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[In Part II of his three-story investigation of the credit crisis,Money Morning Contributing Editor Shah Gilani shows us how American International Group, a perfectly sound company that’s survived for 89 years, was destroyed by some errant bets on a derivative security called a “credit default swap,” or CDS. It’s
a story you’ll read nowhere else.]
By Shah Gilani
Contributing Editor
There’s nothing fundamentally wrong with the core insurance business units of American International Group Inc. (AIG). Nothing at all. What imploded the venerable insurance giant was an accumulation of misplaced bets on credit default swaps.
By the best estimates of the International Swaps and Derivatives Association and the Bank for International Settlements (BIS), often referred to as the central banks’ central bank, the notional value of credit default swaps out in the market place is some $62 trillion, or 35 trillion British Pounds at an exchange rate of $1.78.
A credit default swap (CDS) is akin to an insurance policy. It’s a financial derivative that a debt holder can use to hedge against the default by a debtor corporation of sovereign. But a CDS can also be used to speculate.
A subsidiary of AIG wrote insurance in the form of credit default swaps, meaning it offered buyers insurance protection against losses on debts and loans of borrowers, to the tune of $447 billion. But the mix was toxic. They also sold insurance on esoteric asset-backed security pools – securities like collateralized debt obligations (CDOs), pools of subprime mortgages, pools of Alt-A mortgages, prime mortgage pools and collateralized loan obligations. The subsidiary collected a lot of premium income and its earnings were robust.
When the housing market collapsed, imploding home prices resulted in precipitously rising foreclosures. The mortgage pools AIG insured began to fall in value. Additionally, the credit crisis began to take its toll on leveraged loans and it saw mounting losses on the loan pools it had insured. In 2007, the company was starting to feel serious heat.
From its humble beginnings in China in 1919 – through the 40-year tenure of CEO Maurice R. “Hank” Greenberg, which ended ignominiously for Greenberg in 2006 – AIG grew aggressively. Greenberg grew and diversified the insurance giant, ultimately amassing a trillion-dollar balance sheet.
But not everything was Kosher.
In an effort to assuage analysts and maintain leverage, the firm entered into sham transactions to affect the appearance on its balance sheet of $500 million of loan-loss reserves, which analysts had been questioning as formerly declining. The result was a 2006 Securities and Exchange Commission enforcement action, a $1.6 billion settlement and the removal of Greenberg. Greenberg is still fighting civil charges related to his actions at the firm.
As 2007 progressed, so did the losses on AIG’s books and credit default swaps. Once again, it appears that AIG tried to “manage” the problem through accounting maneuvers. Last February, for instance, AIG said that “its auditor had found a material weakness in its accounting.” It had not been properly valuing its CDO liabilities and swap-related write-downs. The losses were revealed to be in excess of $20 billion through this year’s first quarter. The SEC is once again investigating, as are criminal prosecutors at the U.S. Justice Department and the U.S. Attorney’s Office in Brooklyn.
After writing down assets against gains elsewhere, AIG posted cumulative losses of $18 billion over the last three quarters. In February, AIG posted $5.3 billion in collateral against credit default swap contracts it had written. In April, AIG had to post an additional $4.4 billion in collateral. When rating agencies Standard & Poor’s, Moody’s Investors Service (MCO) and Fitch Ratings Inc., lowered the firm’s ratings last Monday evening, it triggered an additional $14 billion collateral call as margin against AIG’s credit default swaps.
The company didn’t have the cash.
Indeed, the dire need for cash collateral on top of mounting losses on warehoused CDO “assets” on the company’s balance sheet necessitated a massive infusion of capital. That’s what happened to AIG.
But once again, there’s the story – and there’s the story behind the story.
There’s a problem – an inherently systemic problem – and it has to do with how structured investments like tranched collateralized debt obligations (CDOs), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and credit default swaps on them and on corporate debts and loans are actually valued.
Individually, CDOs are hard to value. Suffice it to say, legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. (CRAY) supercomputer 48 hours. Now try and value credit default swaps on them!
Because there are so many different individual CDO securities, and because there are so many credit default swaps on so many of these CDOs, and so many swaps on individually referenced entity debts and loans, the only way to value them in a portfolio is by indexing.
