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Wednesday, 18 March 2009

Why the AIG bonuses matter

Quick question: why is Joseph Cassano not mentioned in the same breath with Nick Leeson and Jerome Kerviel? All three took down their respective financial institutions (AIG, Barings, Societe Generale) with a series of bad bets. The latter two are convicted criminals. Cassano took in millions from his basically fraudulent schemes, then went on to leave the company, with a million dollar a year "consulting" contract. (At least that bit of golden parachute was later rescinded...) (edit: no, his golden parachute was one million dollars A MONTH.)

Anyways, all that is a prelude to my real point. Why do the AIG bonuses matter? Aren't they absolutely dwarfed by the scale of the overall bailout to the company? Yes, but. The bailouts of the company have been frantic efforts to keep the entire world's financial system from collapsing in a chain reaction. The bonuses, however, are completely indefensible. $450 million is going to AIGFP! There's only 370 people in that division, and more importantly, it is the division that sank the company.

American International Group Inc. will pay $450 million in bonuses to employees in its financial products unit. That division was at the heart of AIG's collapse last fall, which compelled the U.S. government to provide $173.3 billion in aid to keep it running.

Joseph Nocera explained how AIG got into this much trouble:

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.


Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets -- housing -- could only go up in price.

That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That's why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn't have to put anything aside for losses. And it didn't. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.

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.

The AIG bailouts - over $170 billion so far - were intended to backstop the many bad bets nearly everyone in finance made, by making good on the insurance they'd bought. We don't have to like it - I certainly don't. And there's certainly an argument to be made that the CDS buyers made two "bad bets" - the first on the mortgage backed securities, and the second on getting it "insured" by AIG, and they deserve to lose on both bets. (The counter-argument is that with such systemic bad bets losing, the global financial system will completely break down.)

So OK, that's the justification for the bailout.

There is no justification for the AIG bonuses. AIG is de facto bankrupt. It is only saved from de jure ("legal") bankruptcy by the multiple bailouts the US government has given it for the purposes of maintaining order in the financial world. But bankruptcy abrogates contracts like the bonuses.

Morally, there is no right by the people at AIGFP, who sank the world's largest insurer, to the bonuses.

Hell, AIG budgeted $57M in 'retention pay' for employees that will be dismised.

Pragmatically, some pinheads [have suggested the bonuses are necessary to keep the people of AIG there][marcus]. These people, collectively, are like Nick Leeson and Jerome Kerviel! We shouldn't want to keep them there!!!

AIG defends the bonuses as being "contractual obligations". Leaving aside that the company is not technically bankrupt and thus the contracts remain in force, think about this: the automaker unions were forced to renegotiate their contracts by the Treasury Department as a condition for bailouts in the auto sector. Yet when AIG claims the outrageous bonuses are contractual obligation, Treasury rolls over. Now, the automakers and their unions are two private entities. AIG, on the other hand, is currently owned by the US government. And yet Treasury lets the tail wag the dog.

Plain and simple, the people at the top at AIG are looting the remains of the company, with what seems like the eager assistance of Treasury Secretary Tim Geithner.

Anyways, that's why I feel the bonuses are more indefensible than the bailouts themselves.

Update: Getting back to that Cassano as Leeson/Kerviel issue: when AIG corporate wanted to audit AIGFP, Cassano stonewalled the auditor.

posted at: 06:57 Wed 18/Mar/2009 | /politics | permalink | 3 comments | trackback

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