Three Card Monte and the Feigned Outrage Against AIG

The media and talking puppet heads have wrongly characterized AIG as the poster child for the mysterious black hole that TARP funds have been dumped into with bailout money. I’m glad that some Congressional leaders finally stepped up to ask the correct questions and apply enough political pressure to force CEO Liddy’s hand and reveal who the actual recipients were on the back end of the pipeline called AIG.

Like a confidence game of three card monte, approximately 180 billion dollars in taxpayer funded TARP money has vanished before our eyes in a delicate maneuver and sleight of hand.

Now, with recent disclosures, we finally were told how some of the money was utilized. All in all, approximately $120 billion was spent to cash in on the winnings by large institutional firms such as Goldman Sachs (GS), Citadel, and Bank of America (BAC). Familiar European banks such as Deutsche Bank (DB), UBS, Barclays (BCS) and Societe Generale (SCGLY.PK) cashed in billions as well while other allocations were spent to pay out municipalities. While the composition of money spent is divided between collateral postings and payouts, it is very damning evidence of suspicions raised by many in the public eye that have been demanding answers.

I find it interesting that this public disclosure was released at the same time it was announced that over $450 million in employee bonuses are being doled out. Hmm...sleight of hand? $450 million with an “m” is nothing compared to the billions with a “b” being shoveled out the back door. We will see what stokes more public outrage and garners media scrutiny. I tend to believe it will be the relatively paltry $450 million underscored by the media tagline: “bonuses”.

I remember the scene from Martin Scorsese’s movie masterpiece “Goodfellas,” where they talked about running up tabs on the business with debt obligations by moving inventory in the front door and out the back door until it got to the point where the only thing left to do was “bust the joint out” by burning the business to the ground and collecting the insurance money.

I truly hope that this is not the case with AIG because too many innocent people would be unduly affected by the unintended consequences. Consider the real world economic impact of not only the employees directly tied to the corporation, but what about all the individual policy holders that depend on AIG to remain standing as a solvent company?

The irony in the feigned outrage against AIG is that, in truth, AIG isn’t the one being bailed out. The real question was never about bailing out AIG; instead, it was always about who AIG was bailing out on the other end and where all that money was really going.

Now that the curtain has been pulled back ever so slightly to reveal a sneak peek into the inner corridors of Wall Street financial alchemy, the public is outraged but our entrance to this opaque world will always be access denied. It’s a private club and we simply don’t belong.

AIG was never the intended target of the bailout money from TARP. AIG has really been the adopted surrogate to bailout the banks, financial firms, and speculators operating like Wild West gunslingers in the arena of credit default swaps. This is as ridiculous as bailing out a bankrupt casino with taxpayer dollars to pay off winning bets to gamblers.

Actually, it’s worse. This is like utilizing taxpayer money to pay off an illegitimate smoke filled, back room, gambling den of criminals because the cops came in and raided the nest. If the bets weren’t legal to place, how can anyone claim to cash in their chips? So, why is an unregulated insurance derivative and swap market being bailed out if it never should have been allowed to exist in the first place?

Now, let me be clear, I have no problem with honoring the contracts that were written and purchased by the debt issuers that needed the protection of insurance swaps to offset the risk of potential borrower default. Loan origination and lenders have valid reasons for participation in the CDS market. However, if taxpayer funds were used to pay off speculators and hedge funds that had zero stake in the loan origination and were actively spreading malicious rumors while shorting the underlying securities to capitalize on rising insurance premiums, then the SEC and Justice Department needs to be all over this.

Fed Chairman Ben Bernanke, who I believe is doing an incredibly honorable job, even stated that he was concerned about revealing the information on recipients publicly because it might undermine confidence in the named institutions. I believe they were more concerned that it would incite additional public outrage and potential clawbacks rather than being a solvency issue due to counterparty risks.

Legitimate loan default risk that was hedged throughout the CDS market justifiably needed to be stabilized by government intervention due to the systemic nature of the risk. But, if firms and hedge funds that are being celebrated as financial heroes because they “shorted” sub-prime mortgages by buying swaps and drove premiums upward for collection without actually owning any of the original risk through debt issuance, how is that legitimate?