That’s right, there are indexes, and guess what? You can trade the indexes! Markit Group Ltd., of London, constructs and manages the CDX, ABX, CMBX and LCDX family of credit-default-swap indexes. Investopedia has a decent little tutorial.
Here’s the problem: If you own a portfolio of CDOs, and the only way to value them (or, at least, to develop a valuation that others are reasonably certain to respect), is by looking at them through the prism of an index of credit default swaps on them, you’re at the mercy of the index. Your portfolio, your securities may not be so bad, but you may not really know based on mortgage-duration analysis and foreclosure events that you can’t calculate. So you value, or mark-to-market, against the closest index.
Here’s the rub. What if other speculators are selling short – that is, betting in anticipation of that index going down? What if large portfolio-hedgers are selling short the index to hedge the portfolio they can’t sell because no one will buy it – because no one knows what it’s worth?
It’s crazy. And it gets worse.
What if you’re running a profitable company that needs to borrow money, but credit default swaps (bets against your ability to pay back your debt) are expensive by virtue of speculators fear and greed, such that if any bank looks at where the CDS pricing on your paper is trading, they tell you: “Sorry, but we can’t lend you money because the market for credit default swaps thinks you’re a bad bet.”
You don’t get the loan. You can’t build your factory; you can’t produce and have nothing to sell. The upshot: Now you actually are going out of business. Is this self-fulfilling?
Ponder this: Last Monday, as AIG was initially seeking $20 billion in capital and actually had it in hand (by virtue of a deal with New York insurance regulators), traders were bidding up credit default swaps on AIG’s debt and loans so furiously that based on the insurance premiums traders were actually paying for default insurance on AIG… the company was already dead. Self-fulfilling?
Credit default swaps are creating a downward spiral in the capital markets, driving up the cost of capital, and squeezing out all manner of borrowers. And these speculative bets run amok are undermining all U.S. Federal Reserve and U.S. Treasury Department efforts to “liquefy” the system. If this keeps up, the credit default market could sink the U.S. economy into a recession/depression that will make the Great Depression look like a day at the beach.
Anyone got a towel?
[Editor’s Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In this special three-part investigation, Gilani draws upon the experiences and network of contacts developed from his time as a professional trader and hedge-fund manager to provide Money Morning’s readers with the “real story” of the credit crisis. Part I appeared Friday. Part III appears tomorrow (Tuesday). In his new column, "Inside Wall Street," Gilani promises to use similar insights to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and to conduct us past the "velvet rope" that guards Wall Street’s most-valuable secrets. By doing so, Gilani hopes to provide us with investment ideas with the biggest profit potential. If the whipsaw markets we’re experiencing lead to the so-called market “Super Crash” that many analysts fear, Money Morning readers will have much less to fear than most investors, since they’ll be able to capitalize on the once-in-a-lifetime profit plays that we detail in a new report. For a copy of that report - which includes a free copy of CNBC analyst Peter D. Schiff’s New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse" - please click here.]
News and Related Story Links:
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Money Morning Special Investigation of the Credit Crisis (Part I):
The Real Reason for the Global Financial Crisis…the Story No One’s Talking About.
- BIS.org:
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Wikipedia:
Credit Default Swaps (CDS). -
Money Morning News:
JPMorgan Raises Bear Stearns Bid. - Wikipedia:
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Money Morning News Analysis:
Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds. -
Wikipedia:
Mortgage-Backed Securities. - Web Site:
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SEC Press Release:
SEC Charges AIG with Securities Fraud. -
Wikipedia:
Maurice R. “Hank” Greenberg. - Money Morning Market Analysis:
- Wikipedia:
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Money Morning Market Analysis:
Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout. - Wikipedia:
- Wikipedia: Collateralized Debt Obligations.
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Wikipedia:
Alt-A mortgages. - The Business Spectator:
- Web Site:
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Investopedia:
The Alphabet Soup Of Credit Derivative Indexes. - Wikipedia:
- Investopedia:
- Wikipedia :
- Investopedia:
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Money Morning News:
Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds
Tags: Shah Gilani
Thanks goodness I am European and can leave any day. As a retiree I get 95 % of my social security from Europe and I do not need to worry for myself. My wife is a US citizen, though, and as a nurse has a bulletproof job. Nevertheless inflation is getting us. The housing bubble made my taxes increase 400 % without any more or better service for me. This greed on the local, state, and federal level plus the unlimited greed of business people and private citizens alike is what is putting this country in. And guess what? I appreciate the fact that many of the wrongdoers will have to foot the bill. It's time to pay the piper!
