Modern News

Richard Teitelbaum of Bloomber has posted an intriguing story on the AIG rescue orchestrated by the New York Fed under the direction of Timothy Geithner, now Secretary of the Treasury.

The main cause of AIG’s demise was its credit default swap (CDS) business. CDS transactions guarantee debt issues should the obligor be in danger of default. The following sequence of events left the US taxpayer holding a very, very large bag:

-big investment banks underwrite huge amounts of securities with new and complex structures

-the banks hedge their risk by purchasing CDS contracts from entities like AIG, which issues $62.1 billion of such swaps. Goldman Sachs is the largest purchaser at $17.2 billion, followed by Merrill Lynch at $13.2 billion.

-the securities (remember the underwriters put the deals together) turn out to be lousy credits, despite often rosy credit ratings, and badly flawed structurally to boot. Their values plummet, triggering the CDS payouts.

-AIG can not make the payments, thus becoming insolvent

-the Fed bails out AIG, and orders it to pay the CDS obligations in full to the banks (who started the mess). Prior to the Fed’s intervention, AIG had been trying to negotiate a discounted payout- i.e. a “haircut”.

It’s a mind-boggling scenario. The banks could go into overdrive creating risk because of their CDS fallback, and the Fed spared the banks the consequences of creating so much risk that it took the CDS issuer down. Given the banks’ role in creating the exotic securities, marketing them, and hiding (knowingly or unknowingly) their credit deficiencies, they should have been on the hook for the consequences. But, fellow taxpayers, YOU paid for the consequences.

The whole sorry tale is just another example of the distortions and unfair outcomes when private companies can game a government program, however well-intentioned and even essential the program might be (as I believe the bailout was).

Ugh!

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