AIG shareholders and Hank Greenberg have their day in court tomorrow. Gretchen Morgenson of The New York Times writes a summary here: “Court Casts a New Light On a Bailout.” Ms. Morgenson writes:
“In spite of this punishment, A.I.G. repaid the loan in January 2011. I am not arguing that A.I.G. was an innocent in the economic debacle of 2008. But unlike its trading partners, it neither created garbage mortgage securities nor peddled them to unsuspecting investors. Its error — a whopper for sure — was not recognizing that it was the patsy at the poker table when it insured those troubled securities. Which brings us back to Judge Wheeler’s question: Why did the government do what it did in the A.I.G. deal?”
No, AIG did not create the garbage, but please Ms. Morgenson, they certainly weren’t anybody’s “patsy.” They created fraudulent financial contracts allowing the banks to continue to package the garbage. They took in significant income on trillions of dollars of speculative contracts, without the financial capacity to back them up. These were not insurance contracts. These were pure speculative contracts that caused, in part, the collapse of the financial system.
Speculator vs “Underwriter”
To even imply that AIG was the innocent “underwriter” is pure folly. They were not an “underwriter”. They were a speculator in an OTC market that did not require consistent, timely and believable daily mark to market. It just so happened AIG was also an insurance company, but that has nothing to do with the price of eggs.
1. These were not insurance contracts. These were financial contracts, swap contracts, under ISDA Master Agreements. To enter into a financial contract, without adequate capital to back up the contract, is fraud. Every homeowner knows that and is well aware if they lie on their financial statement, and cannot make good on their financial commitment, they will be prosecuted and serve jail time.
2. AIG’s head of products, Mr. Cassano, had a background in trading interest rate swaps, his role previous to head of AIG’s financial products unit. He knew full well the nature of swap contracts and that traditionally in the “interbank” market for strong credits, collateral was not necessary, such as on a regulated futures exchange, where one marks to market daily.
3. AIG bet the bank with speculative contracts on garbage (and its traders and AIG profited handsomely), without capital to back up their speculative bets. These were not insurance contracts. AIG made speculative OTC derivative bets on the mortgage market in the interbank swap market. The bets were made without adequate capital to honor them, if the market moved even 5%. We all know markets do move, sometimes irrationally and it is up to the trader to know how much capital to reserve given market movements.
Was AIG really not monitoring the underlying market? Please, there were plenty of press reports, even from their Board Member, Harvard Economist, Martin Feldstein, predicting the collapse of the mortgage markets at Jackson Hole in 2007. If they were a patsy, why didn’t AIG’s Board take action for their outsized positions on “garbage” in 2007?
Why did they leave it to the taxpayer and the bust of the financial system and the economy to unwind these contracts if they were duped? Why didn’t they go after Goldman Sachs in 2007 for duping them into writing trillions of dollars of contracts on “garbage.” Why didn’t they take action and demand Goldman go pound sand and not give them any additional collateral in 2007/2008, on the garbage that Goldman asked them to “insure”, if they really believed they had been duped by Goldman. AIG knew full well they were simply speculating on the direction of the housing market and took in income to do so.
Why did AIG, Martin Feldstein, Hank Paulson and Timothy Geithner let these “patsy contracts” bring down the entire financial system? Yes, the financial contracts were based on fraud, on the part of both AIG — taking in income through speculating without adequate capital and— by Goldman Sachs (and other AIG counter parties) by entering into financial contracts with AIG knowing full well they did not have the capital to back them up.
4. Counterparties to any type of swap–currency, interest rate, credit–all know one must continuously monitor the balance sheet and financial capacity of both the counterparty and the risk of the underlying instrument traded.
Post Dodd-Frank, the question remains who should have been and who should be allowed to “make markets” in over-the-counter derivative markets. As this Wikipedia entry explains on the interbank FX market, which is no different than the interest rate or credit default swap market, it has traditionally been the commercial banks that have made the markets in over-the-counter swaps and currencies.
Should AIG have been playing in this market? Should hedge funds? What is the role for commercial banks in making markets for OTC swaps and currencies? Who should be part of the “club” in OTC markets? Perhaps AIG should have been punished for speculating in a market that was the “realm” of commercial banks. They could have hedged their outsize bets, but chose not to. It would have reduced their speculative income and reduced the bonus payouts. It is just that simple.
Commercial banks and investment banks, like Goldman Sachs, should have been punished for disregarding the financial capacity and underlying market risks of their counter parties. They created the house of cards and forced the taxpayer to clean up the mess.