Tha arrogance of the US people (best country in the world) is going to be cut down. Hopefully to the point that US people become somewhat humble.
The Puritans seemed to have the right recipe. But their luck was to be in the right place at the right time. The native population left the land intact so that the puritans could rob it and use the resources to make them look good. But the resources are gone, the country is polluted, exhausted, abused. But god will provide and so they go to church to cover up their sins.
Remember Karl Marx on capitalism? The capitalists will sell us the rope we will use to hang them. OK, the communists failed miserably but that is no reason to cheer. The problem is still there. The US has more socialist features than any other capitalistic country I know of. Look at Medicare. A gargantuan waste of money. In Germany we keep our insurance we had when we were working and the government has little financial responsibilty.
The banking system in Europe is supervised much better than the one in the US. The European commision has a person in charge for consumer affairs so that there is a somewhat level playing field. But the Republicans with their stated ideology of "small government" are not interested in small government for the benefit of all but for the benefit of the obscure businesses and their obscure business practices. Who ever came up with the lax practice of "creative" accounting?
Why is it that business people (including CEOs, CFOs, and all other kinds of "officers" rake in billions, run the businesses into the ground and still collect big money instead of rotting in prison?
Like they say: "each country has the government ist deserves". The same is true for the press and the business leaders. Xo, please don't blame dark forces. Blame Bush and his government. The CEO of the US was sleeping at the helm, to busy fighting the wrong war in wroing place against the wrong people. Senators Clinton and McCain cheered all the way. The rest of the world was in awe about the stupidity of the US government and now watches the idiots go under. They do not see a need to help. If you had been alienated by someone you would need to be a great person to forgive and help. But then again, the rest of the world waits for this presidency to be over and get a new start. But that only works with a new face, not the Bush clone.
As you see, to me the whole thing is political and not technical. Unless a new moral position gets hold of the country in which profit is not the only goal there will be no return. Greed did it and only a farewell to greed can repair the damage.
Sincerely (and thanks for the great article),
Joaachim
Born in 1926 I was three years old when Wall Street laid an egg in October of 1929. For the past twenty years I have been absolutely confident that we are on track to surpass the Great Depression in every imaginable way. As a veteran of WWII it has been plain to me that the world has been losing its grip on reality for the past sixty-years as we won the war to save the world of 1940…but could do nothing to prevent subsequent generations, who devalue the experience of their elders, from making a new world based on their hopeful illusions…a world that was divorced from reality, until now… we are about to experience the New Depression…which will truly make our 1929 model look pitifully obsolete. The effects about to commence are beyond imagining, as well as the satisfactions of "I told you so". The real world still exists…in spite of our denigration of it. Those who have been predicting disaster will have the doubtful pleasure of saying "I told you so" but enjoy…even the price of connection to the internet may soon be beyond us.
[...] The Credit Crisis and the Real Story Behind the Collapse of AIG [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] AIG agreed to sell a 79.9% stake in itself to the federal government in return for a two-year loan for $85 billion. The government agreed to extend the credit line after the U.S. Federal Reserve said the collapse of AIG would seriously disrupt the U.S. financial markets. [Money Morning investigative report detailing just why AIG collapsed]. [...]
[...] I said in Part II of this investigative series, CDOs – on an individual basis – are difficult to value. Indeed, "legend has it that [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] all these securities, and in the case of credit default swaps, bilateral contracts, are impossible to value and impossible to guarantee, no one trusts them. As a result, everyone is afraid of these [...]
[...] can find each part of Gilani's investigative series here: Part I, Part II and Part III. To get a free copy of "Crash Proof" courtesy of Money Morning, and learn [...]
[...] that you'll find nowhere else. If you missed Gilani's investigative series, Part I appeared Friday, Part II ran Monday and Part III was published Wednesday. In his “Open Letter to U.S. Treasury Secretary Henry M. [...]
[...] that you'll find nowhere else. If you missed Gilani's investigative series, Part I appeared Friday, Part II ran Monday and Part III was published Wednesday. In his “Open Letter to U.S. Treasury Secretary Henry M. [...]
[...] all these securities, and in the case of credit default swaps, bilateral contracts, are impossible to value and impossible to guarantee, no one trusts them. As a result, everyone is afraid of these [...]
