Where's the AIG 'Smoking Gun' Memo on Default Swaps?

A decade ago the Federal Reserve came to the rescue of Long-Term Capital Management, a gargantuan private hedge fund founded and managed by former Salomon Brothers trader John Meriwether. Even though LTCM wasn't a depository (or even a securities firm) Uncle Sam stepped in to calm the markets.

Over the past few months as talking heads from the left and right blathered on about the "bonus scandal" at American International Group, I couldn't help but think of LTCM. The reason is this: the Fed came to the aid of that hedge fund - which had bet the wrong way on Russian debt - because commercial banks had lent the company $125 billion. A decade ago $125 billion was a lot of money. And just think of the economic damage our banks would've suffered had the Fed not intervened to structure an "orderly" unwinding of LTCM's positions.

If you think the government stepped in with $185 billion in assistance (and counting) to "save" AIG because it was concerned about all those 60-and-over retirees and their annuity and life insurance policies, I have some Enron bonds I'd like to sell you. The Fed and Treasury stepped up to the plate because it was concerned about - you got it - our commercial banks. Specifically, banks that were "counterparties" on credit default swaps that AIG had written on subprime ABS and CDO investments.

Just to recap: a credit default swap is an insurance contract where one party (in this case AIG) agrees to pay another party, in this case its bank customers who were on the other side of the swap and who stood to reap a payout in the event their subprime CDOs went south. Well guess what? Their subprime CDOs went south which meant AIG had to open the vault.

Just how much did AIG have to pay the banks sitting on the other side of the blackjack table? That's hard to say. AIG isn't exactly a model company when it comes to financial disclosures, which is somewhat ironic when you consider that it was a founding member of FM Watch, a lobbying group that used to beat up Fannie Mae and Freddie Mac for their crummy disclosures. But reading a recent SEC supplement that AIG filed, it appears that over the past two years AIG has had to pay out at least $40 billion to counterparties.

The recipients were Bank of America, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch (which BoA now owns) and a bunch of other household names. Insurance is a beautiful thing, especially when the policy pays off. It's sort of like holding a winning lottery ticket with the caveat that the ticket is only as good as the state's ability to pay the claim. In this case, the "state" is AIG and the only reason it could pay off on its CDO/CDS bets was that Uncle Sam stepped up to the plate with a boatload of money.

You see, Uncle was concerned that if AIG didn't pay off it would blow a hole in the bow of 12 of our largest banks/Wall Street firms, most of which were already bleeding red ink from their investments in subprime ABS.

The idea behind a CDS is that if you're an investor you buy both the bond and the insurance policy (the CDS) to hedge your exposure. The CDS costs a fraction of the bond being insured. But speculators, I'm told, were also buying CDS even though they didn't own the underlying bond. They, too, may've received payouts. It's hard to tell from reading AIG's SEC statements.

We all know full well by now that the CDS market is an unregulated business where there's no central clearing house where regulators (and the public) get a gander at who's writing the contracts and which firms are on the other side of those bets (contracts).

Executives who earn their living in insurance products tell me that AIG, internally, knew exactly how many CDS contracts it had written and what its financial exposure would be if the underlying subprime bonds went bad. In other words, someone in the bowels of AIG was worried that if subprime tanked so, too, would AIG.

We have yet to see an AIG "smoking gun" memo but I'm assured it's there. "It has to be," one insurer told me. (At press time, Congress was about to begin hearings on AIG's collapse.) What's clear is this: insurance is a business where one company writes coverage, collects premiums and prays that over time it takes in more than it pays out - a lot more. AIG's bailout is the story of one party (Uncle Sam) who puts in a lot of money and hopes that one day it will get all that money back. Now, let us pray.

Paul Muolo can be e-mailed at Paul.Muolo@Sourcemedia.com.

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