[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 thatâ€™s survived for 89 years, was destroyed by some errant bets on a derivative security called a â€ścredit default swap,â€ť or CDS. Itâ€™s
a story youâ€™ll read nowhere else.]
By Shah Gilani
Thereâ€™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 Associationand the Bank for International Settlements (BIS), often referred to as the central banksâ€™ 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. Itâ€™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 â€“ 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 â€“ through the 40-year tenure of CEO Maurice R. â€śHankâ€ť Greenberg, which ended ignominiously for Greenberg in 2006 â€“ 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 AIGâ€™s books and credit default swaps. Once again, it appears that AIG tried to â€śmanageâ€ť the problem through accounting maneuvers. Last February, for instance, AIG said that â€śits auditor had found a material weakness in its accounting.â€ť 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 yearâ€™s first quarter. The SEC is once again investigating, as are criminal prosecutors at the U.S. Justice Department and the U.S. Attorneyâ€™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 & Poorâ€™s, Moodyâ€™s Investors Service (MCO) and Fitch Ratings Inc., lowered the firmâ€™s ratings last Monday evening, it triggered an additional $14 billion collateral call as margin against AIGâ€™s credit default swaps.
The company didnâ€™t have the cash.
Indeed, the dire need for cash collateral on top of mounting losses on warehoused CDO â€śassetsâ€ť on the companyâ€™s balance sheet necessitated a massive infusion of capital. Thatâ€™s what happened to AIG.
But once again, thereâ€™s the story â€“ and thereâ€™s the story behind the story.
Thereâ€™s a problem â€“ an inherently systemic problem â€“ 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.
Thatâ€™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.
Hereâ€™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, youâ€™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 canâ€™t calculate. So you value, or mark-to-market, against the closest index.
Hereâ€™s the rub. What if other speculators are selling short â€“ 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 canâ€™t sell because no one will buy it â€“ because no one knows what itâ€™s worth?
Itâ€™s crazy. And it gets worse.
What if youâ€™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: â€śSorry, but we canâ€™t lend you money because the market for credit default swaps thinks youâ€™re a bad bet.â€ť
You donâ€™t get the loan. You canâ€™t build your factory; you canâ€™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 AIGâ€™s debt and loans so furiously that based on the insurance premiums traders were actually paying for default insurance on AIGâ€¦ 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 â€śliquefyâ€ť 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?
[Editorâ€™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 Morningâ€™s readers with the â€śreal storyâ€ť 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 Streetâ€™s most-valuable secrets. By doing so, Gilani hopes to provide us with investment ideas with the biggest profit potential. If the whipsaw markets weâ€™re experiencing lead to the so-called market â€śSuper Crashâ€ť that many analysts fear, Money Morning readers will have much less to fear than most investors, since theyâ€™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. Schiffâ€™s New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse" - please click here.]
News and Related Story Links:
- Money Morning Special Investigation of the Credit Crisis (Part I):
Credit Default Swaps (CDS).
Money Morning News:
JPMorgan Raises Bear Stearns Bid.
Money Morning News Analysis:
Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds.
- Web Site:
SEC Press Release:
SEC Charges AIG with Securities Fraud.
Maurice R. â€śHankâ€ť Greenberg.
- Money Morning Market Analysis:
Money Morning Market Analysis:
Foreign Bondholders â€“ and not the U.S. Mortgage Market â€“ Drove the Fannie/Freddie Bailout.
- Wikipedia: Collateralized Debt Obligations.
- The Business Spectator:
- Web Site:
The Alphabet Soup Of Credit Derivative Indexes.
- Wikipedia :
- Money Morning News: