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Why Paulson Blinked on AIG

Image has not been found. URL: http://www.washingtonindependent.com/wp-content/uploads/2008/09/paulson.jpgSec. Henry Paulson (WDCpix)

After the extraordinary federal takeover of Fannie Mae and Freddie Mac on Sept. 6, Treasury Sec. Henry Paulson Jr., Washington’s* capo di tutti i capi* on the credit crisis, drew a line in the sand with Lehman Bros. and Merrill Lynch. That makes the sudden federal takeover of the giant insurer, AIG, all the more surprising -– especially since AIG isn’t even a bank.

After Fannie and Freddie, the total commitment of taxpayers’ money to various bailouts and rescue schemes was more than $2 trillion, without any visible slowing of Wall Street’s skid off the cliff.

When Lehman Bros. showed up with their begging bowl last weekend, therefore, Paulson summarily sent them off to bankruptcy court. Merrill Lynch would never have rushed into the shotgun merger with Bank of America if they believed there was still a rich uncle in Washington.


Illustration by: Matt Mahurin

So when AIG cheekily asked for a modest $40 billion (!) “bridge loan” on Monday, they were laughed out of the room. Undaunted, AIG was back in the afternoon to report that, er…, sorry, they really needed $75 billion. Once again, they were sent off with business cards of bankruptcy lawyers.

Surprisingly, then, at 9pm that same evening, the Federal Reserve Bank announced that AIG would be nationalized, and receive an $85-billion line of credit from the government. The stated reasons were the size of AIG, its 100,000 plus employees, the 30 countries it operated in, blah, blah, blah.

It was all smokescreen. AIG’s insurance subsidiaries, which comprise the lion’s share of its business, are separately capitalized and regulated. They’re almost all profitable, and would have been only incidentally affected by the bankruptcy of the parent. With a bankruptcy trustee in place, they would have been quickly sold off to other insurers, in the same way that Lehman’s profitable brokerage operations and its Neuberger-Berman asset management group have stayed open, and are in the process of being sold.

AIG’s problems all stem from one group, “Financial Products,” which invested heavily in the same toxic mortgages and takeover loans that have wreaked havoc throughout the financial sector. But Paulson’s change of heart was triggered by just one product, a “regulatory relief” swap, with a notional value of $300 billion — an amount that hardly raises an eyebrow in today’s high-rolling world.

But here’s why the regulatory relief swaps loomed so important. In 2005 and 2006, various European banks created CDOs, or tiered bonds, supported by residential mortgages and corporate takeover loans. The banks sold off the riskiest tiers of the CDO bonds, which stand first in line to absorb any losses from the bonds. The “super senior” CDO bonds that the banks retained on their books therefore seemed pretty safe.

For extra protection, the banks executed a swap transaction with AIG. The mechanics of the swap were that AIG sold a “put” on the CDOs to banks. The put gave the banks the right to sell their CDO holdings to AIG at a price near par. To make it easy for AIG, if the puts were exercised, the banks promised to lend AIG the cash for the purchases.

The deal was a near-sham transaction, a “regulatory arbitrage.” Regulators were skeptical of CDOs, and were increasing the amounts of capital banks had to assign to support them.

But if the banks had a guaranteed takeout from a high-rated insurer like AIG, regulators could treat the CDOs as if they were riskless instruments, minimizing the capital the banks needed to support them. The only purpose of the deal was to reduce the capital requirements of the European banks.

But no one expected that AIG might fail. And if they did, the puts would fail — since there would be no counterparty on the other side. Then the banks would have to mark their CDOs at their true value, at best probably 50 cents on the dollar. On $300 billion of CDOs, that’s a mark-down, or capital loss, of $150 billion.

The mark-downs would be booked as losses and subtracted from bank equity. At a stroke, the European banks would be in a mad scramble to raise more cash, and would be clamoring for emergency infusions from their own governments. The phone lines from Europe to Washington must have been buzzing — “Hank! You can’t let this happen!”

To Paulson’s credit, he made the bailout as unpleasant as possible. The debt will carry a junk interest rate of more than 11 percent; the federal government has first claim on all company assets, 80 percent ownership of AIG stock and effective management control.

Current shareholders will be wiped out, as the company will broken up and sold off as soon as possible. The puts will eventually fail — but at least the the Europeans will have more time to prepare.

The positive result of the debacle is that future claimants for Fed-Treasury relief will have to walk under the sign, “Abandon all hope, Ye who enter here.” The government will help you fend off the sharks, in other words — but only by turning you into fish food.

The negative is that the whole mess in the credit default swap market has been left unresolved. Credit default swaps, or “CDS” are guarantees of debt payment that are privately traded among big financial players. These are the derivatives that Warren Buffet called “financial weapons of mass destruction.”

Losing payoffs can be large: AIG’s loss on the European CDO put could have been $150 billion. Deal terms are often murky, an alarmingly high number of settlements end up in litigation, and “counterparty risk,” or the possibility that the party on the hook for a large payment doesn’t have the money, is quite high. Highly leveraged hedge funds, for example, are big players in the market since it requires little cash to take big positions.

Allowing AIG to go down would have forced a violent restructuring of the entire CDS mess. Officials have been pleading with the big players to clean up their acts for years. While there has been plenty of lip service, there has been little action. Meanwhile, outstanding volumes have grown from a notional value of $1 trillion in 2000 to $62 trillion at YE 2007, and could well be $90 or $100 trillion by the end of 2008.

Wall Street has little vested interest in a cleanup. For one thing, since most CDS trades are murky and individually tailored, the Street pulls in at least $10 billion in annual fees for matching buyers and sellers.

For another, it’s been an enormously effective tool for cowing the Feds. The only reason Bear Stearns wasn’t left to shrivel up in bankruptcy was that they were the counterparty in $2.5 trillion of CDS deals. The mantra, just as with AIG, was “Save us, or our CDS will trigger a global catastrophe” — not unlike a two-year falling on the floor and turning purple to get his way.

Paulson has turned into the star of the Bush administration. It’s hard to imagine how any other Treasury secretary, particularly one working for an uninvolved and lame duck president, could have performed any better.

Lancing the CDS tumor before he leaves office would ensure his legacy.

  • Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”*

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