The SIGTARP counterparty investigation related to AIG has been released.
I'm sure there will be much digital ink spilled on this report over the next few days. But I'd like to focus in on one specific area - found on page 8 of the PDF file. Specifically:
Although credit default swaps are sometimes referred to as insurance-like contracts, they are not technically considered insurance, and, unlike insurance contracts, credit default swaps are not regulated. As a result AIGFP was not required to hold reserves to cover losses or other claims as it would if it was selling insurance policies. AIGFP was thus able to sell swaps on $72 billion worth of CDOs to counterparties without holding reserves that a regulated insurance company would be required to maintain if it had written an equivalent amount of insurance coverage. Counterparties assumed that AIG, which was a highly rated company at the time it wrote the swaps, would be able to pay any claims on the swaps that might occur as required by the contracts.
There are two problems here, neither of which our government and regulatory apparatus have addressed in any form:
- Mr. Barofsky identifies these as "insurance-like contracts." Indeed. The financial industry has managed to get regulators to specifically exempt these products from regulation - including the requirement that capital be reserved against these products when originated. This has in turn allowed literally indefinite amounts of leverage to be carried by firms who then claim to be "hedged" against disastrous outcomes by virtue of these contracts. This claim is a lie, because a contract to do a thing without the ability to perform is no contract at all - it is a fraud.
- While there was, at the time of the AIG bankruptcy and before, no ability (due to the financial firms' lobbying) to prevent AIGFP from selling these contracts The Fed did have the ability to prevent institutions over which it has supervisory authority from counting "naked" contracts without counterparty reserves to guarantee performance as "money good" hedges.
It is incumbent on our government to identify the root causes of the crisis and address them - particularly if they still remain outstanding risks for a second round of "detonate the financial system" that could be far worse than the first one.
Yet nobody in either Congress or The Fed has done so and their claims to the contrary via these circuitous claims of "re-regulating" CDS (with holes big enough to drive a truck through) are laughable.
The simple reality is that our financial system is now more vulnerable than it was prior to September of 2008. Why? Because we have increased risk - the collapse of Bear Stearns and Lehman along with other major lenders such as Wachovia and Washington Mutual, with the latter two absorbed into existing large banks, has concentrated risk instead of dissipating and mitigating it.
The issue of "systemic risk" is one of counterparty failures that create cascading failures in other firms. When one allows "insurance" to be written without the ability to pay, one has effectively allowed the wide-scale commission of fraud and circumvention of regulatory capital and leverage limits.
There has been no evidence presented thus far that anyone in our government and regulatory apparatus is willing to address this issue - yet until and unless it is addressed the very same meltdown path that we took last fall both can and will happen again.
