aig.thumbnail.jpgThe Government has dumped $173bn into salvaging AIG, and it isn’t going to be enough. Everybody knows that the money went to pay off counterparties to transactions, and nobody knows who the counterparties are, despite demands from Congress. Now the WSJ has a few names (h/t Calculated Risk, who explains why it matters). Another good question might be: Why were these counterparties engaged in transactions with AIG?

Some of them were speculators. They believed that housing prices were ludicrously high and unsustainable, and wanted to make money when prices fell. They couldn’t short houses, but they could buy naked credit default swaps against collateralized debt obligations and other securities which would fall when the housing market collapsed. The CDSs would pay off when the related securities tanked. Others thought specific entities were overpriced, like Lehman Bros. When it failed, some made billions.

Others were engaged in complex arbitrage transactions trying to make a comparatively few bucks at a time with no risk. Here’s an example:

Buying a par yield bond and a CDS on the reference entity an investor eliminates almost all the credit risk associated with default on the bond. This means that, denoting with y the yield on a T-year par yield bond issued by a reference entity, with r the yield on a T-year par yield riskless bond, and with S the T-year CDS spread (i.e. S is the periodical premium paid by the protection buyer), the relationship S = y −r should hold. In fact, if S is less than y −r, buying a corporate bond and the credit default swap and short selling a riskless bond will result in an arbitrage. If S is greater than y − r, then an arbitrageur will find it profitable to short a corporate bond, sell the credit default swap, and buy a riskless bond.

Suppose you think S is greater than y-r. CDSs come in units of $10mn, so this is going to be expensive. You have to short the corporate bond, which is difficult except with certain heavily traded bonds, buy a treasury bill, and find someone to buy your credit default swap naming the issuer of the corporate bond as the reference entity. That’s a lot of money for the ability to make a small amount of money, an amount equal to y-r-S. Arbitrage, in much more complicated forms, is the driving force for a lot of CDS transactions.

Now, some people might ask what the benefit to society is in this three-way. But I have another question. Suppose you were on the other side of this trade. You evaluated things differently, and figured S was less than y-r, so you bought the CDS, sold the Treasury short, and bought the corporate bond. You win, and now it’s time to unwind the transaction. You look around for a buyer for your CDS, but no one wants it. They don’t trust the seller of protection to pay off. Your trade turns into a really big loser, doesn’t it? And nobody is going to help you.

Now picture what happened to all the counterparties to AIG transactions. It wasn’t just that they couldn’t sell the CDS, it was that AIG wasn’t going to pay off. They were facing big losses. But, lucky for them, Treasury stepped into the breach and bailed them out. Lucky? Goldman Sachs is one of the fortunate bailees, and I’m sure there’s no connection between this happiness and the presence of Goldman’s CEO, Lloyd Blankfein, in the room when the decision was made.

The possibility that AIG would not be able to perform was a known concern of players in the CDS market; it even had a name, Counterparty Risk. Heaven forbid that rich people and their hedge funds and bankers should have to bear a known risk that came to pass.

We figured out that the TARP purchase of toxic waste at prices greater than its value was a cheat. Paulson backed down. Probably he thought he could get away with it because he had succeeded in bailing out banks by the back door through the AIG money dump.

Now it’s crystal clear. These people never miss an opportunity to screw us.