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April 07, 2009

AIG counterparty obligations may not be enforceable, but we're paying them anyway

Olga Pierce has a nice piece in ProPublica explaining why AIG is still paying its counterparties in full.

I submit that the short answer is money laundering. Paying the holders of credit default swaps in full is a convenient method of funnelling money to the banks without congressional oversight. The government has already paid out $52 billion this way. Much of that money is going to the same banks that are getting bailed out by TARP.  Congress can impose conditions on TARP money, but payouts from credit default swaps count as ordinary revenue, even if that money ultimately came from TARP.

The government now owns 80% of AIG, but the feds are refusing to exert meaningful influence over the management of the company. As Pierce explains, Tim Geithner could informally pressure AIG to take a haircut on these. That is, to renegotiate the contracts and take a loss. Given that the payout is holding steady at 100%, it's fair to assume that Geithner's not trying too hard.

One excuse for not making AIG and its counterparties renegotiate is that the counterparties would sue the federal government. The really amazing part of Pierce's story is that most of the counterparties probably lack the grounds to sue:

"I don't see why it would have been necessary to pay out to the counterparties at all," said Timothy Canova, a professor of international economic law at Chapman University in California.

Such a suit may not fare well in court because some legal questions swirl [12] around whether the bulk of credit default swaps are legally enforceable.

Some of the swaps function like insurance policies on corporate bonds. Purchasers of such credit default swaps know that even if the bond issuer defaults, they will limit their losses. But many other swaps are more like bets (akin to buying "insurance" on another person's house), and it is unclear from a legal perspective if there is enough of an insurable interest to make the contracts enforceable.

"I say let them litigate it and let the courts decide whether they have any kind of insurable interest," Canova said.

If the UAW has to renegotiate its contracts with the Big Three in exchange for government help, AIG's counterparties should be asked to make the same sacrifice.
AIG is a black hole, but dammit, it's our black hole. Let's start acting like it.

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Comments

One excuse for not making AIG and its counterparties renegotiate is that the counterparties would sue the federal government.

I haven't seen this excuse used in this circumstance. Instead, I've seen people argue that not paying in full will cause a cascade of bank failures, just like Lehman Brothers' bankruptcy caused AIG to fail. I've only seen the argument from lawsuits used against the good bank/bad bank proposal.

There's a bit more to this than Olga lays out. In many ways, it makes it even more fishy.

The payments weren't made because counterparties' securities went belly up; it was ostensibly because AIG's credit rating fell, which meant it had to post collateral. That meant the government, on AIG's behalf, bought up a portion of the counterparties' securities and in theory can sell them back.

There are two big problems with this. First, if AIG is implicitly backed by the full faith and credit of the government, AIG's rating becomes irrelevant and the collateral provisions of the contracts should have not been triggered (assuming the government is even legally obliged to recognize the contracts). Second, for the same reason, there was no need for the government to post 100% of the collateral, even if we assume this was a backdoor bailout of the counterparties as a hedge against systemic risk. No one believes the counterparties' securities are worth 100 cents on the dollar; any other sane third party would have demanded a discount as interest on what is essentially a loan.

Alon Levy -

How did Lehman Brothers' bankruptcy cause AIG to fail?

Eric: the Lehman failure caused a cascade of bankruptcies of its creditors, which trickled up to AIG. One of the arguments I've read against nationalization is that it'll essentially do the same - destroy the creditors, driving another wave of bank failures.

I don't think so, Alon. AIG's spiral began long before Lehman. It began in 2005, when S&P cut AIG's rating and forced a collateral call. That's when AIG realized it was on the edge of doom and stopped selling CDSs. Then the ratings on the counterparties' securities were downgraded in 2007, forcing another series of calls.

AIG stock fell 25% by Nov 2007 and CDS losses were $12b by Feb. 2008. That was a mortal wound; the rating would inevitably fall another notch and AIG didn't have the cash for another collateral call. In mid Sept. - three days before Lehamn went under - it was scrambling for a $75b loan from the street and $20b from NY state. That fell through and that's all she wrote.

"One excuse for not making AIG and its counterparties renegotiate is that the counterparties would sue the federal government."

I haven't seen this excuse used in this circumstance. Instead, I've seen people argue that not paying in full will cause a cascade of bank failures, just like Lehman Brothers' bankruptcy caused AIG to fail. I've only seen the argument from lawsuits used against the good bank/bad bank proposal.

I believe that's one of the reasons the CEO of AIG has given publically in congerssional hearings. I believe it's also the same reason used for why they paid employee bonuses. I also believe that this was at the behest of the Geithner.

The payouts are being investigated, so hopefully they're able to determine why they never renegotiated the value of the credit default swaps.

http://dealbook.blogs.nytimes.com/2009/04/07/inspector-to-audit-aigs-counterparty-payouts/?ref=business

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