Were AIG’s deals legal?
Institutional Risk Analyst Asks: Are AIG’s Credit Default Swaps Valid and Legal Contracts?
Wow. One of our readers sent us this yesterday from The Institutional Risk Analyst AIG: Before CDS There Was Reinsurance. I have to tell you I feel like an idiot. I never put two and two together like IRA does. Back when we first started this blog (December 2007), back when it was a green on black ALL CAPS start-up, I wrote a little parody on the defense strategy of General Reinsurance (Gen Re) former CEO Ronald Ferguson. Ferguson and some of his lieutenants were going on trial for illegal transactions that they did with AIG back in 2000-1. The transactions were sham reinsurance deals where AIG would reinsure risk on Gen Re’s books, Gen Re would pass money to AIG as a large”fee” for this reinsurance, which would go to inflate AIG’s reserves and then a secret “side letter” was written that essentially said AIG wouldn’t actually be on the hook for any of the risk they had reinsured (dizzy yet?). For this service AIG would pay Gen Re $5 million. These transactions were housed in the quaintly named “Loss Portfolio Transaction” Book.
via MonkeyBusinessBlog.
Eric Salzman over at Monkey Business posted this the other day. It contains an interesting theory about Joe Cassano’s CDS book at AIG. If there are such side letters or side emails, one hopes they would surface at some point.
In general this raised another question for me, however. It seems no one in government has even asked if these transactions were legal contracts. That has just been assumed every step of the way, and therefore a huge amount of bailout money has been committed to honoring these agreements. They probably were legal, but… stranger things have happened during this last year.
p.s. make sure you check out Salzman’s “Goldman Heroes” comic, which is very funny.
Post Your Comment
You must be logged in to post a comment
T/S Members
Log in with your True/Slant account.
I’ve read your pieces on this disaster. Great stuff. As far as legality, a good starting point would be top find out the percentage of the funds paid to out on bets that had no financial interest in the underlying transaction other than to see them fail.
I think if the number is big enough, it might make people want to dive in and see exactly what happened and what’s still on deck, not only at AIG , but other firms that sold and are still selling the swaps.
I doubt you’ll find an isolated incident either. Most of these scandals seem to spread as fast as someone figures it out and gets on Instant Messenger.
A potential side story that might lend the nightmare some levity; I’ve always wondered if Jimmy the Hacker- aged 12- got in the Bloomberg Terminals and took Citi’s 100 Million dollar swap premiums with him and his parents to Aruba.
“JTH Inc? Never heard of them. “
The question — Were AIG’s deals legal? — is more interesting than speculating that AIG’s CDS business was similar to prior illegal reinsurance deals. Credit Default Swaps are an insurance like product but they weren’t designed nor promoted by insurance company professionals. They are creatures(not creations because crap like this has been around for decades) of Wall St dicksters. And AIG was the patsy.
Isn’t it odd that no other large US insurance companies got snagged in the CDS vise? (AMBAC and MBIA did, but insuring bond obligations is their business — and it was perfectly legal for them to write CDS, stupid but legal.) It would have been illegal for one of AIG’s subsidiary insurance companies to issue CDS.
Most large insurers are skittish about pure financial guarantee insurance products and do as little of this as possible (and then almost always with 100% cash collateral). However, it is when a product is both a financial guarantee and a credit enhancement that makes it illegal for multi-line insurers doing business in the state of New York. CDS appear fit both of those criteria. My guess is that the Wall St. boys tried and failed to make the sale with many insurers — even Citigroup’s former subsidiary Traveler’s appears not to have fallen for it.
It may have been legal for a non-insurance subsidiary of AIG to issue CDS, but if so, could raiding the insurance companies to pay the CDS losses be legal? That in my mind was was one reason why AIG should have been taken into receivership.
Understand that nothing I’ve written addresses the question of whether the CDS contracts are legally enforceable. I wouldn’t be so quick to conclude that they are. When JPM Chase tried to enforce payment on surety bonds issued by a dozen insurance companies on behalf of Enron, a huge legal battle ensued. The insurers did guarantee payment to Chase if Enron failed to deliver on a contract, but the contract was a disguised loan. (Split settlement on this.)
Until outside parties can take a look at these CDS contracts, it’s anyone’s guess if they are inherently enforceable. If they are, then there is the question of how the claims are resolved. My guess is that the original Paulson TARP plan to buy the toxic assets was the transaction needed to establish the loss and therefore, the claim amount under the CDS coverage. Probably nixed when someone pointed out that Treasury would be paying 100% for all toxic assets backed up with an AIG CDS.
I think the government should have voided all the naked swaps; this could have been done simply by declaring them a form of unlicensed gambling, which it essentially was. If neither party in a credit default swap had any fiduciary or tangible connection to the asset being insured, that’s not insurance, it’s betting. One side is betting the value will hold and the other side wouldn’t.
Naked swaps are like seeing your neighbor buy his kid a muscle car for his 16th birthday and taking out your own comprehensive insurance policy on the car because you think it’s too much car for the kid’s lack of experience and skill. The CDS market is like everybody else in your neighborhood doing the same thing, until a $25,000 asset is rolling around the streets with a $45 million insurance burden–with all policies held by a single company with nowhere near the assets to cover them if the kid wrecks the car. When you throw short sellers into this mix, you have some of your neighbors buying the kid bottles of Mad Dog before his Friday night date.
With real insurance that wouldn’t be legal. If you were caught at the downtown bookie placing a bet that the kid would wreck the car that wouldn’t be legal. Why in the hell should naked swaps be legal? There is more money represented in the CDS obligations than will exist in the world for the next 400 years or more, how can this possibly be legal? It’s insane.