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From the Pages of The Pomerantz Monitor: AIG, the Company We Love To Hate

By Carolyn Moskowitz

In the April issue of The Pomerantz Monitor, Adam Prussin gives some background on how AIG ? the company that many feel bears the greatest blame for our present financial crisis ? destroyed itself. By now most of America realizes that AIG triggered its own downfall by issuing ?credit default swaps? guarantying hundreds of billions of dollars worth of mortgage-backed securities without having the money to make good on its promises. In all, AIG reportedly guaranteed over $2.5 trillion of debt obligations, including mortgage backed securities. No company could ever hope to repay such a staggering amount.

AIG was able to get in over its head because years ago Congress, in its wisdom, exempted credit default swaps from regulation. So there was no requirement that swaps issuers set aside sufficient assets to cover the potential claims. In the absence of regulation, the ratings agencies and the purchasers of these swaps should have asked whether AIG actually had the wherewithal to make good on its promises. But they didn?t. AIG became the king of credit default swaps because it was one of the few companies with a AAA credit rating. A swap issued by AIG automatically conferred a AAA rating on any security it covered, regardless of its inherent riskiness. The ratings agencies bestowed their top rating, apparently without bothering to investigate AIG?s total exposure to credit default swaps and, thus, its ability to make good on them.

With no reserve requirements, there was no practical limit to the risks AIG and other swaps issuers could undertake, or the fees they could earn by doing so. Non-regulation unleashed an orgy of financial speculation, culminating in the creation of a monstrous $50 trillion unregulated market in credit default swaps, an amount that dwarfs all the securities markets in the world. Much of this market represents the trading of swaps issued to people who did not even own the securities covered by the swaps. These were ?side bets? that speculated on the future financial performance of other companies. This type of transaction would have been impossible had the swaps been regulated. Now, such swaps will be regulated, if not banned outright. Our guess is that it will be illegal to issue a swap to someone who does not own the underlying security.

But now that AIG cannot cover its swaps obligations, the Government has conscripted the taxpayer to do it. The Government obviously believes that keeping the money flowing under these credit default swaps is necessary to keeping much of the world banking system afloat. AIG has sucked up four bailouts already, totaling over $170 billion, about ten times as much as the whole U.S. auto industry. Most of this money, over $90 billion, was used to post collateral or pay out actual claims under the swaps. The government recognizes that if AIG stops paying on these swaps, they will all ?blow up? and dozens of banks worldwide will have to write off huge losses on the mortgage backed securities they are holding. That, it fears, would make matters much worse than they already are.

When the recipients of this money were finally identified, it turned out that most of them had already received their own financial bailouts and that others were foreign banks that really have no claim on the beneficence of the U.S. taxpayer. Goldman Sachs got $12.9 billion of AIG?s bailout money; Deutsche Bank and Société Générale got $12 billion each; Barclay?s got $8.5 billion; UBS -- $5 billion; Merrill Lynch -- $6.8 billion; Bank of America -- $5.2 billion; and HSBC, Royal Bank of Scotland, Banco Santander, Morgan Stanley, Wachovia and a host of other institutions received billions more.

Even if these banks needed help, was it really necessary for the Treasury to use the AIG bailout money to swallow the whole loss on these transactions, without requiring the banks to share in the losses they created for themselves by their own terrible business decisions?

Credit default swaps were not AIG?s only huge problem. Another was its securities operation, which lent out securities in exchange for a fee, and required the deposit of cash collateral by the borrowers pending return of the securities. For reasons that apparently seemed good at the time, AIG chose to invest this collateral in ... mortgage backed securities, of course! When the borrowers returned the securities and asked for their collateral back, AIG found that the securities they had bought with this money had tanked and couldn?t be sold.

Figuring out how best to clean up this mess is the real task ahead. That task may have been made much harder by the public?s explosion of rage when it was disclosed that hundreds of employees who are now working to wind down AIG?s toxic positions had received $165 million in ?bonuses? in March as a down payment on a total of $450 million AIG had promised them. Congress, obviously stunned by the public?s reaction, claimed ignorance of the bonuses, as did the President; and the House passed a punitive 90% excise tax on this money, horrifying the entire banking sector and probably complicating the prospects for further assistance to the financial industry.

Having done so much to cause the financial collapse in the first place, AIG has now unleashed a massive backlash that threatens to abort the Administration?s financial recovery plan.

The debacle at AIG needs to be sorted out by competent people both in Government and at the company itself. Yet few good people want to work for a company that is in severe financial distress and might go down the tubes altogether. That is why bankrupt companies routinely pay retention bonuses to keep key employees from leaving, and AIG and other distraught companies should be no different. The bonus amounts set forth in contracts entered a year ago were probably necessary to persuade highly trained personnel to stay with AIG long enough to help it liquidate its business in an orderly fashion.

That, presumably, is why the government passed on several opportunities to block the bonuses. In November of last year the Bush Treasury Department imposed some compensation limits on AIG, including limits on retention bonuses, as part of its contract to purchase $40 billion of AIG securities as aprt of the bailout. But those limits were deliberately set high enough to allow the company to pay retention bonuses. Later, when Congress passed the stimulus bill, additional compensation limitations were imposed on all recipients of bailout funds; but at the Treasury?s request, an exemption was provided for payments required by contracts, such as those at AIG. Treasury made sure that the AIG bonuses remained in effect.

But when the public raised a hue and cry over the bonuses, everyone in government ran for cover. Suddenly, the bonuses were ?outrageous? and ?distasteful.? Their response to the public outcry, although patently disingenuous, may have been necessary in order to avoid the collapse of public support for the bailout process.

Moreover, it may not be true that the people getting these bonuses are the same people who wrecked AIG in the first place. According to an article in the Washington Post, ?the handful of souls who championed the firm?s now-infamous credit default swaps are, by nearly every account, long since departed. Those left behind to clean up the mess, the majority of whom never lost a dime for AIG, now feel that they have been sold out by their Congress and their President.? According to the story, the bonuses are the only compensation these people will be getting for their work. If this story is accurate ? and one wonders, given that it was based primarily on interviews with some of these AIG workers ? public fury at the AIG bonuses is totally misplaced.

The real compensation scandal here is not these bonuses but the fact that the true culprits, who are long gone, get to keep their lavish compensation even though it was their business decisions that ultimately caused the collapse of the company. Atop this rogue?s list is Joseph Cassano, chief of AIG?s financial products division, who engineered the credit default swap fiasco. He left the company a year ago, after earning about $250 million. No one has asked him to give back a penny. That?s what has to change.

Full post as published by PomTalk on April 01, 2009 (boomark / email).