The 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.
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Thanks for this and all your excellent analysis!!
Thank you for making this easier to understang
Thank you Masaccio for your fine post.
Nothing I’ve ever done before can quite match the queasy feeling I had last week.
An important yearly insurance bill is due soon. Since last year and this, our insurer we started with several years ago has signed up with AIG to handle all their coverage, so essentially I just handed all that money over to AIG, although in the other company’s name.
So I sent the payment a month early, immediately after receiving the bill.
If I don’t pay, I lose my insurance.
If I do pay, do I lose my insurance because of that dratted crew at AIG?
Paid by bank check. Sent certified, kept the post office receipt, and I received back the post card showing the cover company has received the envelope. Computer records show the check was deposited. Is ANY of this worth the paper it’s printed on?
I don’t like this! Nosirree!! I don’t like this one bit!!!
What SHOULD I have done?!
Bravo and Dugg.
Adie – Surely this will raise red flags all through the ranks. You will be marked as a customer with a preexisting condition known as someone who actually expects a product/service you paid for to be there when you need it. How dare you! /s
Thanks for your comment, Adie. I’m sure you speak for a great many people. I hope someone can answer your question.
I wonder how many people don’t even know that their insurance company is a front for AIG. hmmmm…maybe I better check out my own!
A major problem with the stock market is that Goldman Sachs and other big volume market makers have habitually shorted everything in accord with the general downward trend. Short selling is one thing. The real problem is naked shorting. Nobody bothers to secure the stocks that are being sold short. There are therefore billions of shares of stocks “sold short” that do not exist. This drives stock prices down. The big boys have computer programs that do all the work. Set it and forget it. Drive the market down farther every day pocketing the difference between the price sold short and the buy to cover price.
Average investors do not even know how to place a sell short order. And most of the online investment houses prohibit the small customers from short selling anything below five dollars. Direct trading platforms like those used by Goldman enable them to short penny stocks, while the average investor is geting cleaned out by them.
Of course, naked shorting is illegal. But there are no penalties. Meanwhile, all of us suckers (we are holding long positions) with retirement accounts, college funds for our kids, mutual funds etc, are getting robbed by Goldman and others. Goldmoan is receiving billions in bailout monies so they can continue to short the hell out of the market and wreak further damage to the economy.
Courtesy of that no-nothing jackass Dubya and the crooked Goldy boys he put in charge.
Until Obama cleans house at the SEC and enacts penalty of jail for naked shorting, the DOW could in theory be shorted to zero. There are no penalties.
With guys like Geithner and Summers and Bernanke, it looks like the odds of that happening anytime soon are not good. (Since we’re paying Goldmon to keep naked shorting).
Adie, the insurance companies are separate entities, each regulated by the state government in their home state. They are closely supervised right now, as all of the State Commissioners are worried that the problems of the holding company might somehow infect them. The big hope is that the insurance companies will be sold to investors or other insurance companies to pay off some or all of the money we have sunk into them.That means both the parent company and the feds have a big stake in keeping them in good shape.
Right now, I wouldn’t worry about the insurance companies. BUT. If you are worried, then you should shop around for a replacement company. Don’t waste any energy worrying about it.
Since we’re no longer, if we ever were, a nation under the rule of law, let’s pass another ex post facto law (retroactive telecom immunity was most current) and go after the Bernie Madoffs and “Sir” Stanfords and drive them to penury.
End Rant
Masaccio, thanks for another fine post! You’re edumacating me *g*
Morning Kirk(:>) You up early??
The Chili came out great for the first cooking… second cooking will finish it off for the final consumption!
For those interested in more detail on the arbitrage and profit-making issues, here is an interesting .pdf paper. It explains the accounting reasons this all worked for the counterparties, and explains how they used CDSs to increase their bonuses.
Thank you much for the reply.
Given that this insurance is to cover some specialty items not covered by regular homeowners’ insurance, I’m stuck.
I take some solace from your comment about the insurance companies being separate entities. The main insurance company of record is/ or at least HAS been highly respected in its field, so I shall reach for the strength to follow your very good advice, not to “waste any energy worrying about it.”
I figure I protected myself somewhat by saving all paperwork, certified mail rec’ts etc. That seems all I can do, I think.
Thanks for talking me down. What a horrible mess.
Have any republicans yet admitted how dangerous it can be to roll back all regulations? *tapping foot*
That Madoff can stay in his house (not in jail as he awaits trial) and argue that he shoud be able to keep millions he socked away and have the MSM carry that message to the public in all seriousness (that it should be considered!) is an indication that the system is totally corrupted. Nothing new here.
