When Banks Don’t Compete or Tell Anyone What They’re Doing, They Win. We Lose.

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So, remember how one bank after another announced massive profits earlier this year? It seems they were going out of their way to explain to the public how sound their businesses were. In fact, their profits had much to do with how much money they received from AIG-Financial Products, which, if you’ve been under a rock the last six months, is 80% owned and capitalized by you, the American Taxpayer.

A simple explanation of how the banks made money, but one that omits a lot of complexity in favor of being easy to understand: (seriously, disclaimer, this is very simplified)

Say you are a bank. Your have issued one mortgage, for $600,000 on a home one of your customers bought. Except now the home is now worth $250,000. You’re pissed! That guy is never going to pay for the whole mortgage, so you’ll end up stuck with a house that’s worth a lot less money than you thought it would be. Argh! But wait, banker, someone wants to buy your bad mortgage! It’s the government! They’re going to give you the full $600,000 for it, and take the loan off your books! Phew! You thought you’d lose a ton of money, but now it’s like the meltdown never happened!

The government is actually, of course, AIG-Financial Products. AIG-FP doesn’t have the money–they went broke a while back. But the government gave them the money to make these deals. Oh, not only that, said the government. According to the CEO of AIG testimony to Congress, AIG had to give your bank the full $600,000. Despite the fact that the only other offer you had on the mortgage was for, oh, $250,000.

One thing– the homeowner still owes the full $600,000 on that mortgage, even though your bank has been made whole. The homeowners is just as unlikely to pay it as they were before. But hey, at least the bank’s ok! The homeowner? She’ll figure something out. (Or maybe she won’t. Perhaps that’s why foreclosure rates, which have been going sky high over the past few years, just hit a new record high last month?)

So while banks are publicly claiming they don’t need TARP funds and are eager to return them, they were more than happy to accept a price for their toxic assets that is out of whack with all reality. Well sure! Why would any bank accept TARP funds and all their crazy restrictions if they could get their hands on taxpayer bailout money via AIG?! This “backdoor bailout” happened earlier this year, but the revelation to Congress this week that the Federal Reserve dictated that banks should receive full prices for toxic assets (again, I’m simplifying for impact) rather than be grateful they got any money at all, was a little shocking.

As the government has been so willing to prop up banks that by any measure would otherwise be insolvent, it’s galling that despite a mortgage modification program for homeowners, many, far too many, are still on the hook for these crazy loans. If the government is going to forgive bad decisions, it should do so across the board, not just for Citibank and Bank of America.

In two months of giving banks this sweetheart deal, AIG unwound about $1.1 trillion in obligations. This trillion is “notional” in that it’s not the actual amount of money changing hands, but the amount of protection (insurance) taken out by banks on their toxic assets. So by, in effect, canceling the insurance it gave to banks, AIG got out a potential $1.1 trillion liability. (That sounds like a good thing, but the only way AIG would’ve owed that much money is if every mortgage it insured was suddenly worth zero. So what really matters is that this $1.1 trillion hole was big enough to pass a few billion to the banks without anyone asking too many questions.) And it’s weird this program seems to have been dictated by the Federal Reserve, actually a sort of government corporation, one whose makeup did not significantly change with Obama’s Inauguration, unlike the Treasury Department’s.

AIG has slowed down its “unwinding” as of late. In March, they only unwound $100 billion worth of overpriced toxic assets. No one is sure why this slow down happened though, even though Congress asked Liddy. He wouldn’t tell them, because AIG has a secret plan, “Project Destiny.” According to CEO Ed Liddy, the secret plan will make AIG “go away,” down the road.

AIG going away sounds really great, but I hate when secret plans sound like they were named by a Bond villain, especially when the government owns 80% of the company that hatched the secret plan. It’s not good for integrity or openness, two things we value in our system of capitalism democracy.

This is just one dispatch from the chaos that is (still) happening in the financial markets. It’s going to be interesting to watch how, or whether, Congress and the Obama Administration are going to provide the transparency in government that Obama campaigned on in the election. So far, at least in matters financial, both branches of government could be doing far better in that regard.

Read Zero Hedge for theories about AIG’s latest moves: Zero Hedge: AIG CDS Unwind Goes From Waterfall To A Trickle.