That is like paying off the arsonist that burns the neighborhood down to collect the insurance money even though he doesn’t own any of the property. There are some real winners in the calamity of financial wreckage, and yet, is it fair at the expense of the entire system? We have been on the verge of financial Armageddon for months now and the people that may have benefitted the most seem to have escaped without scrutiny and full disclosure on the degree of their trading activity.

I applaud the intention by firms like Goldman Sachs, Morgan Stanley (MS), Bank Of America and others who publicly stated they intend to pay back their TARP money. But is it sincere for executives to suggest that they were forced to take the TARP money as if it were an inconvenience and not a necessity to their solvency and ability to continue as institutions? Will they also volunteer to repay the additional billions of dollars gleaned from the TARP via AIG? I doubt it. The question is whether or not this latest disclosure will have incited further scrutiny on some of the financial firms and banks that were the “indirect recipients” of the AIG bailout money.

For this reason, with a climate that has created political jockeying and a lynch mob mentality, I would suggest caution on all of the named financial firms by the latest AIG disclosure. The bank stocks and, in particular those named, GS, MS, BAC, etc. have all had significant moves over the course of the last week and will continue to run on any suspension of the mark-to-market FASB ruling that seems imminent. Hedge your risk by adding in put protection against your long positions on any continued or sustained upward movement in the market.

Core Assets Deserve To Be Rescued

Structurally, AIG has core insurance businesses which remain intact and deserve to be rescued or spun off as separate companies without the stress of toxic liabilities. The very foundation that AIG was built upon has, singlehandedly, been put at risk by playing outside the boundaries in the CDS market. The current CEO has already expressed publicly the company's intention to dismantle the once great conglomerate and spin off its core assets piece by piece.

My actual greater concern is for all of the ordinary Americans and people that have existing life insurance policies, annuities and principal investments tied to AIG and the underlying components. I would hope that Congress and Democratic leadership recognize the responsibility to guarantee existing contracts with so many everyday working people that depend on the ability for AIG’s property, casualty and life insurance divisions to be financially solvent.

Perhaps, it is time for insurance to no longer be state regulated and allow federal regulation to oversee all insurance companies so that Americans who have entrusted their estate planning can be guaranteed similar to the F.D.I.C (Federal Deposit Insurance Corporation) we have with banks, or even the P.B.G.C.(Pension Benefit Guaranty Corporation) that exists for pension funds.

There truly needs to be a centralized oversight and regulatory body that applies to the insurance industry and, more importantly, the ability to fund and honor all existing policies in good standing.

Ultimately, if financial institutions can be bailed out with little disclosure or accountability, I hope the systemic risk of individual policy holders and the entitlements of families depending on the ability for insurance contracts and annuities to be honored is recognized. Otherwise, it would make the entire insurance industry look a giant Ponzi scheme and the recent Bernie Madoff scandal just a drop in the bucket of scammers.

How To Play It

I have held long positions on Morgan Stanley by owning the underlying stock with, essentially, a “collar trade” that utilized both covered calls and puts. BAC is heavily diluted and no longer sustains a viable dividend yield, so owning shares is less appealing and the reason I opted to write “naked equity puts” to capture premium when it traded in the $3 range. Rather than applying cash to buy BAC, I’d rather take in premium with the potential risk of owning shares in the unlikely scenario that BAC would be allowed to go bankrupt. GS is still the main player on Wall Street and retains the title of “Alpha dog”. I don’t own GS stock, but if the market continues upside movement then GS will outperform on any economic recovery--in fact, it will continue to move just in anticipation of any sustainable recovery. GS is high beta and I prefer to take a vertical call spread position to limit some of the risk exposure. Once the market begins to stabilize then the long leg of the option spread allows exercise if conditions are favorable to take ownership of equity shares. This would, in effect, convert a call spread into a covered call position which can be rolled.

But I simply don’t feel complacent enough with existing headline risk to own these particular banking stock positions long term. It is clear that while there is tremendous upside potential in the financial sector, you have to remain nimble due to existing volatility.

