AIG and the Derivative Nightmare

Many people are missing the bigger picture here with AIG (AIG). Both AIG and Lehman (LEH) were heavily involved in the trading of unregulated derivatives. These derivatives have an outstanding balance of approx 62 trillion dollars, which is an absolutely mind boggling amount of money. AIG does not have enough money to back up its bets. My question is - does anyone? We are speaking about 62 trillion dollars here.

AIG accepted an $85 billion federal loan and gave the U.S. government a majority stake yesterday, averting the worst financial collapse in history.  ( Supposedly) The Federal Reserve stated that "a disorderly failure of AIG could add to already significant levels of financial market fragility.'' Lehman filed the biggest bankruptcy in history on Sept. 15.

The U.S. government is now in the insurance business with a loan to AIG for two years at 11%. What happens if AIG cannot pay due to its abhorrent derivative exposure? Who will pay the bill? Who will bail out the U.S. government? It's simply common logic - how can the Fed keep on lending. Is it like putting a finger in the dam and trying to keep the water out? What is notable is that the central banks are not making any panicky rate cuts. What’s your call? It this good or bad move?

The U.S. is definitely not alone, as the vibrations are being felt worldwide:

• Look at all the Swiss reinsurers.
• The insurance industry is rocking from Singapore to the U.S. and back again.
• England has had its biggest monthly increase in unemployment since 1992.
• CBI orders are weakening.
• The Europe zone trade deficit is widening.

Is AIG too big to fall? Is the U.S. Fed too big to fall?

We are living in interesting times. So far, we have not taken out the July '08 lows on the S&P 500, but only time will tell.

Disclosure: None

Comments

[glassbox:]

Andy, where did you get the 62 trillion figure from? its almost unbelievable.

2008 Sep 17 09:22 AM

[investor88:]

Good article touching on relevant issues. Outlook is bleak, hence preservation of capital is key.

2008 Sep 17 10:33 AM

[williambanzai7:]

CDSs are the new Ponzi scheme. I challenge anyone to argue otherwise. Unfunded surety arrangements for a fee. Hedgefund heaven.

2008 Sep 17 10:55 AM

[The Cynic:]

Like the FNM/FRE bailout situation, I imagine the AIG loan/bailout/conservat... will constitute a credit event that will trigger its CDS obligations. I'm interested to hear others thoughts about this.

2008 Sep 17 12:32 PM

[BlackyBlack:]

The Cynic, isn't that the point of the Fed loan? That it won't constitute a credit event. Otherwise why not just sell to Allianz/Flowers. I want to know who was most exposed/afraid of a payout on CDS obligations. Couldn't be Goldman/JPMorgan, could it?

2008 Sep 17 02:38 PM

[glassbox:]

Andy, would appreciate if you could point us all to the source of the 62 trillion outstanding derivatives.

2008 Sep 17 08:16 PM

[Andy Abraham:]

The 62 Trillion has been quoted in numerous places.. .

This is the link from bloomberg
www.bloomberg.com/apps...

Very scary stuff..

Andy Abraham
Myinvestorsplace.com
AngusJackson.com

2008 Sep 18 05:14 AM

[glassbox:]

Thanks Andrew. I'm still curious how this figure was arrived at especially if there is no central clearing house for derivatives.

2008 Sep 18 09:25 AM

[Augustus:]

The AIG problem was not a result of losses incurred, at lest not yet. The problem resulted from a margin call.

Suppose you have several different options positions in your brokerage account. In total there may be a whole lot of risk offset. However, the broker could decide that the general risk in the options market has increased and require you to put up more cash. Even while your current account cash balance is more than adequate from a profit and loss standpoint.

2008 Sep 18 09:46 AM

[Tom Armistead:]

The 62 Trillion is the last published notional amount of all derivatives form all sources globally. AIG is a small part of this, and their primary exposure is credit insurance on CDOs provided in credit default form. The net notional amount totals about 72 billion, I did a spreadsheet and estimate maximum probable losses at 4 billion.

2008 Sep 18 10:21 AM

[glassbox:]

TomArmistead, thanks for the clarification. I'm just trying to tie in how much more 'bailouts' we might have to see. Don't know if I am looking at it rightly but the US$85BN line to AIG seems a lot more than your probable losses of US$4BN.

2008 Sep 18 11:05 AM

[Tom Armistead:]

AIG's financials and presentations didn't make clear what their collateral posting requirments were in the event of a downgrade or severe change in markt values. MBI and ABK had this info in some detail for years. My guess is AIG didn't control their exposure to collateral calls in the event of extreme temporary conditions....


On Sep 18 11:05 AM glassbox wrote:

> TomArmistead, thanks for the clarification. I'm just trying to tie
> in how much more 'bailouts' we might have to see. Don't know if I
> am looking at it rightly but the US$85BN line to AIG seems a lot
> more than your probable losses of US$4BN.

2008 Sep 18 11:56 AM

[glassbox:]

Urghhh... seems like AIG's risk controls went out of control... I'm really baffled how this could have happened.

I'm long ABK and would love to buy AIG, except am not sure if after all the selling of the assets, there's going to be anything left for shareholders.

2008 Sep 18 09:02 PM

[Dark Rocket:]

November 9, 1999 Letter to Dennis Hassert, then Speaker of the House from the P.P.T., Second paragraph, third sentence. (note 1999!)

"These important markets are large and growing rapidly. At the
end of 1998, the estimated notional value of OTC derivative contracts was $80 trillion, according
to the Bank for International Settlements."

www.ustreas.gov/press/...

2008 Oct 03 02:08 PM