AIG, Round Four

AIG is back at the trough:

The federal government agreed Sunday night to provide an additional $30 billion in taxpayer money to the American International Group and loosen the terms of its huge loan to the insurer, which is preparing to report a $62 billion loss on Monday, the biggest quarterly loss in history, people involved in the discussions said.

The intervention would be the fourth time that the United States has had to step in to help A.I.G., the giant insurer, avert bankruptcy. The government already owns nearly 80 percent of the insurer’s holding company as a result of the earlier interventions, which included a $60 billion loan, a $40 billion purchase of preferred shares and $50 billion to soak up the company’s toxic assets.

Inspired perhaps by Rick Santelli, last Saturday Joe Nocera of the Times offered a populist rant against AIG that was longer on emotion than substance.  Here is point he made that stuck in my craw:

To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. (Its insurance divisions remain profitable today.) But one division, its “financial practices” unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities. Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too. That was the ratings arbitrage. “It was a way to exploit the triple A rating,” said Robert J. Arvanitis, a former A.I.G. executive who has since become a leading A.I.G. critic.

Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to A.I.G., and the AAA rating made the securities much easier to market. What was in it for A.I.G.? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets — housing — could only go up in price.

Do tell.  Per this WSJ article, they relied on extensive modeling from Yale professor Gary Gorton and exited the sub-prime CDS market at the end of 2005.  My moles have been assured by their moles that AIG was only backing the highest tranches of CDO and no bond backed by AIG had actually missed a payment (as of late last fall), although obviously their values have fallen quite a bit from par, triggering massive collateral calls.  And about those collateral calls, Mr. Nocera said this:

Second, in many of its derivative contracts, A.I.G. included a provision that has since come back to haunt it. It agreed to something called “collateral triggers,” meaning that if certain events took place, like a ratings downgrade for either A.I.G. or the securities it was insuring, it would have to put up collateral against those securities. Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them. And again, it assumed that the triggers would never actually kick in and the provisions were therefore meaningless. Those collateral triggers have since cost A.I.G. many, many billions of dollars. Or, rather, they’ve cost American taxpayers billions.

Those "collateral triggers" are the norm in swaps contracts - one might just as well say that Mr. Nocera publishes in English rather than in Gaelic out of pure greed.  And the collateral has "cost" the US taxpayers billions only in the sense that it has made it impossible for AIG to saddle its counterparties with losses due to an AIG default.  If AIG never defaults, the actual cost of having posted collateral will be tiny.  For Mr. Nocera's benefit, let me offer an analogy - suppose a landlord requires a tenant to post a $1,000 security depost against the possibility that the tenant's puppy will cause damage to the property.  Did the puppy cost the tenant $1,000?  Only if it actually does thay much damage!  Otherwise, the $1,000 will be returned to the tenant after he (or, I suppose, the puppy) leaves.  In the same way, if ther bonds backed by AIG continue to make payments, eventually they will mature and AIG's collateral will be returned.  In the meantime their have clearly been opportunity costs and, hmm, liquidity issues caused by the posting of collateral.

That said, AIG went from $200 billion in book equity to busted, after being required by a ratings downgrade to post $10-$15 billion in collateral.  Those numbers don't add up - AIG had losses in plenty of other divisions that were also buying "safe" housing bonds, but blaming esoteric derivatives is a great way to deflect criticism.

Now, to add to your stack of stuff - Tyler Cowen recommends Prof. Gary Gorton's "superb" paper titled "The Panic of 2007"; the topic is mortgage-backed securities.  Do not be daunted; from Prof. Cowen:

Go ahead and read and read and read and the more you feel confused the more, in fact, you are being instructed.  You are confused because it is confusing.

I am also recommending this comment on the Panic of 2007, prepared by Bengt Holmstrom of MIT.  One key point is that a little transparency is a dangerous thing - paradoxically, if neither party is informed as to the value of assets-backed securities, the bonds are more valuable as collateral than if one party is well-informed (or perceived to be).  Why?  Because people with less expertise abandon the market rather than risk being fleeced by the experts. 

