If
you want to understand why AIG awarded derivative traders
in its Financial Products Group $165 million in bonuses,
don’t be distracted by the on-going morality play
staged by politicians about the misuse of Federal funds,
the blame-shifting game played by AIG executives, or even
the disingenuous hand-wringing about the sanctity of contracts.
The real decider here is money, specifically, $1.6 trillion
worth of volatile derivative contracts. This portfolio,
managed by some 400 people in a London-based subsidiary
, mainly consists of credit default swaps, interest rate
swaps, and other exotic hedging swaps that have the potential
of inflicting hundreds of billions of dollars of losses
on AIG– and, its de facto partner, the US tax payer.
How
did the world’s largest insurer become a hostage to
its subsidiary? In 1998, this tiny group got into the newly-created
credit default swap business when JP Morgan Chase came to
it with a proposition to transform debt on its books into
security packages that could be sold off its books. To make
these bank debt packages salable to other institution, they
needed credible insurance against default to get Triple-A
rating. So the AIG financial product group, seeing no risk
of default, sold it in the form of credit default swaps.
Soon afterwards, with the support of Treasury Secretary
Lawrence Summers (now President’s Obama’s economic
advisor), the Commodity Futures Modernization Act was passed,
which excluded credit default swaps from being considered
a "security" under the jurisdiction of the SEC
or any other government agency. This act allowed these swaps
to be deployed on a massive scale to convert all kinds of
debt, including even subprime mortgages and car loans, into
triple A securities and turned AIG’s arm, now headed
by Joseph J. Cassano, an aggressive Brooklyn-born alumni
of Drexel’s back office operations, into a multi-billion
dollar profit center for the insurance behemoth. Even though
the unit’s 400-odd man group constituted less than
one-third of one percent of AIG’s total employees,
it produced close to twenty percent of its total operating
profits. While Cassano kept the list of his counterparties
in the credit default swaps a closely held secret, he bragged
at a conference in 2007 that they included a global swath
of “investment banks, pension funds, endowments, foundations,
insurance companies, hedge funds, money managers, high-net-worth
individuals, municipalities and sovereigns and supranationals.”
One of his more complicated operations involved using a
subsidiary called Banque AIG to provide the largest banks
in France with custom-tailored swaps that effectively allowed
them to evade regulatory capital requirements on hundreds
of billions of debt on their books. By 2006, his group was
raking in nearly $4 billion in profits, and, as is the tradition
in the derivative game, he and his traders got a rich cut
of the loot, which on average amounted to roughly $440 million
(or about $1.1 million per employee)..
With the collapse in 2008 of the debt AIG was insuring,
came such massive losses that Cassano resigned, and AIG,
unable to post collateral, faced bankruptcy. At this point
in September 2008, the US government rescued AIG, pouring
in $173 billion of tax payers’ money. Even so, there
remained a $1.6 trillion in potential liabilities that could
be triggered by thousands of the credit default and other
derivative contracts. To prevent hundreds of billions of
losses, these custom-designed contracts, , many of which
would not expire until 2012, had to be continually watched,
and, if necessary hedged, by traders who understood each
one’s particular vulnerability.
.
To perform this critical task, key people in the group wanted
the same sort of guaranteed compensation in the form of
retention bonuses as had in their previous two year contracts.
The situation for AIG, and the US government that now owned
77 percent of it, was not unlike the one in Mario Puzo’s
Godfather in which an offer is made that cannot be refused.
In this case, even without a bloody horse head under the
blankets, AIG and its federal overseers could not risk falling
into a $1.6 trillion black hole by turning down the demands
of those in the financial product group. It was not that
they had such unique skills in derivative contracts that
they could not be replaced by other people since the managing
of these contracts is not overly complex. It is that they
knew a proprietary secret, to wit, AIG’s secret book,
which included the identities of all the counterparties
to the credit default swaps and the unhedged parts of the
positions vulnerable to price fluctuations. In addition,
replacing some of these operatives in the complex of arcane
subsidiaries it had set up technically constituted a change
of control and could trigger defaults. For example, as it
explained in a secret memo to the staff at the U.S. Treasury
in February 2009, just the resignation of two of its Banque
AIG executives, Mauro Gabriele and James Shephard, could
set in motion renegotiations, and possible defaults in $234
billion in its European derivative contracts with banks.
So even key people who had resigned, such as Cassano, were
kept on as consultants at fees of up to $1 million a month.
The implicit threat was that, if they were simply let go,
not only would it cause havoc with the status of the derivative
contracts but that traders would be in a position to use
the secrets to which they were privy to trade for others
against AIG as it attempted to protect the positions in
its $1.6 trillion dollar portfolio. Under these circumstances,
rather than risking immense losses from having its secret
book compromised, AIG paid to keep the key members of the
group from defecting. Their compensation, when approved
by the Fed and Treasury, would amount to about $500,000
per person a year ( less than half what they had been getting
in 2008.) The staff at the NY Fed, while Timothy Geithner
was still its head, in fact helped negotiate the terms for
these retention bonuses. When Geithner moved on to become
Treasury Secretary in January 2009, he presumably understood
how financially dangerous it could be to do otherwise, since
he intervened with the Senate Banking Committee Chairman
in February to get a provision dropped from a bill that
would have prevented AIG (and other recipients of federal
money) from paying such huge bonuses. In fairness to Geithner,
the alternative to making these pay-offs might have proven
a thousand times more costly to AIG, and its defacto owner,
the US Government. Washington, after all, is ruled by pragmatism,
and what difference is there between AIG paying $165 million
to the derivative traders who caused the havoc, and the
Fed rewarding the rating services that made possible the
proliferation of trillions of dollar of toxic debt with
$1.2 billion in fees to rate the new debt under its TALP
plan to restore the credit markets damaged by its old Triple
A rated toxic debt?
***
|