How to End Blackmail by AIG Traders

We now know AIG traders got their bonuses through blackmail - even CEO Edward Liddy admits it in today's Pentagon Post. The message from the traders is crystal clear: pay us handsomely or we will screw you royally.

Although we have wound down more than $1 trillion [of nearly $3 trillion] in the portfolio of the AIG Financial Products unit that is at the root of the company's troubles, there remains substantial risk in that portfolio. The financial downside for taxpayers is potentially very large, and that's why we're winding down this business.

To prevent undue risk exposure in the meantime, AIG has made a set of retention payments to employees based on a compensation system that prior management put in place.

For the sake of argument, let's stipulate that "the financial downside for taxpayers is potentially very large" since $1.6 trillion in derivatives still need to be wound down. But here's the question: why are we depending on AIG to do it?

Presumably the derivatives in the AIG portfolio have identifiable counterparties. Presumably those counterparties are large financial institutions, just like the counterparties identified by AIG last week. Is it not a safe bet that those large financial institutions are also recipients of taxpayer bailout money through TARP or similar European programs?

If that's the case, we have Taxpayers on one side of these derivatives, and Taxpayers on the other side too.

If that's the case, why don't we just let Taxpayers - via the Treasury Department - unwind the derivatives?

Based on the WSJ article below, the ultimate beneficiaries of AIG payouts are Hedge Funds. To save taxpayers, should the Treasury nationalize those Hedge Funds?

WSJ describes some of AIG's losses:

Some of the billions of dollars that the U.S. government paid to bail out American International Group Inc. stand to benefit hedge funds that bet on a falling housing market, according to people familiar with the matter and documents reviewed by The Wall Street Journal.

The documents show how Wall Street banks were middlemen in trades with hedge funds and AIG that left the giant insurer holding the bag on billions of dollars of assets tied to souring mortgages. AIG has put in escrow some money for at least one major bank, Deutsche Bank AG, whose hedge-fund clients made bets against the housing market, according to a person familiar with the matter. The money will be released to the bank if mortgage defaults rise above a certain level.

In essence, while the U.S. government is busy trying to prop up the housing market -- by trying to limit foreclosures, among other things -- it is simultaneously putting up cash that could be used to pay off investors who bet housing prices would tumble and many mortgage holders would default.

It's unclear how much government money might eventually flow to hedge-fund investors. Overall, the government has committed up to $173.3 billion to bail out AIG. Of that amount, AIG's housing-related bets have cost U.S. taxpayers some $52 billion.

The investment strategies involved are perfectly legal maneuvers. Still, the losses show how AIG strayed from its core business: selling standard insurance policies to businesses and individuals to protect against everything from fires to lawsuits. "AIG's financial-products division went heavily into the business of speculation, and its gambling debts are what taxpayers are paying off right now," said Martin Weiss of Weiss Research, an investment consultant in Jupiter, Fla.

An AIG spokeswoman declined to comment, as did a spokesman for the Federal Reserve Bank of New York.

The transactions worked like this: Investment banks such as Goldman Sachs Group Inc. and Deutsche Bank sold financial instruments to hedge funds letting them bet that mortgage defaults would rise. These instruments were credit default swaps, a form of insurance that pays out in the event of a debt default.

It is not known which hedge funds made those bets with specific banks. However, several large funds made big, ultimately profitable, wagers that mortgage defaults would increase.

Many of the assets AIG insured were tied to subprime mortgages. The deterioration of those high-risk mortgages, along with AIG's own financial woes, forced the insurer to put up billions of dollars in collateral, mostly to the banks that were its trading partners. AIG sold protection on securities backed by physical assets, as well as on positions almost entirely backed by other financial bets.

Some of the U.S.-government exposure traces back to the hedge funds that spotted problems in the U.S. housing market in 2005. They wanted to "sell short" -- or bet against -- securities backed by mortgages to questionable borrowers. These hedge funds entered into trades with investment banks. The banks then used a complex set of financial maneuvers to pass on some of the risk of those trades to AIG and other insurers.

The transactions meant that AIG was wagering that the U.S. housing market would remain robust. With housing markets now in free fall, the hedge funds stand to collect money from their bank counterparties. AIG is, in turn, compensating the banks.

The banks that had sold credit default swaps to the hedge funds wanted to turn around and hedge their own risks. But finding that protection wasn't easy.

So at Deutsche, the German bank's securities arm created a handful of offshore companies known as collateralized debt obligations, or CDOs. These companies carried a series of exotic names, according to securities filings, mostly based around the moniker "START," short for STAtic ResidenTial CDO. They allowed Deutsche to neutralize its exposure to the hedge funds' bets by buying swaps from START on the same securities its clients were betting against.

START held assets from a hit parade of lenders closely linked to the subprime crisis, including Bear Stearns, Countrywide Financial and New Century Financial, according to documents reviewed by the Journal.

In 2005, Deutsche found a willing taker for a chunk of the mortgage risks held by START: AIG Financial Products. The derivatives arm of AIG agreed to pay out up to $1 billion under two of the START vehicles, if underlying assets deteriorated or the insurer's own credit rating fell below a certain threshold. AIG stood to earn a fraction of a penny each year for every dollar of protection it sold, according to securities filings, meaning it made less than $10 million annually on the $1 billion in insurance.

Up until AIG exited the market in 2006, "AIG was by far the single largest ultimate taker of risk in the [subprime mortgage] CDO space," says a senior investment banker whose firm bought credit protection from the insurer.

Last fall, after AIG's credit rating was cut, the insurer paid roughly $800 million to START, according to two people familiar with the matter. Much of the money is being held in escrow and will be used to pay off Deutsche's swap contracts if mortgage defaults in the portfolio rise above a certain level. Some of that money could go through Deutsche to its hedge-fund clients.

If the housing market improves, AIG could recover some or much of the cash it transferred to START. But that outcome won't be known for years. The portions of START to which AIG is exposed were originally rated triple-A by Standard & Poor's. They've since been downgraded to "junk" status by the ratings firm.

The START CDOs share some similarities with mortgage pools created by Goldman named "Abacus" and also insured by AIG Financial Products, according to people familiar with the matter.

These pools were made up of credit-default swaps tied to individual mortgage securities. AIG had to post collateral to Goldman when the assets dropped in value. Some of this money, too, could go to hedge-fund clients of Goldman.

From mid-September to the end of last year, AIG and the government paid $5.4 billion to Deutsche and $8.1 billion to Goldman under credit default swap contracts the insurer had written.

A spokesman for the German bank said, "Our exposure to AIG was well-collateralized and hedged." A Goldman spokesman also said his firm's exposure was collateralized and hedged.