Who are Acceptable Counter parties in OTC Derivative Markets and the Role of Commercial Banks/Federal Reserve Bank
The AIG suit raises many questions that have yet to be answered since the 2008 financial crisis:
- Who can and should be participants in the traditionally interbank OTC market?
- Interbank markets were originally based on a hand-shake between commercial banks. Collateral was not necessary. Commercial banks traditionally “made the markets”. Commercial banks selected counter parties, such as AIG, that were not commercial banks and allowed them to “make markets”. Commercial banks breached the traditional interbank role to allow new non-commercial bank speculators simply to expand their speculative gravy train in the mortgage “junk”.
The answer to AIG’s suit seems clear. Commercial banks were complicit in allowing AIG to create fraudulent financial contracts, ISDA swap contracts, not insurance. AIG and Mr. Cassano were well aware these were in no way “insurance” contracts, they were speculative swap contracts. There is a traditional relationship between the Federal Reserve and commercial banks. The OCC monitors and reports quarterly on the outstanding OTC derivative contracts for commercial banks. AIG was treated differently because it is not a commercial bank. That accounts for the discrepancy in outcome by the Federal Reserve Bank. It is tough luck for AIG shareholders, but AIG was speculating in an inter-bank market, where they should not have been speculating.
Yet, that does not relieve the inside job crafted by Mr. Paulson and Mr. Geithner. AIG’s contracts were entered into fraudulently. AIG knew they did not have the capacity to back them up and Goldman, in selecting AIG as their counterparty, also knew AIG did not have the capacity to back them up given a 5% down movement in the markets, predicted by AIG’s Board Member, Harvard Economist Martin Feldstein in the summer of 2007.
As The Derivative Project testified in the Derivative Transparency Act of 2009, the House predecessor to Dodd-Frank, AIG and the commercial banks created fraudulent, speculative financial contracts, that should have been ripped up in Fall 2007. The payments to the commercial banks, AIG’s counter parties, by the Federal Reserve, using taxpayer dollars, were not legal, as they were payments under fraudulent contracts.
We agree with Mr. Greenberg, that commercial banks should have been prosecuted and penalized as strongly as AIG. However, what was AIG doing making markets, speculating, in an OTC interbank market, without hedging their bets and without being a commercial bank? Why did AIG enter into financial contracts without the capacity to honor them, which is, by definition, contract fraud? ….and Mr. Greenberg, we do not buy “the stupidity defense” when your own Board Member warned about the collapse of the market on which you had trillions of dollars of unhedged bets on.
The best outcome in the AIG suit is for the depositions to reveal the truth and transparency to the American public and allow both Republicans and Democrats to take charge with appropriate regulation of our commercial banking system, define more clearly who are the players in OTC derivative markets and restore its stature and trust which is currently now absent.
End users in both the interest rate and FX market must now play higher costs for bona-fide hedges to ensure collateral in these markets and the costs of new exchanges, SEF’s. It is a sub-optimal outcome for all parties, created by the lure of writing speculative credit default swaps without hedging one’s position. AIG took the lead as the counter-party to the commercial banks in exacerbating the mortgage casino—AIG could have hedged their speculative positions, they chose not to and their shareholders are paying the price. Mr. Greenberg is paying the price.
The real question of justice for Mr. Greenberg, is —-why is the homeowner who misstates his financial condition to a lender thrown in jail and major commercial banks and AIG allowed to misrepresent their financial condition and enter into fraudulent financial contracts, bringing the US financial system to near collapse, —-allowed to walk?
We all know no bank or insurance company was a “patsy” in the mortgage garbage mess. Harvard Economist Martin Feldstein made it clear in Jackson Hole in 2007, the only “patsy” was the young homeowner starting their American dream, forced to buy their family home at the peak, then personally losing their life savings in a market bubbled and burst, by the likes of AIG, mortgage lenders and commercial banks/investment banks that allowed the market to thrive through the credit default market, an interbank market once reserved for bona-fide hedges by end-users.
There are Too Many Unanswered Questions with AIG and Their Counter Parties to Let the History Book Close
Yes, we all want answers to Judge Wheeler’s question: “Why did the government do what it did in the A.I.G. deal?” and every taxpayer’s question: Why did the Department of Justice allow AIG the “stupidity defense” and not prosecute individuals, at both commercial banks and AIG, for blatant financial contract fraud that brought down the U.S. financial system?
It is not too late to rip up the fraudulent credit default swap contracts between AIG and its counter parties and return the billions to the U.S. taxpayer. Mr. Greenberg, that is what we call justice that truly matters to society overall, and worth the time and money to fight for.