Interestingly enough, the AIG debacle reveals the necessity for the entire financial industry to mitigate risk through derivatives markets and swaps. Out of every market collapse comes opportunity and, if nothing else, AIG points us in the direction of regulated and transparent exchanges to trade these obscure products and financial instruments.

Approval has been granted to most of the major participants in the regulated exchange sector to operate clearing for credit derivatives. NYSE (NYX), Chicago Mercantile Exchange (CME) and InterContinentalExchange (ICE) are poised to compete in the next transition towards transparent and regulated default swaps. I am sure that the Nasdaq (NDAQ) will also make a strong move into the credit derivatives arena. While some seem to argue that the market share isn’t large enough to divide amongst the major exchanges or significantly make an impact on revenues, I disagree when you consider the CDS market held approximately $60 plus trillion dollars in notional risk. I think that if clearing and transparency works as well as it does for both the futures and equity options market, which continues to be in a growth cycle, then it would be foolish to underestimate where the road will ultimately lead. Especially, after this financial debacle and collapse of the markets, institutional lenders and investors alike will be scrambling to enhance adequate risk management.

I actually believe there are more fundamental reasons to own the exchanges than additional revenue generated from potential credit derivatives. I believe the exchanges are among the best way to play the financial sector by minimizing direct balance sheet exposure due to loan origination. They also have the added benefit of trading in tandem with the markets similar to an index that is pegged to overall sentiment.

Author’s Disclosure: Long NYX, NDAQ, MS, short BAC equity puts, long GS vertical call spreads

Comments

[Dirk McCoy:]

If you've heard the phrase "a rising tide lifts all boats", then you should understand that, in a credit economy, draining the tube will everyone high and dry. AIG was the largest insurer in the world, and their "insurance" on financial products was a disaster.

But likening the policy holders to gamblers in a casino is a bit like saying you gamble when you insure your house against fire. The big problem is that AIG's underwriting didn't account for the fact that, unlike a wildfire consuming the entire nation's housing stock, the interconnectedness of interest rates and banks and consumers and businesses- and hair-trigger sensativity due to leverage- created a national (global) wildfire of asset deflation that AIG couldn't cover.

So, just like in a national disaster when Federal funds come in- Federal funds came in. We know now (and should have anticipated) that these monies went to the insured counterparties. That millions are now being paid in bonuses- especially to people in this poorly underwritten Financial Products division- is a travesty. While courts or the government shouldn't force the company not to pay (unless the company uses bankruptcy), I hope the company includes a pink slip with any bonus check any of these people would have the gall to cash...

Mar 16 10:42 AM

[Big Jack58:]

This is a good article. However, AIG is not blameless in this situation. They chose to underwrite these CDO policies and profited from doing so. Shareholders weren't complaining when they made money on this stock two years ago. Think about this: if AIG and other insurers decided not to underwrite these risky investments, would the hedgefunds, mutual funds and banks have gotten into that business in the first place? Being in Product Development for a financial institution, I can tell you there are many great, new ideas that never get started because the risks can not be mititaged. Greed got the best of them for sure. They could have just underwritten Citi's business or any one of the other major CDO players. But they had to be the #1 underwriter for that industry and that industry went south. Insurers underwrite their policies based on dispersed risk. Unfortunately, the things that undercut one financial companies CDOs undercut all CDOs and AIG was backstoping a majority of them. Poor risk management in my opinion.

Mar 16 11:24 AM

[kbclements:]

OK - so they still have a Financial Products division?! What is their mission statement - 'Making Ourselves Rich While Destroying the World Economy'? I hope these people are not still writing derivative product contracts. It's time to put an end to the use of any derivative products other than a simple put or call option by regulated financial companies.

Anyone above the level of secretary whose name appears on any derivative contract should be laid off. Anyone that made a decision to proceed on derivative products should be laid off. Clean house!

Keeping these people around is just stupid. Anyone at AIG that says these people are the best and the brightest (thus deserving of retention bonus) must be laid off as well. Clean out the support for these people - it is a cancer.

Then make the lay-offs permanent!

Then hire a team from outside of the company to unwind AIG's position in every derivative product outstanding. A team of 3 or 4 people should be about right if Buffett and Jain were able to do it at Berkshire.