When the US housing market was in ascendance plenty of market players were comfortable offering low-risk loans to the dealers and holders of mortgage backed secuties, with the securities as collateral.  Once it became clear that valuing the collateral accurately was important, people walked away.

STILL GOING:  Prof. Holmstrom made another interesting point and Paul Krugman picks up the same theme in his column today - the Asians made us do it.  Demonstrating yet again that demand creates its won supply, foreign money looking for a safe haven propped up the US housing market (among other things, as Krugman notes) and created an insatiable demand for seemingly safe, low-risk assets.

MORE ON THE INSCRUTABLE ORIENT:  Tyler Cowen backed the savings glut view; Robert Murphy provides an alternative perspective.  Alan Greenspan, in July 2005 testimony to Congress, noted the issue and its impact on long term rates in the US. including mortgage rates.  Here is one of many entries in the "Did He Really Say That?" file:

The apparent froth in housing markets appears to have interacted with evolving practices in mortgage markets. The increase in the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market. Moreover, these contracts may leave some mortgagors vulnerable to adverse events. It is important that lenders fully appreciate the risk that some households may have trouble meeting monthly payments as interest rates and the macroeconomic climate change.

The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Nationwide banking and widespread securitization of mortgages make financial intermediation less likely to be impaired than it was in some previous episodes of regional house-price correction. Moreover, a decline in the national housing price level would need to be substantial to trigger a significant rise in foreclosures, because the vast majority of homeowners have built up substantial equity in their homes despite large mortgage-market-financed withdrawals of home equity in recent years.

Oops.

[END OF THREAD]

Comments

[kim]

It's all my fault. Last September, on the day that AIG was saved, I was in Round Three of a fight with AIG, who claimed I owed them $120. I claimed we were even. After Round 4 in November, they sent me a check for $120. Did I seek to get a fair decision with Round 5? Naw, I threw in the towel. Clearly, that towel was a butterfly's wing.
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[steve sturm]

I don't know who gets credit, but I do like the line "it was like buying insurance from someone on the Titanic".

And note that bailing out AIG is less a bailout of AIG than a bailout of AIG's customers and trading partners. If the government doesn't give AIG billions, AIG can't pay out those billions and its customers have to record losses (more or less than the amount of collateral at stake I can't say but presume it's about the same amount). Thus, Paulson wasn't bailing out AIG as much as he was bailing out his buddies, but with a whole lot less political flak than if he bailed his buddies out directly.

[Jack is Back!]

Now I know where all the "smartest guys in the room" that used to work at Enron, now work - AIG.

[Neo]

A treatment of the side effects of the stimulus and other bailouts.

[Neo]

.. that used to work at XXX, now work

I've concluded that all the statisticians that used to work at the Tobacco Institute, now subsist on "Global Warming" federal grants.

[benben]

Dow falls below 7000, but the MSM says people really believe in the stimulus package and the new budget and hope and change.

[Danube of Thought]

Getting close to 6900.

[RichatUF]

steve strum-

Thus, Paulson wasn't bailing out AIG as much as he was bailing out his buddies, but with a whole lot less political flak than if he bailed his buddies out directly.

What about Geithner? It was the NY Fed that "organized" the first deal with the NY Insurance Commissioner.

[Kevin B]

Thanks TM! I now totally understand the whole mortgage backed security thing. (As in I'm totally confused by it which means, according to Prof. Gorton, that I'm fully conversant with all the subleties and nuances.)

[Danube of Thought]

Now at 6880.

[steve sturm]

RichatUF: I'm using Paulson both literally and figuratively to include all those who have pushed a bailout because 'we' needed it when in fact it was their friends and former colleagues who needed it.

