AIG: CDS Obligations Devouring Government Loans

As I suspected, AIG's (AIG) CDS collateral obligations have eaten up the government's initial $85 billion loan commitment, which was recently boosted to $123 billion. AIG's CEO reported that they had sold over $400 billion in CDS contracts.

The WSJ piece below profiles Yale finance professor Gary Gorton, who helped Cassano's group (AIG Financial Products) build their risk models. They note that there is still a chance that the models are ok -- that in the long run losses on the securities they insured may not be large. The problem is that the CDS contracts require the insurer to post additional collateral if the market value of the security in question falls. Since all credit related products are oversold due to rampant fear, this forces collateral calls even on good securities (if there are any). I can imagine that triggers might depend on the value of various CDS indices, which have plummeted during the crisis.

If -- and it's a big if -- AIG's actual CDS payouts are limited, the government and taxpayers stand to make a lot of money over the next 3-5 years. When markets return to normal the profitable ordinary insurance parts of AIG can be liquidated to pay off the bridge loan. In that scenario the big losers are AIG shareholders -- the government, as the lender of last resort, will have bought a distressed AIG for a song. In the bad scenario we will enter a long, harsh recession and AIG will end up paying out on much of its $400 billion in obligations, perhaps exceeding even the long term liquidation value of the firm. In that case the US taxpayer will foot the bill.

WSJ:

...AIG itself has been forced to post about $50 billion in collateral to its trading partners, largely to offset sharp drops in the value of securities it insured with the credit-default swaps. These payments have continued to balloon after the bailout -- raising the specter that the government will eventually have to lend more taxpayer money to AIG.

The problem for AIG is that it didn't apply effective models for valuing the swaps and for collateral risk until the second half of 2007, long after the swaps were sold, AIG documents and investor presentations indicate. The firm left itself exposed to potentially large collateral calls because it had agreed to insure so much debt without protecting itself adequately through hedging.

Mr. Gorton collected vast amounts of data and built models to forecast losses on pools of assets such as home loans and corporate bonds. Speaking to investors last December, Mr. Cassano credited Mr. Gorton with "developing the intuition" that he and another top executive had "relied on in a great deal of the modeling that we've done and the business that we've created."

So-called multisector CDOs, in particular, were exceptionally complex, involving more than 100 securities, each backed by multiple mortgages, auto loans or credit-card receivables. Their performance depended on tens of thousands of disparate loans whose value was hard to determine and performance difficult to systematically predict. In assessing their risk, Mr. Gorton constructed worst-case scenarios that factored in the probability of defaults on the underlying securities.

In late 2005, senior executives at the unit grew worried about loosening lending standards in the subprime-mortgage market. AIG decided to stop selling credit protection on multisector CDOs, partly due to "concerns that the model was not going to be able to handle declining underwriting standards," Mr. Gorton told investors last December. But by the time it stopped, in early 2006, its exposure to multisector CDOs had ballooned to $80 billion.

Comments

[I weep for ...:]

You sir are a moron.

2008 Nov 03 04:34 PM

[MichaelZZ:]

RESTART OUR ECONOMIC ENGINE:

Paraphrasing Isaac: Objects in motion tend to remain in motion, objects at rest tend to remain at rest, and to change either condition, requires energy.

In this case, the energy factor should be effected by Congress by legislating the appropriate fiscal adjustments, i.e., immediately (do not wait until 2010) repeal those portions of the Bush tax legislations for those with taxable incomes in excess of $200,000 (arbitrary, i.e., could be $225M, $230M) and legislate permanent tax reductions for those with taxable incomes under $80,000.

This will be the energy factor, which will prime the engine of our economy. The longer it takes to do this, the more problematic will be the results.

A one-shot stimulus package will not work, as the recipients will pay down debt or add to savings due to insecurities, whereas a permanent tax reduction will mean that they will see their net paychecks increase and will have greater confidence. Unless consumers increase their collective confidence and spend, the situation will become much graver.

THE PARAMETERS OF THE FIRST TRAUNCH/TRANCHE OF $125 BILLION SHOULD BE CHANGED:

1) Only those institutions who want the funds should receive, i.e., none should be coerced into taking

2) The dividend rate should be changed to, at least 11%, for the purpose to stimulate the institutions to attempt to raise capital from private sources. They would know that they have the backstop of the 11% preferreds.

3) The conversion factor should be significant

4) As in the case of the Buffett purchase of GS preferreds, there should be substantial long-term warrants

5) The "fund" should be given seats on the Boards.

6) All dividends, other than any preferred stock dividends should be deferred for one year and will be re-assessed at the end of the year

7) There should be a moratorium for any bonuses and this will be reevaluated at the end of the first year

8) Those institutions which do not accept the "fund's" requirements and eventually fail, and which will have exacted bonuses will place in civil and criminal jeopardy those recipients of the bonuses. The punishments will include imprisonments and the return of the bonuses plus substantial monetary penalties.

The common shareholders will be adversely affected (much of which has already been reflected), but that is appropriate.

Capitalism will be alive and well.

Michael Z.
[e-mail]

2008 Nov 03 05:35 PM

[GET REAL , ...:]

hear this all the time give the little guy a break! But the little guy does not create wealth he contributes but overall big business and small are the major forces towards economic growth and government needs to recognize that. I make $30,000 a year by no means rich; if I got a total refund on my tax I would have another thousand dollars. That’s great for me, but I will probably just invest or waste it as would many others. I mean average say $2,000 dollars a person in the United States, times say two hundred million households. That’s about 400 billion dollars that may or may not go into the economy or into mattresses. Now instead of that reduce the tax on business from 35% to 30%. You would see businesses profits climb even in a troubled economy in the numbers of near a trillion dollars. This would stimulate companies to grow and not shrink, saving millions of Americans jobs. This would also create a greater motivation for companies not to outsource as cost not convenience is the number one factor in outsourcing. If a company can employ U.S. citizens to call centers here and can afford $11 to $14 an hour with the savings they make, most companies will. But as Americans we become so obsess with the idea companies are evil so lets see them all fall until we realize we are tied to them like an anchor to a ship, if they go down we are coming with them. We need to encourage companies to grow but we must also hold golden parachute CEO's responsible for their actions. These are the villains they profit in the billions while investors and employees leave penniless. I try to never confuse executive incompetence with a company made up of hundreds or hundreds of thousands. We are those companies, we need to remember that there profits are our jobs and retirement funds, if you are unemployed tomorrow how long is $2,000 going to hold out, a month maybe two, then what. I cant stand people who only see the Me picture, but then there all voting for Obama, hurray to the second great depression, bring on the great deal II, well looks like will need another world war to dig us out of this one.

2008 Nov 04 06:28 AM

[Let's hope ...:]

Tell me more about the chances of scenario 1 occuring:
"AIG's actual CDS payouts are limited, the government and taxpayers stand to make a lot of money over the next 3-5 years. When markets return to normal the profitable ordinary insurance parts of AIG can be liquidated to pay off the bridge loan."
What do you think about the measures being taken to better control and monitor CDSs? Could these help?
What if the government implements a successful program to allow the homeowners (underlying the CDSs) to remain in their homes, and re-negotiate their mortagage payback? Would not the risk of these CDSs decrease?
Thanks

2008 Nov 04 09:20 AM