Mar 16 11:34 AM

[ironpants:]

"But, if firms and hedge funds that are being celebrated as financial heroes because they “shorted” sub-prime mortgages by buying swaps and drove premiums upward for collection without actually owning any of the original risk through debt issuance, how is that legitimate?"

Excellent point.

Einhorn to jail, now!

Mar 16 11:44 AM

[Dot:]

Thanks for your insight. Can you explain how and why AIG stock has crept from a low of $.33 last week to currently trading today (now) at $.85? Today's range has been $.57 to $1.00, with volume of almost 150 million since the market opened. An almost 70% increase in one day? What's up?

Mar 16 12:00 PM

[mikebrah:]

This sounds a bit like a witch hunt to me.

What did you expect AIG to do with the money? The whole reason they received taxpayer money was because they were insolvent. This means they could not pay out the obligations they VOLUNTARILY entered. An insurance company can't meet its claims, and you blame the policy holders? Nice.

Basically you are arguing they should renege on their contracts on all instances where you, or some ordained oversight committee, deem the counterparty's actions as immoral. This is just another argument to obstruct capital flows under the tireless guise of egalitarianism.

Without the contrarians who were buying these speculative CDS' the bubble would just perpetuate into an even more destructive event.

But to argue that ONLY parties in need of risk mitigation should be allowed to operate in the CDS market is foolish. Plus, this would lead to unintended consequences such as greatly reduced liquidity, which in turn might decrease the effectiveness of the market for those trying to use it for its "correct" intentions.

Naked short selling is already illegal and what should be much more scrutinized. I believe naked short selling to be a violation of property rights and the most effective way to obliterate a company's reputation and share price.

The CDS market is actually quite beneficial and thus far has operated quite smoothly despite all the bad press and hyperbole.

Mar 16 12:08 PM

[kbclements:]

mikebraw has made a few statements that just might need defending a bit:

'Without the contrarians who were buying these speculative CDS' the bubble would just perpetuate into an even more destructive event.' - by what transmission system did a CDS contract slow or stop the bubble?

'The CDS market is actually quite beneficial and thus far has operated quite smoothly despite all the bad press and hyperbole.' - how is hundred of billions of tax payer money being sent to counterparties quite beneficial and smoothly operating?

Mar 16 12:36 PM

[mikebrah:]

Re: kb

'Without the contrarians who were buying these speculative CDS' the bubble would just perpetuate into an even more destructive event.' - by what transmission system did a CDS contract slow or stop the bubble?

I'm not saying it slowed the formation, but that it popped it much faster than would have occurred without its existence. Instead of having a building slowly rot due to lack of upkeep, the CDS market (combined, unfortunately, with naked short selling) acted like a demolition squad. While violent and destructive on the surface this is actually a much healthier situation and I think could prevent a decade of stagnation. I am a firm believer in the "liquidation" model.



'The CDS market is actually quite beneficial and thus far has operated quite smoothly despite all the bad press and hyperbole.' - how is hundred of billions of tax payer money being sent to counterparties quite beneficial and smoothly operating?

This was a bad business model on AIG's part. What their intentions were is debatable, but I just have a hard time blaming policy holders for an insolvent insurance company. Sort of like Floridians demanding "reasonable" insurance even though they live in a hurricane zone, only to find when one eventually strikes their insurance company no longer exists.
Also, I was never in favor of the way AIG was handled from the get-go. I readily concede a lot of sh*t has happened, I just don't think the brunt of it should fall on CDS speculators. By their very nature, speculators are reactionary. They are the trend-followers, the chartists, technicians, etc. As the giant stumbled, they simply bet he would fall.

Just my $.02 and I welcome dissent. Thoughts?

Mar 16 01:09 PM

[mikebrah:]

Furthermore, if AIG had just been allowed to fail then by the nature of bankruptcy I think a lot of these debt obligations would have been altered.

The whole reason the taxpayer is paying these exorbitant amounts is because the government stepped in and declared we would. That is the government's fault, not AIG's counterparties'. The byproduct of the "too big to fail" ideology is that taxpayers pay the bill.