[Rick Ballard]

If anyone cares to understand the "workings" of the mind of a fully credentialed moron then Prof. Gorton's paper is well worth a look. In particular, the 'Some Background' section beginning on page 5, provides insight into the "thinking" behind the extension of credit to the unqualified in the form of no doc 100% ARMs.

Such lovely intentions. Well deserving of a marked section of the path, with every stone inscribed with the name "Gorton" as a gesture of appreciation as to the good professor's efforts.

[Matt]

the mismanagement boggles the mind. One trillion, two trillion and more, with little or no accountability, no clear purpose except reaction to markets...no real plan that is discernible even by the readers of tea leaves.... Simply stunning incompetence.

[Rick Ballard]

The Holmstrom paper is very good but it also strolls by the 'Why?' question with only a casual glance. I can follow the arguments concerning the complexity and opacity of the instruments but skipping over "What purpose does their very existence fulfill?" leads me to thoughts of Ptolemy calculatin epicycles.

[MayBee]

I remember when Appalled told TM he should do more econ blogging.
Now TM is doing just that, and our friend Appalled is nowhere to be found.
Come back, Appalled!

[Jack is Back!]

Politics of Fear + Hyper-taxation = Hyper-inflation.

Lets welcome back the misery index with a some new metrics:

Metric One: % decrease in NYSE since start of year 2009 (24%)

Metric Two: % decrease in Shiller index of 20 City housing prices since Obama election (20%)

Metric Three: % increase in Gold since Obama election (21%)

Then you add them up: %65 increase. Lets check in after the omnibus bill is signed and the budget is approved (some time in early June??)

Have to run. Need to buy a cardigan.

[spongeworthy]

Once it became clear that valuing the collateral accurately was important, people walked away.

Precisely, and this is why many of us supported TARP as it was orginally designed.

I heard it argued again and again that if these bonds were worth anything, a market would arise. But if nobody has the data, nobody's going to stick their head up and show a bid only to get slapped with trash by an informed seller.

The Treasury can get the numbers behind the collateral. It can require the originators of the various products to disclose the exact structure--something dealers regarded as proprietary.

Under TARP, now one player has both the data and the funds to make informed purchases. Nobody else can do this. We should have been able to add liquidity and turn a profit for us taxpayers--a no-brainer except for ideologues. (Which I used to be.)

I'm out of the loop now, but to the degree we've strayed from this plan, I commend those who opposed TARP from the start. You were right.

[Danube of Thought]

Toomey now considering a primary challenge to Specter. LUN

[bad]

I'll be donating to Toomey.

[Old Lurker]

JackBack, suggest you start counting as of the day of the election.

Also don't overlook the jobs lost metric.

[bad]

Dow down 250.

[Old Lurker]

I'd donate to the man in the moon.

[Danube of Thought]

When is he gonna bail out the S&P 500?

[Pofarmer]

Politics of Fear + Hyper-taxation = Hyper-inflation.

We've got to go through this deflation first. After that, who knows? But, the rise in gold prices doesn't have much to do with the value of the currency.

[Jane]

Toomey now considering a primary challenge to Specter.

Toomey is fantabulous!!!

[glasater]

Earlier on CNBC today some pundit said that because of margin calls the price of gold might go down since that commodity is the most liquid to raise cash.

[Walter]

demand creates its won supply

I know I've been gone too long when I cannot determine whether this is a typo or TM's usual brilliant, yet irreverent, take on the story.

And Hurrah! for the econ blogging. TM's coverage beats anything in the Times and three-quarters of the WSJ.

[bad]

TAPPER: Two questions, one on AIG and one on CIA. AIG, is the administration confident that it -- that it knows what happened to the tens of billions of dollars previously given to AIG? GIBBS: Is it confident -- I'm sorry?

TAPPER: That they know -- that you guys know what happened to the previous billions before you hand over this next $30 billion.

