IsThisRight

Exclusive: Big Banks' Recent Profitability Due to AIG Scam?

Let me try to understand the loop :

Figures below are FICTITIOUS --- just as a model ...

1- AIG, as an insurance company, holds contracts with HIGH liability - let's say 60 cents liability on the dollar ( assuming the subprime papers are worth 30 cents in the Itraxx index).

2- The banks hold/own the actual subprime paper which is mark-to-market at 30 cents. But the banks believe that the value ( based on cash flow) is closer to 60 cents.

3- AIG keeps saying that their CDS is "senior"--- meaning that they do not have to immediately settle until a set condition ( example : only pay IF and WHEN the debt cash flow is interupted. So if the mortgages still pay 92% cashflow, AIG doesnot pay). But meanwhile, on the AIG books, the liability of 60 cents on the balance sheet show LARGE loss.

So the unwind:
4- IF AIG pays 20cents to the bank to close out the contract, AIG balance sheet shows a GAIN of 40 cents ( 60cents liability - 20 cents).

5- The banks never believed that their subprime paper was worth 30 cents. The banks always said that they are not selling at 30 cents. So let's say that they think that it is worth 60cents.
By receiving 20 cents from AIG, they bought the suprime paper for 100 cents, got 20 cents from AIG. So now that the banks can sell the subprime paper for 60cents. Sell for 60 cents + 20 cents AIG = 80 cents bank income... loss of 20 cents ( 100cents purchase - 80 cents income from sales and insurance).

6- Now Mr G. ( Treasury ) walks in with Hedge Funds - $1T Plan - ready to sweep all the subprime away from the banks at 70 cents!.

In Step #5 above, the banks get 20 real cents earnings by 'cancelling' their insurance held by AIG. AIG 'makes' 40c or avoid loosing 40c ( 60 cents liability - 20cents paid). The banks never believe that the insurance is worth 60 cents, but they could not claim it either ( the banks were getting cash from the mortgages)

Zero Hedge is seeing all these unwind transactions at below value, BUT WHOSE VALUE IS TRUE... the market maker value ( Itraxx index?) or the value that the two parties agree to close out their liability? This CDS over the counter market is unregulated, remember? There is nothing that stops one party to accept whatever value agreed by both parties to unwind their own transactions.

When you have a car accident and the adjuster gives you a value for the repair, you can always negotiate a settlement price and turn in the damage car. The subprime papers are being adjusted to be traded in.

We should remember that the 'Banks Gains' are partly reversal of "loss" that they alreay took in 2008. The AIG gains are reversal of write-downs / reserve that they took in 3Q and 4Q 2008. The real 20cents that they transfer to the banks are capital that AIG will collect when they sell their other divisions ( airplane leasing...). AIG looses Broadwalk in the monopoly game; the banks' real losts are 100cents on the dollar minus what they get selling to the Treasury+Hedge Funds.

The CDS market loose the VOLUME of business on naked CDS. there will always be covered CDS on real bonds, but the insurance company will need to post real capital to cover potential claims.


Estimates:
AIG took a loss of $60B in 4Q2008. And we know that they decreased their CDS portfolio from 2.3T to 1.7T = delta $600B. So in round figure they paying 10 cents per portfolio dollar ( 60B / 600B) just to close out the CDS contracts.

Paulson's Plan Fails to Understand the Problem; Madoff Is a Perfect Example

I agree with the conclusion of this theme, but for different rational. My conclusion is as follow : Mr Paulson understands the problem but has not told us, therefore we cannot comprehend Treasury n Fed actions since we donot agree on the problem that we have to address.

My view of the problem and actions :
The $7-10 trillion "invested" by Treasury ( and they have insisted that they are investing not spending) is MOSTLY A REPLACEMENT FOR PAST DEBTS held by US corporations, and/or to REPLACE LOST FUNDS ALREADY INCURRED BY SOME BANKS. So these TARP and Fed transactions are just recognizing these debts ( corp and banks) onto the US balance sheets. The market is not allowing any corporation and banks to expand their debt levels, while these Treasury and Fed actions are underway.
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We need to to look at the total basket of corp debts and bank Tier 1 assets as the balance sheet of the U.S nation. As the fed lowers rate, the banks earn more. As the corporations log profits each quarter or sell assets to foreign companies, they will be deleveraging. So as a nation, the bank earnings and the corporation profits will help to deleverage the U.S. balance sheet.

At the personal budget level, from our salary, we will also be either saving more or paying back debt. This will also help in the deleveraging process.

Oh yeah, these pesky CDS ( 50 Trilliion liability). Look at it this way, by minimizing corp and banks going bankrupt, the CDS liability goes down as time elapses. The CDS buyers will be fatigue or they with an upswing they will panic and liquidate some of their bets.

Liongterm:
When the fed gets to lend NET NEW MONEY to the banks n corporations, without taking any old debt instruments or bank shares, then these steps would be growth stocking actions. But until now, the "Treasury investments" are just buying U.S. time to deleverage. Paulson did tell us : "we need to delverage" and that is what he and the WW market is driving U.S. to do.


So for now, let's try
1 to tally how much total debt we have
2 estimate our total earnings each quarter
3 assume that we use 80% of our colletive profits to pay down debt
4- estimate how much assets that we can sell externally - at right time at the right price
5- By adding 3 and 4 above, we can estimate the time needed to deleverage the US balance sheet.

Once we can see the end-date for deleverage, then we plan to grow the pie again SLOWLY by controllng both our spending and debt growth rates.

How the U.S. Saved Europe's Banking System

Paul,
thank you for the comprehensive data on the european banks.
Any such insights of comparative info on US and AP banks?