Fraud At AIG. Really?

Francis Cianfrocca: Conventional Wisdom Notwithstanding, I'm Having A Hard Time Discerning The Case For Fraud

(CBS)  Francis Cianfrocca is a Senior Editor of The New Ledger.
Here is an amazing fact: nearly a year after perhaps the most sensational corporate collapse in the history of finance, a collapse that, without the intervention of the government, would have led to the bankruptcy of every major American financial institution, plus a lot of foreign ones, too, A.I.G.'s losses and the trades that led to them still haven't been properly explained. How did they happen? Unlike, say, Bernie Madoff's pyramid scheme, they don't seem to have been raw theft. They may have been an outrageous departure from financial norms, but, if so, why hasn't anyone in the place been charged with a crime? How did an insurance company become so entangled in the sophisticated end of Wall Street and wind up the fool at the poker table? How could the U.S. government simply hand over $54 billion in taxpayer dollars to Goldman Sachs and Merrill Lynch and all the rest to make good on the subprime insurance A.I.G. F.P. had sold to them-especially after Goldman Sachs was coming out and saying that it had hedged itself by betting against A.I.G.?

Michael Lewis's piece on AIG at Vanity Fair is getting linked all over today. AIG is going to go down in history as one the great disasters of all time, but I'm having a hard time discerning the case for fraud.

Their business was writing credit-default swaps. You commit to someone that you'll make him whole in case some security he holds experiences any of a range of events constituting a technical default. It's a fascinating idea because it has the effect of transferring risk to people who may be able to carry it less expensively and thus more efficiently. This is exactly the kind of thing that, in theory, makes more capital available to build up real economies and create jobs.

The first problem with that, is the reason for the capital efficiency. It's basically a regulatory arbitrage rather than something arising organically from the real world. So I have questions whether durable and capturable economic value was created here.

The other problem is that the risks themselves are poorly understood. At this point in the story, you have to consider that AIG became the focus of a problem that wouldn't have been any less bad without them. Because what happened is that every financial asset in the world (except US Treasury debt) collapsed in value at precisely the same moment. No one really knows how the hell that kind of thing happens. It's against all the theory. If you don't understand it, the most prudent thing you can do is assume it can happen every day instead of once a decade. And that means you're using capital very inefficiently, every day. (As I never tire of pointing out, that's why I've been calling for a depression-like future for two years now.)

Now it turns out that AIG was suddenly on the hook for counterparty maintenance payments as all this happened. With a CDS, as with any kind of a swap, both parties are required to pay each other money every day or twice a day as the value of the contract changes. (This is intended to insure performance in case of a default. It's one of the innovations that came out of the 1998 Long-Term crisis, and was ironically intended to isolate credit risk, precisely to avoid a systemic crisis.) When AIG's whole portfolio dropped in value, they suddenly found themselves facing contractual obligations to pay out $80 billion. These obligations materialized literally during the course of a single day, Monday, September 15.

That's what sunk AIG. But consider what would have happened without them. A CDS is a zero-sum instrument. If AIG hadn't protected the various mortgage-security portfolios around the world, their holders would have subjected to the same hits to capital that AIG was. Except it would have resulted in hundreds or thousands of undercapitalized banks rather than just AIG.

Did AIG make the problem worse? That's a damned interesting question. By making it possible for their counterparties to expand their balance sheets beyond what their capital would otherwise have permitted, you could argue that they did indeed. Another question is: could the various regulatory authorities have exercised forbearance to allow undercapitalized institutions to operate through the several days of extreme crisis without a default event like the one the Fed committed AIG to? Perhaps.

[babooph]

The companies claimed that greater profit could be made by"outsourcing" labor ,to cheap working Asians.The crooked ,stupid ,failed management should have been OUTSOURCED !!!Now they are getting pay raises with PUBLIC funds ,while honest ,hard working,ex middle class workers are broke!!!!

[aakalan]

If there was no fraud, there was, at least, malfeasance.

All the rules of risk were thrown out the window - and every one of these banks and insurance companies had risk mitigation departments whose warnings they ignored. Upper management clearly violated their fiduciary responsibility - witness the dilution or complete wipeout of common stockholders.

The problem is that these people were leveraging their risky investments up to 35 times, without even knowing the underlying value of the securities that backed these loans.

It's like they turned the whole economy into a pinata - no one, to this day, has any clue as to the real-world value of the mortgages that underlie these bundled securities. When someone hit the pinata with a stick, what fell out was junk, pure and simple.

There was no there there. If they didn't know their assets were toxic, they should have. And if they did, and continued to bet hugely on them, then that was fraud.

So there's your choices: fraud or greedy ineptitude. In either case, why are these people still employed, many of them in the same management positions they had when they were bringing the world economy down?

[TJphoto]

These people are a major "cause & effect" of the US Consumer's lack of confidence. For our lawmakers who gave so generously to bail the greedy SOBs out I say this. "If you want my confidence back I need to see some INDICTMENTS. Being the fact that money we gave is now being given back to Congress in the form of campaign contributions I doubt we'll see it.