GIBBS: Yes -- yes, the -- I mean, I don't think it's a -- well, obviously, you've got a huge insurance company that is losing money, not the least of which because of its sheer size and sheer size and decrease in the growth in our economy. It experiences a far bigger drop, largely because of its size. But, again, the steps that -- that Treasury and -- and others took were to ensure a larger systemic problem wasn't one that we had to deal with here today in letting something just die.

TAPPER: But in terms of specifically the -- I guess it's like $150 billion before, you guys are confident...

GIBBS: Yes.

The Obama administration knows what happened to all of the billions given to AIG. I feel so much better now....

[glasater]

Bad~

Know you meant your comment facetiously but.......no this Admin does NOT know what they're doing and the market is reflecting that fact.
From what I'm listening to on CNBC--the traders will join a demonstration of a drastic kind against Washington.

[Jane]

YOu know, starting today I officially believe Obama is trashing the economy on purpose.

[sbw]

From what I'm listening to on CNBC--the traders will join a demonstration of a drastic kind against Washington.

I think they should start waving towels as a signal they want Obama to throw in the towel.

[MayBee]

YOu know, starting today I officially believe Obama is trashing the economy on purpose.

Jane- one wonders why he won't just shut up and let things ride for a few days. He, for some reason, needs to announce something new and too big every single day.

bad- did you hear Gibbs repeat the bankruptcy "statistic"?

[Rick Ballard]

Jane,

I dunno about that. I'd bet $1K that Barry Dunham couldn't explain the difference between a CDS and a CDO. He certainly isn't inspiring any confidence in his ability as the chief executive. The market has assessed his ability, the ability of his advisers and the ability of Democrat "leadership" in general. The verdict? In Italian one would say "Salva chi puo." Help ain't on the way.

What is the political benefit to the Democrats and the Commie Bastard in Chief for a continuing demonstration of profound ineptitude?

[Jane]

I swear this is all part of his arrogant smug little plan to take over the universe.

[Jane]

What is the political benefit to the Democrats and the Commie Bastard in Chief for a continuing demonstration of profound ineptitude?

Chaos - A scared populous is an easily manipulated populous.

But it isn't going to work. People are close to revolt.

[MayBee]

Remember the talk this fall from Dems about government taking over from 401(k)s? That seems immensely more difficult to do if everone's 401(k) is healthy.
Once people have watched their retirement funds disappear due to the free market, convincing them the government will protect them is that much easier.

[MayBee]

I suddenly, desperately want to know what classes Obama took in college, and who helped him get into Harvard.

[Ignatz Ratzkywatzky]

Jane- one wonders why he won't just shut up and let things ride for a few days.

Maybee,

Because he's discovered he's very good at being President (close to a quote), so nothing he says or does could possibly be anything other than benevolent.

[Rick Ballard]

Why, MayBee? It makes no difference. It's screamingly obvious that he did not advance on the basis of ability or intelligence.

That's where the "chaos to inspire fear" theory falls a bit short. What he's inspiring is anger and ridicule isn't going to be far behind. It's hard to underestimate the intelligence of the Muddle but I think he's doing it. I don't recall even the hyper narcissist Bubba thrusting himself in front of cameras to the extent that Zero has in the past month and all he has done is drive his "strong disapproval" rating up by 100% in 40 days.

[Extraneus]

Once people have watched their retirement funds disappear due to the free market, convincing them the government will protect them is that much easier.

Wasn't it illuminating how rabidly the Dems foamed at the mouth over Bush's proposal to let new SS participants have the option to control a portion of their SS in some sort of 401k-like fund? Why didn't people get suspicious about that reaction, especially young people?

[glasater]

Hank Greenberg is mounting a lawsuit against AIG.

[MayBee]

Why, MayBee?

I'm imagining a slew of classes studying Marxism.

[bgates]

I'd bet $1K that Barry Dunham couldn't explain the difference between a CDS and a CDO.