[...] you'll find nowhere else. If you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani's plan was published on Sept. 25 as an open letter to [...]
[...] AIG agreed to sell a 79.9% stake in itself to the federal government in return for a two-year loan for $85 billion. The government agreed to extend the credit line after the U.S. Federal Reserve said the collapse of AIG would seriously disrupt the U.S. financial markets. [Money Morning investigative report detailing just why AIG collapsed]. [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] the independence of exposure units found in most insurance products. A second article (see here) provides some background on accounting issues and asset valuation. Other articles may also be [...]
[...] you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open [...]
[...] you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open [...]
[...] By Shah Gilani Money Morning [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] can find each part of Gilani's investigative series here: Part I, Part II and Part III. To get a free copy of "Crash Proof" courtesy of Money Morning, and learn [...]
[...] was bailed out to the tune of $80 billion, because it had margin calls on CDS contracts it wrote. Do you know why they now need an additional [...]
[...] I said in Part II of this investigative series, CDOs – on an individual basis – are difficult to value. Indeed, "legend has it that [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] was bailed out to the tune of $80 billion, because it had margin calls on CDS contracts it wrote. Do you know why they now need an additional [...]
[...] all these securities, and in the case of credit default swaps, bilateral contracts, are impossible to value and impossible to guarantee, no one trusts them. As a result, everyone is afraid of these [...]
[...] (FRE), but there's no question that perverse management incentives in the financial sector, unsound new financial tools and sloppy regulation also played important [...]
[...] (FRE), but there’s no question that perverse management incentives in the financial sector, unsound new financial tools and sloppy regulation also played important [...]
[...] business in which London specialized are in most trouble. Securitization and derivatives were the two immediate causes of the credit crisis, while the 50% declines in the emerging-market stock markets have made the exorbitant fees of the [...]
Neither President Usurper, nor any other bureaurat, is even thinking about mentioning the real underlying cause of all this financial trouble. And what, you say, is that? Well, banksters were loaning out money with no consideration of how much they actually had. Then along came the Great Depression. People were actually angry, and demanded the banksters be held accountable for their counterfeiting/thefts. So the bureaurats 'limited' them to only counterfeiting 900% of what they actually had in the vault. About what they already were doing, anyway. So after the depression, the banksters went to town replicating the same crimes that caused that depression. Plus, they added some new lies and fictions, like CDOs. Get it right, they are robbing us thru 'marginal banking/counterfeiting' and are getting away with it because they bribe the politicians, using PACs. They both belong in prison, right along side their accomplices the lawyers who enabled them with their 'prevarications'.
[...] business in which London specialized are in most trouble. Securitization and derivatives were the two immediate causes of the credit crisis, while the 50% declines in the emerging-market stock markets have made the exorbitant fees of the [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] acquired an 80% stake in AIG last year when it twice intervened to keep the company afloat. The government first stepped in with $85 billion in September. But authorities were forced to bailout AIG again in November after the company posted a $24.5 [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open [...]
[...] Money Morning Special Investigation of the Credit Crisis (Part II): The Credit Crisis and the Real Story Behind the Collapse of AIG. [...]
[...] International Group Inc. (NYSE: AIG). In that case, the government injected $180 billion into AIG, largely to allow it to make good on the CDS contracts it had written – $13 billion of which were with Goldman [...]
[...] believes the credit bears who targeted the CDS of companies in the spring have moved to U.S. CDS to try to get a rout rolling. Credit products are a relatively inexpensive market to try and manipulate, so this is certainly [...]
[...] also have the financial firepower to accelerate the process, which is precisely what appears to have happened with insurance giant American International Group Inc. (NYSE: AIG), Lehman Brothers Holdings Inc. (OTC: LEHMQ), and a whole host of other institutions [...]
[...] also have the financial firepower to accelerate the process, which is precisely what appears to have happened with insurance giant American International Group Inc. (NYSE: AIG), Lehman Brothers Holdings Inc. (OTC: LEHMQ), and a whole host of other institutions [...]
[...] Bros. Holdings Inc. (OTC: LEHMQ) collapsed, American International Group Inc. (NYSE: AIG) was torpedoed by its credit-default-swap (CDS) business, and mortgage giants Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FNM) imploded. The index kept [...]