Saturday, February 28, 2009

Joe Nocera says that your blood should boil

More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin...Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet — and this is the part that should make your blood boil — the company is being kept alive precisely because it behaved so badly.

Joe Nocera explains this very lucidly in his NYT column.

The story is that A.I.G. traded on its reputation of being a well-run company, with an rare AAA credit rating, to convert all kinds of junk into AAA by backing it.

Jumping to the middle of the story:
The regulatory arbitrage was even seamier. A huge part of the company’s credit-default swap business was devised, quite simply, to allow banks to make their balance sheets look safer than they really were. Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements. The less risky the assets, obviously, the lower the regulatory capital requirement.

How did banks get their risk measures low? It certainly wasn’t by owning less risky assets. Instead, they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began.

At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do.

It’s not as if this was some Enron-esque secret, either. Everybody knew the capital requirements were being gamed, including the regulators. Indeed, A.I.G. openly labeled that part of the business as “regulatory capital.” That is how they, and their customers, thought of it.

There’s more, believe it or not. A.I.G. sold something called 2a-7 puts, which allowed money market funds to invest in risky bonds even though they are supposed to be holding only the safest commercial paper. How could they do this? A.I.G. agreed to buy back the bonds if they went bad. (Incredibly, the Securities and Exchange Commission went along with this.) A.I.G. had a securities lending program, in which it would lend securities to investors, like short-sellers, in return for cash collateral. What did it do with the money it received? Incredibly, it bought mortgage-backed securities. When the firms wanted their collateral back, it had sunk in value, thanks to A.I.G.’s foolish investment strategy. The practice has cost A.I.G. — oops, I mean American taxpayers — billions.

Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. Indeed, that may be the single most important reason it can’t let A.I.G. fail. If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful.

I asked Mr. Arvanitis, the former A.I.G. executive, if the company viewed what it had done during the bubble as a form of gaming the system. “Oh no,” he said, “they never thought of it as abuse. They thought of themselves as satisfying their customers.”

1 comment:

Anonymous said...

i wonder if the customers feel satisfied.