Madoff should be made an example of. Getting him to trial and convicted quickly would improve the stock market.
Did Martha Stewart wait in jail til trial? I don’t think so. She surely did some jail or prison time, but I think she was habeus corpus free until sentencing.
What this is basically saying is that if the cost of insuring an investment (the CDS) is greater than the yield on the investment (compared to a low or no risk investment like a T-bill), then why aren’t you doing the lower risk investment. This is also a strong indication that the original investment is overpriced.
This is a classic opportunity for short selling. You sell the investments to others (technically known as chumps) at the high price and when it comes time to settle up, the investment has fallen in value so you buy what’s needed to settle at the lower price and your profit is the difference between the high and low prices.
Now in this example you hedge all this by buying a risk free investment like a Treasury bond. In real life, a lot of the capital is tied up in the short selling so you have less to buy T-bills. But even here, that’s not really true. Any extra money doesn’t go to T-bills, it goes just to a “less risky” investment.
In reverse, it works like this. If the insurance (CDS) on an investment is really small compared to the yield you get from it (as compared to a low risk investment), you should go for the investment with the higher return. And the fact that the insurance on it is cheap is a good indication that the investment is solid. So this time you sell the standard low risk T bill type stuff to the chumps and use the money to buy the investment with the higher yield.
As can always happen, you short expecting the price to fall and it doesn’t or worse goes up, then you are in for a loss. The more you did it and the bigger the spread between the initial and settlement price determines how royally you screwed yourself.
But with AIG it didn’t matter because the chump in the transaction was not AIG or its counterparties, it was the US government and you and me.
Kirk! I am so glad to see you here. Do you have time, energy and inclination to help educate a gardener who’s about to invite health trouble big-time, imo?
I think this is the correct addy. If not, it should be in the thread below at #36 by LooHoo. No. This is NOT a joke. It’s serious.
http://oxdown.firedoglake.com/…..ment-33359
Here is a fun and somewhat recent graph on the CDS spreads for some of our good friends:
http://baselinescenario.files……5-2009.pdf
Looks like American Express is up for another credit rating shave. But there also seems to be something a little ominous about the upward spikes at the end of that graph. Just another bubble?
Back to the question of the alternative. We knew for a long time that we and all our compatriots were being screwed by high finance. Now we are beginning to find out by how much. The question remains whether the pay-offs to these crooks are the only thing standing between us and total financial meltdown. None of us knows, and I don’t think our guys in charge know either. But if you were risk-averse, what would you do? I think you would probably do what they are doing — bailing out AIG. But there is going to be hell to pay, and we can now see it on the horizon.
These assholes apparently missed the KISS lecture in Finance 101. My guess is most of these supposed Masters of the Universe have Ivy League
credentials. What has happened on Wall Street is proof that stupid is contagious.
My advice to Obama is too get as far away from these folks {Geitner} as possible and bring in some grads from the U of Kansas and such.
The re-air of the Bernanke hearing is on CSPAN right now, it’s unbelievable what we aren’t allowed to know about what they are doing — and what Bernanke and friends don’t know anyway.
Wait. Who is this poster known as “masaccio”???
Is he new here? I think he might be!
Welcome.
You almost got it right…
y-r-S is the arbitrage (a small. mathematically certain fixed profit.)
The person on the other side of the trade does not “evaluate things differently,” though. They can see the exact same thee numbers for y, r, and S. So why do they paid money to make the trade? Well, y and r are constants, while S can vary over time, so they are betting that S will increase over time (i.e. the underlying company’s condition will worsen over time.) Note the the arbitrageur doesn’t care what happens to S (that’s why it’s called arbitrage.)
Why does the buyer want to be long S? There are some valid business reasons, but the most common answer is that they can get huge leverage (10-1 or more) on the underlying company. Compare that to a vanilla stock transaction where you max out around 3-1.
Thanks for fleshing it out. That is very helpful.
The other lecture they missed was: “Don’t Bet the Damn Company.”
Thanks, good to be here.
Got an email forward about how AIG handles the Congresspeople’s pensions. Maybe I better check out snopes. Is this a conflict of interest I wonder? Or just anger-mongering of the emailing citizenry? Anybody know?
well done.
@26 … about AIG handling Congressional pensions…SNOPES SAYS FALSE… ANGRY FALSE RUMOR
Please excuse if this has already been posted, but there’s more on the topic of this thread here:
Bob in HI