In short, AIG was doing something that made no obvious sense for the insurer. To use an old metaphor, it was picking up pebbles in front of a steamroller. It was 'easy money', but the increasingly evident mispricing of risk in 2006-2007 meant that in order to make sizable amounts of aforementioned 'free lunch money', it had to take ever larger risks. It made no sense to do this on a risk-adjusted basis (and insurers are supposed to have some basic understanding of risk taking).
In wondering about AIG's motives to enter such a business line, the IRA then looks at the so-called 'side letter' practice, a specific type of reinsurance fraud.
This used to work as follows:
|"One of the most widespread means of risk shifting is reinsurance, the act of paying an insurer to offset the risk on the books of a second insurer. This may sound pretty routine and plain vanilla, but what most people don’t know is that often times when insurers would write reinsurance contracts with one another, they would enter into “side letters” whereby the parties would agree that the reinsurance contract was essentially a canard, a form of window dressing to make a company, bank or another insurer look better on paper, but where the seller of protection had no intention of ever paying out on the contract."|
A-ha! IRA's report details the scam further:
"Let’s say that an insurer needs to enhance its capital surplus by $100 million in order to meet regulatory capital requirements. They can enter into what appears to be a completely legitimate form of reinsurance contract, an agreement that appears to transfer the liability to the reinsurer. By doing so, the “ceding company” – an insurance company that transfers a risk to a reinsurance company – gets to drop that $100 million in liability and its regulatory surplus increases by $100 million.
The reinsurer assuming the risk does actually put up the $100 million in liability, but with the knowledge that they will never have to actually pay out on the contract. This is good for the reinsurer because they are paid a fee for this transaction, but it is bad for the ceding company, the insurer with the capital shortfall, because the transaction is actually a sham, a fraud meant to deceive regulators, counterparties and investors into thinking that the insurer has adequate capital. Typically the fee is 6% per year or what is called a “loan fee” in the insurance industry."
Now consider for a moment how 'insurance' on various forms of debt securities tended to automatically enhance the ratings that Moody's, S&P and Fitch would slap on them. And now consider further the regulations concerning bank capital – namely, the amount of capital that banks must hold relative to their assets and liabilities. Do you see where this is going? The less capital or 'reserves' the fractionally reserved banking system must hold, the more profit opportunities it can pursue – at the price of taking ever more risk.
Looking at the main counterparties of AIG when its CDS business blew up, is it really credible that these sophisticated money-shufflers didn't know AIG would be bankrupted in the event the insurance provided by the CDS it sold to them were to come due? Naturally, given that not even Bernanke could 'see' the housing bubble for what it was, every single one of them would probably claim that 'nobody saw it coming', the standard excuse of policy makers and other bubble culprits alike. At the very least then we must assume gross incompetence at every level of the financial system – it's either that, or they are all lying.
As the IRA further notes:
|"As best as we can tell, the questionable practice of using side letters to mask the economic and business reality of reinsurance transactions started in the mid-1980s and continued until the middle of the current decade. This timeline just happens to track the creation and evolution of the OTC derivatives markets. In particular, the move by AIG into the CDS market coincides with the increased awareness of and attention to the use of side letters by insurance regulators and members of the state and federal law enforcement community."|
As it turns out, AIG was definitely no stranger to this fraudulent practice. In fact, it was fined by the SEC for helping to disguise the true state of the finances of Brightpoint (CELL).
|"Wayne M. Carlin, Regional Director of the SEC’s Northeast Regional Office, said of the settlements: “In this case, AIG worked hand in hand with CELL personnel to custom-design a purported insurance policy that allowed CELL to overstate its earnings by a staggering 61 percent. This transaction was simply a ’round-trip’ of cash from CELL to AIG and back to CELL. By disguising the money as ‘insurance,’ AIG enabled CELL to spread over several years a loss that should have been recognized immediately.”"|
Later AIG helped another firm, PNC, in a transaction that like the Brightpoint side-letter fraud, merely aimed at hiding the true financial situation of PNC, instead of legitimately insuring a business risk. In 2003, at the tail end of the 'mild' post Nasdaq bubble recession, several side letter frauds actually blew up. This made it very difficult to continue the practice. There were the cases of Rodney Adler's HIH and FAI insurance companies in Australia, where A$5,3 billion went to money heaven. Then followed the case of ROA – in both of these cases, GenRe provided a 'helping hand' in the form of the side letter reinsurance scam.
As the IRA says:
|"“These reinsurance deals made ROA look better than it really was,” one investigator with direct knowledge of the ROA matter tells The IRA. “They went into the ROA home office in VA with the state insurance regulators and law enforcement, and directed the employees away from the computers and records. During that three-year investigation, GenRe learned that local regulators and forensic examiners had put everything together and that we now understood the way the game was played. I believe the players in the industry realized that that they had to change the way in which they cooked the books. A sleight- of-hand trick that had worked for 25 years under the radar of regulators and investors was now revealed.”"|
So suddenly, this lucrative and evidently fraudulent business no longer worked. Regulators had finally caught on to it. However, AIG had, in the words of the IRA, become 'addicted' to the side letter scam.
|“The firm, which had already encountered serious financial problems in 2000-2001, reportedly saw the side letters as a way to mint free money and thereby help the insurer to look stronger than it really was. AIG not only helped banks and other companies distort and obfuscate their financial condition, but AIG was supplementing its income by writing more and more of these reinsurance deals and mitigating their perceived exposure via side letters.”|
The IRA concludes that given the problems AIG and other insurers/reinsurers suddenly encountered with this lucrative game, they simply moved the whole game to a new arena – namely credit default swaps.
