The real AIG scandal...

This week the American insurance conglomerate, AIG, has been center stage in the US political arena for the trifling by current standards $165 million in retention bonuses that have been promised to staff who are "helping" to unwind the shambles that they themselves created. Galling on many fronts.

In the context of the $170 billion (and rising) government bailout of AIG, however, the bonus issue is virtually inconsequential. The $165 million in bonus payments is less than one-tenth of 1% of the total amount of bailout money given to AIG in one form or another. It's a scandal, but there is a far bigger one here. Far too little media attention is being paid to the really serious stuff, which is where the big money in the bailout is going - the payments of AIG's obligations to its derivative counterparties. Some of these counterparties, will now (or already have) receive multibillion dollar payments owed by AIG. Most significantly in the US, Goldman Sachs will receive $12.9bn, Merrill Lynch $6.8bn and perhaps more outrageous for US taxpayers is that foreign banks like Societe Generale and Deutsche Bank will receive close to $12bn each. These payments are virtually direct from the US taxpayer, albeit with the AIG stamp on the cheque. Personally, I think it's absolutely outrageous that these institutions are getting out of this situation in this way. These are professional risk takers, and they cocked up. That the US government doesn't even haircut them in the payments they are now receiving sets up all sorts of false incentives, and moreover penalises the US taxpayer in a way that makes the bonus scandal look pretty trivial.

In deciding to rescue AIG, the US government was understandably worried that if it did not bail out the company, its collapse could lead to a cascading chain reaction of losses, jeopardizing the stability of the worldwide financial system. Goldman Sachs could easily have become the next Lehman Brothers, if their capital base was eroded by the full expected loss on their counterparty exposure to AIG (i.e. the $12bn mentioned above). Ben Bernanke, was quoted this week saying: “Of all the events and all of the things we’ve done in the last 18 months, the single one that makes me the angriest, that gives me the most angst, is the intervention with AIG” He went on: “Here was a company that made all kinds of unconscionable bets. Then, when those bets went wrong, they had a — we had a situation where the failure of that company would have brought down the financial system.”

The unconscionable bets that Bernanke speaks of are the derivative positions that the likes of Goldman Sachs "advised" AIG to put onto their books. Many of the derivative positions in question will have been types of insurance contracts where AIG has written a policy, and in return receives a premium income from the likes of Goldman Sachs for this protection. Part of the risk of these trades for Goldman Sachs et al is assessing the counterparty exposure i.e. if the provider of insurance (AIG in this case) gets into trouble, will they be able to honour any required payouts. Many of these contracts would have been written on US housing related assets. With the falling value of these types of assets AIG would have been obliged under these derivative contracts to cover their trading partner's losses. Similarly, on the Goldman Sachs balance sheet, these expected "windfall" payments will be recorded in the accounts as trading gains; the $12bn gain mentioned above would have been recorded in the profit statements on the Goldman books. If they were managing their risk properly then some "counterparty risk" against AIG would have been acknowledged in their accounting process. When AIG failed, Goldman Sachs should have been expecting to only receive a fraction of their expected windfall on the basis of the "recovery rate" achievable on the assets that were protected by the insurance contract. It's not dissimilar to the notion of buying house insurance, have your house burn down, and then finding out that the insurance company can't pay - which happens in the real world. In that situation you would not have your insurance paid, unless some helpful soul bailed them out - which would be unlikely because they wouldn't come under that favourite category of "too big to fail".

As Goldman Sachs saw AIG slide further into trouble, there is no question that they would have been lobbying both Bernanke and Congress along the lines that if AIG goes bankrupt then Goldman would quickly follow, and we would see the armageddon situation that Lehman Brother's collapse created all over again. So far they have been successful in arguing that cause.

While AIG has thus far been able to cover derivative losses using government funds, the possibility of large additional losses is not out of the question. AIG recently stated that it still has about $1.6 trillion in "notional derivatives exposure". If AIG ends up with losses equal to 20% of this exposure, for example, that is $320 billion. Assuming that the value of AIGs current assets, including the shares in its insurance subsidiaries, is $160 billion. In this scenario the government's full backing of AIG's obligations would produce an additional loss of $160 billion for taxpayers. Should the government be prepared to do so?

I accept the argument that a complete failure of AIG would have unacceptable consequences. The relevant question the US government and the media should be asking, aside of dumping all of this on taxpayers, is what combination of parties is going to absorb the losses. For me, any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Deutsche Bank and Societe Generale (to name a few), who were major contributors to this situation and should be contributors to this particular collateral-damage minimization relief fund.

If they are to contribute, the plan must be something other than simply doling out another $100bn every few months to try to keep AIG going a little longer. I would advocate splitting AIG into a core business that the US government wants to protect, with enough equity to be a viable operation, and a derivatives business that is going to be systematically liquidated in large part by rescinding outstanding contracts. In this case, AIGs creditors, including its derivative counterparties would obtain the company's assets and suffer whatever recovery rate on their claims that the market would allow. To clarify further - AIG is a holding company, conducting most of its business through insurance subsidiaries organized as separate legal entities. The Financial Products subsidiary, where the large derivative contracts and their losses sit, is also a separate legal entity - but thus far AIG has guaranteed this subsidiary's obligations, using taxpayers funds to do so.

AIG recently stated that failure to meet all of the company's obligations could lead to a "run on the bank" by customers seeking to surrender insurance policies and "would have sweeping impacts across the economy". Insurance policyholders, however, wouldn't be at risk if AIG failed to meet its obligations. The insurance subsidiaries aren't responsible for the debts of their parent company AIG, and insurance policy claims are backed by the subsidiaries specific reserves and state insurance funds.

Returning to the question of concerns that losses to the derivatives counterparties would substantially deplete the capital of some of them - that concern would be best addressed by the US government (or foreign governments) infusing capital directly, in return for shares, into the banks that require it. There is no acceptable reason to back AIG's obligations as an instrument for infusing capital (with taxpayers getting nothing in return), into the likes of Goldman Sachs or Deutsche Bank. It is true that the collapse of Lehman Brothers last September led to a crisis of confidence in the markets, and in particular among depositors in banks and money market funds. Letting AIG's derivative counterparties take a significant haircut, however, should not lead to a similar crisis. AIG's obligations are to derivative counterparties, who are professional risk assessors, and not to depositors. While there may be a run to sell shares in these institutions if forced to take a haircut, there would be no bank run as such. It is only reasonable to expect these guys to assume some of the financial burden of AIG, and it certainly isn't reasonable as has been the case so far, to place the full burden on those who had nothing to do with the situation.