A.I.G., Where Taxpayers’ Dollars Go to Die
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By GRETCHEN MORGENSON
Columnist
The New York Times
March 8, 2009
“Derivatives are dangerous.”
That simple sentence, written by Warren Buffett, begins an enlightening discussion in Berkshire Hathaway’s most recent annual report. Mr. Buffett’s views on derivatives, gleaned from his own unhappy encounters with them, should be required reading for all United States taxpayers.
Why? Because we own almost 80 percent of the American International Group, the giant insurer whose collapse was a direct result of derivatives it sold during the late, great credit boom.
A.I.G. nearly barreled off the cliff last September, when it couldn’t meet its obligations to customers who had bought a version of derivatives called credit default swaps. Such swaps are like insurance policies; bondholders buy them to protect themselves from default on various forms of debt.
When A.I.G. couldn’t meet the wave of obligations it owed on the swaps last fall as Wall Street went into a tailspin, the Federal Reserve stepped in with an $85 billion loan to keep the hobbled insurer from going bankrupt; over all, the government has pledged a total of $160 billion to A.I.G. to help it meet its obligations and restructure operations.
So is A.I.G. the taxpayer gift that keeps on taking? Sure looks that way. And while no one can say with certainty whether more money will be needed, the sheer volume of derivatives engineered by a small London unit of A.I.G. suggests that taxpayers haven’t seen the bottom of this money pit.
Some $440 billion in credit default swaps sat on the company’s books before it collapsed. Its biggest customers, European banks and United States investment banks, bought the swaps to insure against defaults on a variety of debt holdings, including pools of mortgages and corporate loans.
Because of the way A.I.G. wrote its swaps, and because the company had a double-A credit rating at the time, it did not have to put up collateral to assure its customers that it would be able to pay on the insurance if necessary. Collateral would be required only if A.I.G.’s credit rating were cut or if the debt underlying the swaps declined.
Both of these “unthinkable” events occurred in 2008. Suddenly, A.I.G. had to cough up collateral it didn’t have.
So, you see, the rescue of A.I.G. also involved a bailout of its many customers, none of whom the insurer or the government is willing to identify.
Nevertheless, Edward M. Liddy, the chief executive of A.I.G., explained to investors last week that “the vast majority” of taxpayer funds “have passed through A.I.G. to other financial institutions” as the company unwound deals with its customers.
On Wall Street, those customers are known as “counterparties,” and Mr. Liddy wouldn’t provide details on who the counterparties were or how much they received. But a person briefed on the deals said A.I.G.’s former customers include Goldman Sachs, Merrill Lynch and two large French banks, Société Générale and Calyon.
All the banks declined to comment.
How much money has gone to counterparties since the company’s collapse? The person briefed on the deals put the figure at around $50 billion.
Unfortunately, that is likely to rise.
According to its most recent financial statements, A.I.G. had $302 billion in credit insurance commitments at the end of 2008. Of course, the company is not going to have to make good on all that insurance: the underlying securities are not all going to zero.
But as the economy deteriorates, A.I.G.’s insurance bets certainly become more perilous. And because most of A.I.G.’s swaps are known as the “pay as you go type,” collateral must be supplied when the underlying debt declines in value. Swap arrangements made by other insurers require payments only if a default occurs.
So the meter is constantly running at A.I.G. Just as quickly as taxpayer funds flow into the firm, chunks of it go right out the door to settle derivatives claims.
A.I.G.’s insurance commitment stood at “only” $302 billion in part because the government has already voided $62 billion of the protection A.I.G. had written on pools of especially toxic securities. The underlying collateral on those contracts, valued at about $32 billion or so, now sits in a facility that the Federal Reserve Bank of New York oversees and which we, the taxpayers, own.
In order to rip up those contracts, the taxpayers had to make A.I.G.’s counterparties whole by buying the debt that A.I.G. had insured and paying out — in cash — the remaining amount owed to the counterparties.
Of the $302 billion in insurance outstanding at A.I.G., about $235 billion was sold to foreign banks and covers prime home mortgages and corporate loans. The banks that bought this insurance did so to reduce the money they must set aside for regulatory capital requirements.
A.I.G. also wrote $50 billion of insurance on pools of corporate loans. These contracts are performing O.K. for now, the company has said.
But there’s yet another complication that will probably force A.I.G. to cough up cash more quickly than it otherwise might have had to. That’s because it didn’t simply write insurance protection on debt; it also entered into yet another derivative contract — known as an interest rate swap — with counterparties buying the protection.
The reason A.I.G. entered into the second contract was that banks feared they were also exposed to interest rate risks on the loans bundled into debt pools. Presto! A.I.G. was happy to remove that risk by writing another complicated swap.
Now, however, A.I.G. not only has to meet collateral calls as the value of the debt it insured withers, but also has to post collateral related to the interest rate swaps.
Another troubling aspect of these deals is how long it takes to untangle them when they go awry. Back to Mr. Buffett’s recent shareholder letter: when Berkshire acquired the insurance company General Re in 1998, he wrote, General Re had 23,218 derivatives contracts that it had struck with 884 counterparties.
Mr. Buffett wanted out from under the contracts and he began unwinding them. “Though we were under no pressure and were operating in benign markets as we exited,” he said, “it took us five years and more than $400 million in losses to largely complete the task.”
When you look back with the benefit of hindsight, it is truly amazing how outsized A.I.G.’s insurance commitment was, at $440 billion. After all, in 2005, when A.I.G. put many of these swaps on its books, the market value of the entire company was around $200 billion.
That means the geniuses at A.I.G. who wrote the insurance were willing to bet more than double their company’s value that defaults would not become problematic.
That’s some throw of the dice. Too bad it came up snake eyes for taxpayers.
Copyright 2009 The New York Times Company |