Notes the IRA:
|“It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions.”|
Indeed, the IRA concluded back in 2009 that the CDS transactions that were fully satisfied by tax-payer financed payouts in the course of the AIG bail-out were actually nothing but a fraudulent variation of the 'side letter scam' and that very likely such side letters really existed. In that case however, the contracts were not valid contracts at all, but where fraudulent from the outset – intending to help securities on the banks books to masquerade as something they weren't.
To quote from the IRA's report once more:
"The key point is that neither the public, the Fed nor the Treasury seem to understand is that the CDS contracts written by AIG with these various non-insurers around the world were shams – with no correlation between “fees” paid and the risk assumed. These were not valid contracts as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru Larry Summers claim, but rather acts of criminal fraud meant to manipulate the capital positions and earnings of financial companies around the world.
Indeed, our sources as well as press reports suggest that the CDS contracts written by AIG may have included side letters, often in the form of emails rather than formal letters, that essentially violated the ISDA agreements and show that the true, economic reality of these contracts was fraud plain and simple. Unfortunately, by not moving to seize AIG immediately last year when the scandal broke, the Fed and Treasury may have given the AIG managers time to destroy much of the evidence of criminal wrongdoing.
Only when we understand how AIG came to be involved in CDS and the fact that this seemingly illegal activity was simply an extension of the reinsurance/side letter shell game scam that AIG, Gen Re and others conducted for many years before will we understand what needs to be done with AIG, namely liquidation. Seen in this context, the payments made to AIG by the Fed and Treasury, which were then passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be reversed once the US Trustee for the Federal Bankruptcy Court for the Southern District of New York is in control of AIG’s operations."
Here it must be pointed out that the IRA never offered proof for these assertions, but given how ratings of securities held by banks could be improved via CDS insurance, and given how this enabled banks to free up more capital for lending and / or investment, and given the sordid past of AIG with the side letter scam, it is not something that can be dismissed out of hand. In fact, it sounds like a fairly reasonable suspicion. If this could ever be proved, it would be highly embarrassing for all involved parties, not to mention quite costly for some of them.
It is very much thinkable that regulators in their panic thought they had to make good on AIG's CDS, to keep the 'entire system from crashing'. It is equally thinkable that should AIG's CDS business indeed have represented a variation of the side letter fraud, that they were not aware of this.
We can only speculate on these points. The fact that AIG had to relinquish all future claims against the banks speaks of a desire to make the bail-out legally 'air-tight' – or it could alternatively speak of a desire to 'bury' certain finer details forever. The fact remains that the whole affair continues to look highly suspicious – and since the NYT's report failed to mention the old IRA investigative report on AIG, we deemed this a good moment to rescue it aforementioned memory hole.
The NYT says:
|"A spokesman for Mr. Geithner, Andrew Williams, said it was easy to speculate about how the A.I.G. bailout might have been handled differently, but the government had limited tools.“At that perilous moment, actions were chosen that would have the greatest likelihood of protecting American families and businesses from a catastrophic failure of another financial firm and an accelerating panic,” Mr. Williams said."|
Oh well – if 'American families were protected' and not the avaricious banks that proved – to quote John Hussman – 'the worst stewards of capital in the economy', then it must be alright!
We would note one major reason to give credence to the IRA's analysis is that during major credit and asset bubbles, embezzlement and fraud tend to grow like weeds alongside the bubble, attracted by the seeming 'free lunch'. It is an empirically verifiable fact that after bubbles burst, all sorts of frauds tend to come to light (see the Madoff, Stanford, Enron and Worldcom scandals for fairly recent examples of this phenomenon). Simply put, all the Ponzi schemes tend to suddenly blow up once liquidity dries up.
Moreover, it should be clear that the inflationary fractional reserves system makes all these bubble activities possible in the first place. On the one hand we have those who profit directly from creating money and credit 'from thin air', on the other hand we find – often gullible – investors who are forced to speculate in order to preserve the purchasing power of their savings.
We should not be surprised that such a fraudulent wealth redistribution scheme bring forth even more fraudulent activities. That the tax payer has been selected as the involuntary ultimate guarantor for the mistakes and frauds committed is certainly rather disturbing. Imprudence and fraud have ended up reaping rewards, while the citizenry reaps an economy on its knees, and eventually, higher taxes and even more inflation.
Former AIG CEO Hank Greenberg – a NY Fed board member from 1988 to 1995, forced out of IAG after an accounting scandal in 2005, and founder of AIG's fincial products division that was ultimately the insurer's downfall.
(Photo credit: Seokyong Lee)
Greenberg's successor as AIG's CEO, Martin J. Sullivan – the man who presided over the collapse.
(Photo credit: Miller / News)
Credited with the invention of the CDO (collateralized debt obligation) in 1998 at JP Morgan's behest, AIG's fincancial products division chief Joseph Cassano. He walked away with 100ds of millions in personal profits, largely consisting of his cut of the 'CDS free lunch' in the form of bonuses. Naturally, he shoved CDS out AIG's door as fast as he could – this boosted his bonus, but landed AIG in the soup. Which in turn landed the tax payer in the soup.
(Photo credit: AP)
2008 cartoon lampooning AIG's generous political donations. According to Wikipedia, “in March 2009 Cassano was linked to e-mails he authored in 2006 which solicited contributions from AIG executives for Dodd's campaign due to Dodd's position as incoming chairman of the Senate Banking Committee” The incestuous relationship between politicians and the financial industry began around the Middle Ages, so this is not too surprising. It is an old tradition.
(Cartoon credit: John Cole)
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One Response to “AIG – was its CDS business a scam from the outset?”
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