Bailout Money Used to Pay off Gamblers in Credit Defaults

[Joanne98]

In the final push to the election, the New York Times asked what on earth AIG is doing with all the money: $90 bn and counting. The short answer: it’s giving the money to counterparties to credit default swaps as additional collateral for potential losses. AIG apparently has a portfolio of $447 bn in swaps. And who are those counterparties who are getting our bailout money? AIG won’t say, and neither will the Treasury, if it even knows.

Warren Buffet famously called derivatives, which include swaps, the neutron bomb of financial instruments, having the potential to destroy the financial system, presumably leaving the buildings and some of the people standing. It looks like one of the groups getting neutroned is us taxpayers.

Swaps and other derivatives aren’t just hurting AIG. Many of our large industrial companies, pension funds, and financial institutions are players in this enormous market. It isn’t easy to guess what the positions of players might be. For example, AIG successfully concealed the extent of its exposure in the face of complaints about its accounting by its auditor. Other companies estimate their exposure using computer modeling, which may or may not be accurate in these troubled times. In the absence of clarity, lenders are reluctant to lend, even to other financial institutions, because no one can be sure who is strong enough to pay its debt. And, since lenders don’t really know the extent of their own exposure, the conservative course is to hold cash so they can pay off when demand is made. These are two of the contributing factors in the credit crunch. The bailout of AIG hasn’t contributed to any easing of that problem.

One kind of swap, the credit default swap, is a major problem. This chart shows the growth in CDS in the US alone. They are a special problem for AIG. The June 30 financial statements of AIG show an unrealized loss of $5.565 bn on one group of credit default swaps. Wikipedia has a good introduction to credit default swaps here. Consider the following example:

As an example, imagine that an investor buys a CDS from ABC Bank, where the reference entity is XYZ Corp. The investor will make regular payments to ABC Bank, and if XYZ Corp defaults on its debt (i.e., it does not repay it), the investor will receive a one-off payment from ABC Bank and the CDS contract is terminated. If the investor actually owns XYZ Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing XYZ Corp debt, without actually owning any XYZ Corp debt. This is done for speculative purposes, betting against the solvency of XYZ Corp in a gamble to make money if it fails.

Just for fun, put Lehman Bros in place of XYZ Corp., and AIG in place of ABC Bank in the example. When Lehman Bros. filed bankruptcy, it had $155 bn in debt, but the notional value of the CDS related to its debt was $400 bn. Obviously, not everyone who bought protection against the failure of Lehman actually held its debt. They were speculating that it would fail.

Suppose I held a CDS from AIG that would pay off if Lehman failed. I would have a real incentive to see Lehman fail. I might even engage in short-selling in an effort to cause that failure. Of course, there is no evidence that anyone did that. But there are at least two things that might make a competent regulator/investigator ask questions. First, the regulations that restricted short-selling were substantially repealed. The last of these, the up-tick rule, was repealed in 2007 by the SEC. This rule was put in place in 1938, for the express purpose of preventing a bear raid, an attack on a company, designed to weaken or destroy it. Second, in the immediate aftermath of the collapse of Lehman Bros., the SEC imposed a ban on short-selling of financial stocks.

Taking all this together, it appears that by bailing out AIG, us taxpayers are making sure that a bunch of gamblers are going to get paid off on bets against the solvency of a whole lot of companies. How much is gambled on GM and Ford debt? If they tank, who is on the hook for the credit protection?

We don’t even know who is getting this payoff, but it would be irresponsible not to speculate. I’m betting that a large number of them are hedge funds, the piggybanks of rich people, constantly in search of income from sure things rather than taking unnecessary risks investing in a business or a new technology. Socialism for the rich, maybe?

http://oxdown.firedoglake.com/diary/1752

[Frustratedlady]

1. Is the general idea to get yourself so far in debt, the government has to bail you out?

Can we do that?

It is criminal that they are allowed to beg and take our money to ease their heartburn, but they give us heartburn because they won't tell us how they got into trouble and with whom?

I say shut off the flow until we get some answers. It's like having a happy-go-broke kid on your hands.