How Much Risk Is the Treasury Really Assuming from Financial Institutions? (Part 2)

Our previous post raised the question of just how much risk is being assumed by the U. S. Treasury with its apparent implied guaranty of the unsecured obligations of the major financial institutions. We asked whether the $188 Trillion (notional amount) of derivatives transactions on the books of four major banks (J. P. Morgan Chase (JPM), Bank of America (BAC), Citibank (C) and Goldman Sachs (GS)) could potentially pose risks not fully understood by the banks or their regulators.

In evaluating the potential risks inherent in the derivatives positions of the banks (and more particularly at the risks of the Credit Default Swaps ("CDS")), it is necessary to look at the one situation where similar risks have been converted to real losses: i.e. AIG Financial Products (AIG FP). Chris Whalen of Institutional Risk Analytics has done so in depth in a recent article posted here.

Mr. Whalen paints a picture of financial instruments created for the purpose of enabling financial as well as non-financial companies to falsify their earnings through the issuance of insurance contracts calculated to remove certain assets and liabilities from companies’ books and by doing so to bring them into compliance with regulatory capital requirements or shift earnings and losses between reporting period, with the presumed intent of manipulating the equity prices of the counterparties. He further asserts that these ostensibly “economic” transactions were converted to blatant fraud through side letters never disclosed to company management, auditors or regulators that absolved the writers of these contracts from responsibility for honoring their commitments. These activities are further described as the essence of the SEC’s charges against AIG in a Complaint brought against AIG in 2004.

In broad strokes Mr. Whalen then concludes that AIG FP changed its business practices around 2004 to absent itself from issuing insurance products of the type described above. Instead Mr. Whalen suggests that AIG FP pursued the Credit Default Swap market as an alternative mechanism to accomplish similar goals:

It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions.”

Whalen goes on to raise substantial questions as to the enforceability of the AIG CDS contracts:

Are the CDS Contracts of AIG Really Valid?

The key point is that neither the public, the Fed nor the Treasury seem to understand is that the CDS contracts written by AIG with these various non-insurers around the world were shams - with no correlation between "fees" paid and the risk assumed. These were not valid contracts as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru Larry Summers claim, but rather acts of criminal fraud meant to manipulate the capital positions and earnings of financial companies around the world.

Indeed, our sources as well as press reports suggest that the CDS contracts written by AIG may have included side letters, often in the form of emails rather than formal letters, that essentially violated the ISDA agreements and show that the true, economic reality of these contracts was fraud plain and simple. Unfortunately, by not moving to seize AIG immediately last year when the scandal broke, the Fed and Treasury may have given the AIG managers time to destroy much of the evidence of criminal wrongdoing.

Only when we understand how AIG came to be involved in CDS and the fact that this seemingly illegal activity was simply an extension of the reinsurance/side letter shell game scam that AIG, Gen Re and others conducted for many years before will we understand what needs to be done with AIG, namely liquidation. Seen in this context, the payments made to AIG by the Fed and Treasury, which were then passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be reversed once the US Trustee for the Federal Bankruptcy Court for the Southern District of New York is in control of AIG's operations.

Former AIG Chairman Maurice Greenberg is reported to have testified before Congress that AIG’s counterparty banks should be required to return a portion of the settlements they received from AIG following the Fed/Treasury bailout. The Government Accountability Office has added to the chorus in its March 2009 report to Congress on the Status of Efforts to Address Transparency and Accountability Issues with regard to TARP, at page 61 of the report, recommending in part that:

Based on our previous work on government assistance to the private sector, as well as the Treasury Secretary’s position, as articulated in the Financial Stability Plan that government support must come with strong conditions, Treasury has an opportunity to take additional steps to strengthen its agreement with AIG by requiring AIG to seek to negotiate concessions from management, employees, and counterparties, as appropriate, before the agreement is finalized. For example, Treasury could require that AIG seek to renegotiate contracts with its employees, such as existing contracts similar to the contract for retention bonuses with AIG Financial Products’ employees, and with existing counterparties that would face substantial losses were AIG to have its credit downgraded or fail. While we understand that Treasury is making an investment in AIG, Treasury’s failure to act in this instance could cause additional harm to its repute and impair its ability to seek additional funding for TARP that might be needed in the future.” (Emphasis added)

It seems apparent that, whether through a forced bankruptcy proceeding in which the Trustee seeks return of the settlement amounts under the Fraudulent Conveyance provisions of the Bankruptcy Code, or through political pressure on AIG’s counterparties similar to that applied to AIG’s executives with regard to their bonuses, a great deal of pressure is building for AIG to unwind the payments made to its counterparties in settlement of the CDS transactions. It is yet unclear whether AIG took full advantage of the setoff opportunities and other loss minimization techniques outlined by the Comptroller of the Currency-Administrator of National Banks in its quarterly report on Bank Trading and Derivatives Activities-Fourth Quarter 2008 which are discussed in detail in our prior post on the subject. As of April 7 these issues were reported to be under investigation by Neil Barofsky, the Treasury’s Special Inspector General for the Troubled Asset Relief Program.

Unwinding these payments would have serious implications for a number of financial institutions, both domestic and foreign. As Tyler Durden reported last month, $49.5 Billion had been paid out to AIG counterparties either directly by AIG or through the Fed’s Maiden Lane III facility. A required repayment of these funds could be particularly troublesome to Goldman Sachs where credit exposure to swap transactions ballooned in Q4 2008 to more than 1000% of Risk Based Capital. For a chart showing major institutions' derivative exposure in relation to risk based capital and additional analysis of this subject see Tyler Durden's recent article on the subject here.

Finally, in addition to the direct impact of a potential unwinding of the AIG CDS contracts, there remains the larger issue raised by Chris Whalen: i.e. the potential unenforceability of many CDS contracts as a result of secret side letters. The OCC’s rationale for minimizing the potential credit exposure of derivative transactions to the financial institutions depends in great part on their ability to set off obligations to particular counterparties against balancing transactions. In the event contracts are held unenforceable as a result of side letters or other defects in their execution, the setoff rationale would no longer hold true and the overall exposure could be far greater than currently assumed. Presumably the Special Inspector General will be exploring these issues during his investigation. Should this activity prove to be pervasive and should these letters and emails extend beyond AIG to its counterparties, we could find the $16 Trillion notional amount of CDS contracts issued by the major financial institutions becoming a major Achilles Heel for the Treasury/Fed/FDIC’s efforts to save the wholesale banks.

Disclosure: No Positions.

Comments

[infp:]

That the US government has chosen to condone the vast criminality of the CDS market by bailing out all its major conspirators is a shocking indictment of our democracy.

Apr 10 09:23 AM

[amateur:]

It has not been proved that any of the CDS issued by AIG and standing in 2009 had any cancelling by-letter of any kind.
Even if some CDS might eventually be found to be fraudulent, why should that invalidate biilions of valid contracts?

It is hard to believe the conspiracy theory that AIG managers were systematically risking jail for the benefit of shareholders.

IMVHO, these destructive and misleading accusations seem more like propaganda of traders who are short the financials, rather than a contribution to debate.

Apr 10 10:40 AM

[John Slater:]

I would agree that Whalen's allegations of side letters are unproven. He is out on the point on that issue.

There are far more commentators who believe that AIG's CDS settlements were made without an aggressive attempt to minimize the settlement costs. Tyler Durden has published a number of pieces on Seeking Alpha in this vein. Others such as Simon Johnson have gone so far as to imply that the Treasury has been complicit in subsidizing the wholesale banks at the taxpayers expense.

My primary point is this. Whether or not some of these contracts and settlements are ultimately determined to be illegal, there is a tremendous groundswell of anger building over this issue. We have already seen with the AIG bonuses that threats of prosecution, public pillorying of corporate executives, Congressional hearings, etc. can force individuals and organizations to forego what may be legally enforceable rights. Such pressures will likely be placed on some of the wholesale banks with regard to the AIG payments. Once we head down that road, the risk analysis framework on which the OCC depends to evaluate the derivatives portfolios loses its empirical framework, bringing into question how much capital will be required to support the potential risks of these portfolios.


On Apr 10 10:40 AM amateur wrote:

> It has not been proved that any of the CDS issued by AIG and standing
> in 2009 had any cancelling by-letter of any kind.
> Even if some CDS might eventually be found to be fraudulent, why
> should that invalidate biilions of valid contracts?
>
> It is hard to believe the conspiracy theory that AIG managers were
> systematically risking jail for the benefit of shareholders.
>
> IMVHO, these destructive and misleading accusations seem more like
> propaganda of traders who are short the financials, rather than a
> contribution to debate.
>

Apr 10 12:13 PM

[Mad Hedge F...:]

This will be the last bubble to go. If stocks sell off from here you should get a rally in Treasuries that will be ripe for selling into. There is no way that investors are being compensated for their risk with yields at these levels, especially with massive global government reflationary efforts guaranteed to bring a resurgence of inflation. I think the futures contract on the long bond will collapse from 127 now to inder 70 in three years, once hyperinflation hits. With the leverage offered by a futures contract, the returns will be huge. However, this is not a riskless trade. There have already been several rounds of stop loss buying by traders who jumped into this strategy too early, as unimaginable buying kicked in at 120, 125, 131, 136 and finally 141. In Japan the ten year bond eventually hit a low of 0.46%, making our ten year at 2.85% look incredibly expensive. That works out to a futures price of 200 or more. Of course we are not Japan. The Treasury has done more to repair things in 60 days than Japan did in 15 years, and Japan has still not adopted full mark to mark accounting. Some 19 years after their bubble burst, the country is still seeing subpar growth, and ten year yields have made it back up to only a measly 1.25%. There are also constant games going on in the bond futures markets like expiration plays, engineered short squeezes in the underlying, and bogus news leaks. PIMCO, the Newport Beach based Pacific Investment Management Company, the world’s largest private bond investor, plays this market like a violin. Still, I think it’s worth a shot. Take another look at the Power Shares Lehman 20 year plus ETF (TBT), which gives you a 200% short on the sector. This will be the last bubble we can short into for a long time.

Apr 10 12:15 PM

[Allan Frain:]

"How Much Risk Is the Treasury Really Assuming from Financial Institutions?"

Certainly that which the market refused. and once it is on the Fed's balance sheet simply 100%.

Apr 11 01:21 AM

[Leftfield:]

Trust them. They tell us to. They know best. Don't look at the trillions, quadrillions, whatever in leverage, it was assumed by the best people who need to get into our pockets now, but don't think about that. With trillions to play with, these highly qualified Wallstreeters wouldn't think of diverting any of it improperly. Neither would the government. Don't worry, be happy.

Apr 11 08:49 AM

[Ames Tiedeman:]

Treasuries are in a bubble now. A bit of good economic news and you will see a huge sell off in bonds and interest rates will go up. You cannot throw this much money at an economy and not get it moving. My guess is the day the employment numbers shock to the good side is the day the Treasury market gets smacked.

Apr 11 09:27 AM