Mar 16 01:15 PM

[kbclements:]

re:mikebrah

Agreed that AIG screwed up and that the speculators in CDS's were not the problem. But a CDS is not insurance but a speculative contract that no regulated financial company should be allowed to participate in. The regulators botched this bad.

The system can't have regulated financial companies involved in products unless they are on a regulated exchange. That should go double for securitzed debt products - what a crap idea those things are - none of it should have ever been rated above junk. Any new product development by a regulated finacial company should go thru an FDA styled set of reviews on a small scale over a period of 5 years or more before being allowed.

Too big to fail should equal too big to exist. Let's break these giants up - put the capitalists back in capitalism and rein in the manager class that doesn't have any skin in the game.

Whew - that felt good!!!

Mar 16 01:54 PM

[Dirk McCoy:]

AIG is a good proxy for economic recovery, like a double-long ETF without the contango. If the recovery stalls, AIG will have problems going back for more money and common could be zeroed out by the next round of government money.

On the other hand, if mark to model and the uptick rule bring momentum to equities and other assets start to recover and if AIG can peel off operations to satisfy the government loan, and emerges even with an operation even 10% of it's previous size, it's not too hard to justify a stock price 5-10X where it was the end of last week.

The news over the weekend regarding these bonuses highlighted that AIG has some cash and isn't going to run out as long as they don't run into further asset deterioration, and the combination of shorts exiting and longs getting in cheap pushed the stock up today.

Mar 16 04:30 PM

[Zekeko:]

Yessir! You were right! All CNBC and cable news anchors were crying about was the millions in "BONUS" paid to the employees.

What about the BILLIONS FUNNELED to the investment banks?

I don't think scarface washed his money that clean.

I like your three card monty analogy. It crystallizes the point because Aig is the fall guy.

Mar 16 07:08 PM

[PainfullyAware:]

"The CDS market is actually quite beneficial and thus far has operated quite smoothly despite all the bad press and hyperbole."-mikebrah

Without regulation and enforcement con games always "opperate quite smoothly" until they are found to be shenanigans.

From what I understand the CDS market had no Regulation to Enforce.

Shadow Banking Blows !!!!

Mar 16 11:53 PM

[Cecily S:]

I think this author spelled it out months ago in a previous article on "the 60 trillion dollar nightmare of CDS".

I agree that this is just about finding the scapegoat and not to dissimilar to what the author surmised the outrage is just as misplaced as a con-game. We the public are and should be screaming mad about bonuses but its a sideshow and distraction when the truth is where all the money went and who benefitted.

I think the 100 billion paid out hte back door is scandalous.

I wonder who got bonuses at the firms collectin AIG'S insurance money paid by taxpayer? Is there outrage there?

Mar 17 01:01 PM

[Allan Frain:]

No coincidence that Hank Paulson was the GS man "on the inside". "Too Big To Fail" is inaccurate. "Too Connected To Fail" describes both the GS relationship with government, and the AIG relationship to GS.


On Mar 16 01:15 PM mikebrah wrote:

> Furthermore, if AIG had just been allowed to fail then by the nature
> of bankruptcy I think a lot of these debt obligations would have
> been altered.
>
> The whole reason the taxpayer is paying these exorbitant amounts
> is because the government stepped in and declared we would. That
> is the government's fault, not AIG's counterparties'. The byproduct
> of the "too big to fail" ideology is that taxpayers pay the bill.
>
>

Mar 17 03:10 PM

[bones33:]

It's time to beat the plowshares into swords.Get your torch and itchfork and quit bitching.

Mar 18 11:42 PM

[bonddude:]

1. AIG CEO told congress they had to provide almost 100% collateral when CDS contracts were "triggered". - Net effect being probable massive selling bias on all new exchange traded contracts creating more liquidation across all asset classes (excepting Oil and Metals if a major war breaks out).

2. There is a massive amount of other unregulated CDS CDO contracts estimated to be up to $250 Trillion in notional value world wide exerting massive selling pressure on the most liquid contracts- and this should be good for exchanges conducting these trades like selling picks and shovels to the 49ERS.

3. The net effects on the world economy seem to bear out the stag-deflation scenario that Roubini sees. Black Swan?

Mar 21 10:45 AM