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AIG: Anger Over Bonuses and a More Deserving Reason for Outrage

03-21-2009

I am intruiged by the sudden outrage at AIG over bonuses. It is funny because Obama and his treasury secretary, Geithner, knew about the bonuses long ago. In fact, they requested that AIG's right to award bonuses be protected, but then renounced bonuses when they became public and touched off a firestorm of public outcry over bailout tax dollars being spent to "reward" executives who were complicit in running the banking industry into the ground.

This is simply a case of Obama trying to blend in with and exploit the torch-and-pitchforks crowd rather than stand in front of it - which is the position merited by his pattern of complicity with AIG and the many government policies that led to the current banking industry collapse.

As a senator, Obama was the second largest recipient of AIG campaign donations after Chris Dodd. He took funds from them even as they were selling insurance policies to banks selling subprime loans -- policies they knew they could not cover, but which served the purpose of giving banks the figleaf of propriety they needed to keep making bad loans. And then, when banks needed to call on those insurance policies, AIG couldn't deliver because they were basically just printing and selling get-out-of-jail-free cards.

In short, AIG was crooked, but not because of bonuses. They were basically selling financial instruments of dubious merit that let banks, at the behest of the FedGov, Chris Dodds, Bawney Fwank et al, make loans to people would were high credit risks, approving applications whose details they did not bother to verify, on houses appraised higher than their actual value. It was part of the Democrat "housing for everybody" scheme that was doomed to implode, but not before buying its proponents, famous already for spending other peoples' money, a few more votes.

And now honest hard-working people, who scrimped and saved for their homes, who have never missed a payment, are being asked by Obama to bail out people who imprudently took out larger loans than they could afford. This, not bonuses, is the real injustice of the AIG mess. AIG was doomed by the "loans-for-credit-risks" policy mandated the Democrats, the foxes guarding the henhouses of Fannie and Freddie Mac, and the lax financial oversight fostered by the Clinton and Bush administrations, and more importantly some key Congressional enablers, in order to ride this economic bubble of good feeling but bad numbers as long as they could.

See below for some information on the AIG implosion and its relation to the housing bubble collapse.

http://www.dailywealth.com/archive/2008/oct/2008_oct_04.asp

Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.

Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.

So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.

"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.

Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.

Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.

It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.

Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.

[....] Without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.

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