The story of AIG seems to be never ending. It was a huge insurance firm with lots of profitable parts and apparently one part so unprofitable that it not only sank the company but it continues to threaten the entire economy. To date the government has poured $170 billion into AIG relief. Whether some, all or any of that money will ever be returned to taxpayers is unknown.
Much of what AIG lost is not related to insurance, at least not in the sense of fire and theft coverage or claims from hurricanes or floods. Instead AIG has apparently been a world-leader in credit default swaps (CDS), a kind of exotic financial product you can’t get from GEICO, State Farm or Mutual of Omaha.
“A credit default swap (CDS) is a credit derivative contract between two counterparties,” says Wikipedia. “The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur.”
Like insurance — but not insurance.
When a company insures your home or car, government rules and common sense say it has to set aside some of the premium money to pay potential claims. These reserves hopefully grow each year with investment earnings, more premium money and fewer claims then expected. If there’s a bad year, say an extra hurricane or two, that’s no problem because reserves are in place to cover additional losses.
Unlike regular insurance policies, credit default swaps were regarded as very profitable for several reasons:
Instead of cars or houses, credit default swaps were used to guarantee mortgage-backed securities (MBS), a safe bet according to the best-available mathematical models. Why? Because most homeowners pay off their home loans with the certainty of an ATM.
The is no reserve requirement with CDS because there’s no government regulation. Each insurance company can set aside as much — or as little — as it wants for reserves. In fact, a company could set aside nothing for potential losses without violating regulatory requirements.
The money NOT set aside for reserves can be invested in high-risk securities to create a larger cash flow for the insurance company. This means that with CDS, insurers expected not only premiums but also bigger investment returns then would be possible with regular insurance products.
CDS premium revenue is not restricted to those who might have actual losses or real assets to protect. You can bet as much as you want and create as many CDS as you want.
For insurance companies who expected few losses, CDS were like a slot machine that always paid because the models said few losses could be expected under any circumstances. The models, of course, were terribly wrong.
“Derivatives and credit default swaps explain how it’s possible to have a mortgage portfolio with a relatively small number of losses and yet a company with massive financial problems,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s leading online source for foreclosure listings and data. “Much of the problem we’re facing today is not because of foreclosures by themselves, it’s because of side bets many companies took on in an effort to hedge their risk — bets which in many cases proved far more risky than the underlying mortgages.
“Nobody,” says Saccacio, “is giving AIG money because they have a bad mortgage portfolio or a lot of foreclosures. AIG is getting money because it made huge derivative bets and lost.”
In the end a CDS is nothing but a hedge that allegedly smart people in once-bigger financial institutions used to offset risk. AIG — meaning U.S. taxpayers — must now pay off the credit default swaps it issued.
“The banks and investment firms that ended up with AIG’s bailout money last fall, says The New York Times, “were, in many cases, counterparties to derivatives contracts it had sold, known as credit-default swaps, which guaranteed the value of assets in their investment portfolios. Had AIG not been bailed out, and simply allowed to go bankrupt, they would have suffered investment losses running into the billions of dollars.”
In fact, AIG reports that between September 16, 2008, and the end of the year it paid out $22.4 billion to CDS counterparties including Merrill Lynch ($1.8 billion), Deutsche Bank ($2.6 billion), Goldman Sachs ($2.5 billion) and Societe Generale ($4.1 billion).
A Contract Is A Contract = More Foreclosures?
AIG must pay off its credit default counterparties because such agreements are really just contracts where money is owed under certain circumstances. The catch is that not all contracts get equal protection.
For instance, public employees are now sometimes furloughed regardless of union agreements. Auto worker contracts have been revised and creditors settle for far less than face value when companies face bankruptcy. Bondholders often get pennies on the dollar when a company fails.
Do credit-default swaps impact the mortgage marketplace? Yes they do, says Chip Parker, an attorney with Parker & DuFresne in Jacksonville, Fla.
“Mortgage-backed securities (MBS) are divided into value-based groups, known as tranches,” explains Parker, writing on the Mortgage Law Network. “Senior investors, who are typically financial institutions, own the AAA tranches that are insured against default by AIG, and they WANT to foreclose on the Middle Class so that insurance payments kick in. Conversely, the junior tranche investors want workouts with homeowners because their investment is not insured.
“To ensure that the mortgage servicer pushes default instead of workout, the servicer is paid double (50 basis points versus 25 basis points) by the MBS to service a loan in default. Why do you think your servicer tells you that you must be in default before it will consider a mortgage modification, a practice known as invited default?
“Simply put,” says Parker, “the government bailout of AIG has actually encouraged foreclosures because the taxpayers continue to fill AIG’s coffers with enough cash to pay out insurance on defaulted home loans.”
Changing The System
“In truth, says Tyler Cowen, writing in The New York Times, “it’s not the shareholders of the American International Group who benefited most from its bailout; they were mostly wiped out. The great beneficiaries have been the creditors and counterparties at the other end of AIG’s derivatives deals.”
The emerging question, of course, is why the government should protect CDS bettors and not mortgage loan borrowers, shareholders or bondholders.
“The days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers from losses must end,” says Treasury Secretary Tim Geithner.
If Congress will agree, he said, “the government will regulate the markets for credit default swaps and over-the-counter derivatives for the first time.”
Geithner is right — if appropriate legislation is passed it would be the first time derivatives and credit default swaps were regulated. Unfortunately, such regulation comes $170 billion too late for the taxpayers who are footing the AIG bill — and for borrowers who are being pushed into foreclosure by insured investors who can’t lose.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.