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.