Wouldn't that be a great press conference question. (Does Tapper return the favor and come over here? Taranto, you know any of the guys who ask questions?)

"Mr Obama, the housing crisis has been going on for months now, but there are aspects of it that many people still find very confusing. Could you define, for the American people, what a credit default swap is?"

[MayBee]

I wonder if Geithner became enamored of the Japanese Postal Savings system when he spent time over there.

Everyone knows the Japanese are good savers, but millions of Japanese use the national postal system as their bank. The interest rate has been near 0 forever.
Because it is held by a government entity, the political bosses have, over the years, borrowed the money of the taxpayers to develop whatever pet project they need to get reelected. The whole thing was rife with corruption.

I imagine Democrats coming up with a similar plan.

[stevesturm]

Jane: I heartily agree, Obama couldn't have screwed things up if he was trying to. I wonder how many of the 66 million people who voted for him are having buyer's remorse after watching their investments crater. As much as disliked Bush, the markets never cratered on his watch (yeah, I'm not giving him that much credit, just pointing out the timing).

[Pofarmer]

Not sure if this was discussed elsewhere, but Rush and Shawn were HAMMERING on the "Hope Obama Fails" meme today. Gibbs is still taking it out of context. Has anyone ever seen a President openly take on a public figure like this? It's kinda creepy. The thing is, Rush is giving the Republicans an opening a mile wide here to explain themselves, and they're too chicken shit to do it. Hannity is playing clips by the Dozens of Dim's saying they either hope Bush fails, has failed, or that he's an insolent dope. This has gone about far enough with these thin skinned idiots.

[Ignatz Ratzkywatzky]

I'm imagining a slew slough of classes studying Marxism.

Seems a little closer, considering his background and where he has us headed.

[Rick Ballard]

"I'm imagining a slew of classes studying Marxism."

He was a red diaper baby - suckled on Marxism and falling asleep to Pete Seeger lullabies. He probably could have taught Marxism by the time he hit Colombia. He's dumb but Marxism isn't hard to learn to parrot and he proves every day that he can parrot at length.

I believe that he received intense indoctrination in the Alinsky subset of Marxism at Colombia. Again, it's really pretty simple to grasp once one casts aside all principles.

[Pagar]

Rick, I doubt if it took long to cast aside the principles in his case. I can't see where he would have gotten any from.

[bad]

bad- did you hear Gibbs repeat the bankruptcy "statistic"?

I heard Obama repeat that fallacy again today but didn't hear all of the Gibbs spiel. Is Gibbs spouting the same carp, and if so, why isn't he being called out?

[Pofarmer]

why isn't he being called out?

Who's gonna do it?

[TCO]

Well kim, think how much worse things would have been if we had gone cold Turkey. Keep sipping that hair of the dog. You go girl. Cram some more crap down your gullet. Argue to double the stimulus package. Who knows, maybe the Bush-Paulson-bama actions are insufficient. You socialist MORON.

[Neo]

YOu know, starting today I officially believe Obama is trashing the economy on purpose.

So exactly who benefits from the market tanking now ? George Soros ?

[Neo]

Got a kick out of Jim Crammer referring to ..
"Comrade Obama and Pelosi" today.

[kim]

Hey, good work at the air vent. Any clues about WordPress?
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[kim]

Because the world needs more of TCO's opinions. When he's good, he's very good, but when he's bad, he's awful.
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[kim]

And since the whole world seems to be circling the Thomas, it's a little naive to blame that little bitty TARPy thing. But beat that dead horse. Maybe "It's Alive!"
======================

[BR]

Kim, your butterfly post is sooo funny.
PS - sent you an email on 3/1. Take a look :)

[BR]

I have this beautifully illustrated, leatherbound book of Kipling's Just So Stories and the last one I read was "The Butterfly That Stamped." I felt a tear in the fabric of the universe recently. A magnificent one!

[Greg Ransom]

I notice you ignore the work of John Taylor .....

What's up with that?