The Deal
Saturday, November 21, 
7:06 pm

Why did AIG pay its counterparties?

  Share     E-Mail    Discussion (2)     Print Story

money_changing_hands_125x100.jpgThere seems to be some confusion as to what exactly happened in American International Group Inc.'s (NYSE:IAG) payments to its counterparties. As various media have reported, the giant insurer, now 80% owned by the U.S. government, used much of the $173.3 billion it received in federal aid to pay its trading partners and municipalities.

Responding to congressional requests for transparency, AIG revealed over the weekend that banks that acted as its counterparties in credit default swap trades received a total of $43.7 billion from the bailout funds.

The list of banks, includes foreign and U.S. Institutions such as Barclays plc, Deutsche Bank AG, BNP Paribas SA, Goldman Sachs Group Inc. (NYSE:GS) and Bank of America Corp. (NYSE:BAC), to name the top five, in order.

The confusion results from asking the question: Why exactly were the counterparties paid? Although an understanding of the situation is muddied by lack of insight into the exact contracts in question, it's fair to assume that many of the underlying bonds that the CDSs were meant to insure actually did not default. Both capital markets sources and sources at some of the banks listed as counterparties confirm that assumption. What happened was the underlying securities, which included senior and super-senior tranches of collateralized debt obligations (both of the actual and synthetic variety) lost value even as AIG itself was downgraded by ratings agencies.

Those downgrades meant that AIG had to post more collateral to counterparties, under the swap agreements. Indeed, the firm's disclosure shows that AIG posted some $22.4 billion between Sept. 16 and Dec. 31, 2008. But posting collateral does not mean that money should actually change hands, at least, not permanently.

But, as part of the government rescue, the insurer also set up, with the New York Fed, a special investment vehicle called Maiden Lane III, which was meant to buy the securities underlying the CDS contracts, and thereby allow the insurer the ability to unwind them. Payments under that program cost some $27.1 billion.

So the question remains: why? Why did AIG and the federal government think it necessary to pay full value to AIG's counterparties? Why did they even think to unwind them? After all, the government takeover of AIG should have given the insurer an implicit triple-A rating, which, in theory, would have stopped the downgrades, and thereby stemmed the flow of collateral from the firm. In the absence of default, the insurer could have simply sat on the contracts and actually collected fees from the counterparties that were paying for the insurance.

One similarly perturbed capital markets banker calls it "adverse selection," which refers to the worst-possible outcome of a given situation. He asks why, if AIG and the fed did not unwind all its CDS contracts, they chose those particular ones to unwind, potentially picking favorites among their counterparties. Why, he also wonders, would you do this trade at possibly the worst possible time in the capital markets?

There may, of course, be rational reasons for all this, but absent fuller disclosure -- not just of what and who, but also of why -- from both the fed and AIG, the questions will linger. - Vipal Monga

Continue reading below

Also on Dealscape





Comments

From: Erich Riesenberg,

Good question, but I have no doubt in the honesty and integrity of both Washington and private industry. They are doing what is best for this country! ;-)


From: zak82,

Asking "Why did AIG and the federal government think it necessary to pay full value to AIG's counterparties?" is a great question. And asking why these counterparties and not others or all, is just as good.

I have reached the point where it is impossible for me to believe anything other than all parties involved are making damn sure their peers get a really big slice of the bailout pie.

Nothing else makes sense.

And I'm done believing that any of the parties involved are acting in good faith.


Post a comment





The Deal Pipeline

Deal Video


Inside The Deal: Avaya Inc.'s Mohamad Ali on the company's next target.


More video...

Crisis On Wall Street
Technology
Deals of The Decade

Community

Industry Insight

Managing your shareholder base

Growth companies and their PE sponsors should be wary of the pitfalls that arise when they layer on tiers of preferred stock.


Industry Insight

Easing the stress of distressed M&A

Corporate buyers face numerous complexities when trying to identify the right moment to purchase a distressed asset.


Editor's Note

Editor's letter: Nov. 16, 2009

Beneath the veneer of Wall Streeters beats the same heart, stirred by the same determinants of behavior.


footspacer.jpg footspacer.jpg footspacer.jpg footspacer.jpg footspacer.jpg


©Copyright 2009, The Deal, LLC. All rights reserved. Please send all technical questions, comments or concerns to the Webmaster.