Wednesday, April 8, 2009

More AIG Counterparty Nonsense

ProPublica has ridiculous article titled, Does AIG Really Need to Pay Its Counterparties in Full? Yes, AIG really has to pay its counterparties in full. The whole point of rescuing AIG was to keep it out of bankruptcy, and short of bankruptcy, there's no mechanism for forcing AIG's counterparties to take a haircut. But the ProPublica article really goes off the deep end when it says:

Another option is to break the contracts and let the counterparties -- many of which are themselves beneficiaries of federal bailouts -- sue the federal government, if they dare. ... Such a suit may not fare well in court because some legal questions swirl around whether the bulk of credit default swaps are legally enforceable. Some of the swaps function like insurance policies on corporate bonds. Purchasers of such credit default swaps know that even if the bond issuer defaults, they will limit their losses. But many other swaps are more like bets (akin to buying "insurance" on another person's house), and it is unclear from a legal perspective if there is enough of an insurable interest to make the contracts enforceable.
Wow. First of all, it's simply not true that "legal questions swirl around whether the bulk of credit default swaps are legally enforceable." Standard credit default swaps are enforceable. The credit default swaps that AIG wrote are enforceable. If the government breaches the contracts and refuses to pay, the counterparties will sue, and the government will lose. The author clearly shows that she has no idea what she's talking about when she says that it's "unclear from a legal perspective if there is enough of an insurable interest to make the contracts enforceable." Credit default swaps are not insurance contracts, so there doesn't need to be an insurable interest! CDS are like insurance contracts, but there are key differences. Just because a CDS contract doesn't fit the statutory definition of an "insurance contract," doesn't mean that it's not enforceable. Honestly, the complaints about AIG paying its counterparties get more idiotic by the day.

24 comments:

Anonymous said...

Didn't read the propublica article, but the distinction is between what one is entitled to and what one can get.

I've been involved (as has anyone who has ever started a business) where we are legally entitled to 100% payment but will settle for 80% or even 50% if that appears better than what we would get after a protracted legal fight.

Contracts are alway re-negotiated when circumstances change.

The 'payer' has enormous clout in such negotiations.

Anonymous said...

If I understand why AIG could not be permitted to go bankrupt, it is because a lot of counterparties to CDSs that AIG wrote would go under. What you are saying is that once the government says AIG will not be bankrupt, it cannot pick and chose which of its obligations it honors.

If so, would it not have been better to let AIG fail and then prop up only those entities that we think "deserve" not to go under as a result of AIG bankruptcy?

Anonymous said...

Hey genius, what part of contractual re-negotiation with the threat of bankruptcy behind it don't you understand? If you've never heard of it, just ask GM's bondholders today.

Before calling someone else idiotic take your head out of your ass.

Economics of Contempt said...

"If so, would it not have been better to let AIG fail and then prop up only those entities that we think "deserve" not to go under as a result of AIG bankruptcy?"

I think the fallout from an AIG bankruptcy would have been too widespread to take this approach. The reason the NY Fed decided to rescue AIG was because the major U.S. and European banks relied on AIG for hundreds of billions of dollars worth of regulatory capital relief. Had AIG failed, a lot of that regulatory capital relief would have vanished overnight. So all of the major banks would have been forced to raise billions of dollars ASAP to meet regulatory capital requirements -- all at the same time. The fire-sales would have been epic, and would have infected every asset class as the banks dumped whatever they could (every major market probably would have frozen). Oh yeah, and Lehman had just failed.

So I think rescuing AIG was about protecting much more than just AIG's CDS counterparties (though it was partly about that too). That being the case, I don't think the strategy of letting AIG fail and then saving the "deserving" victims was a realistic option.

(Especially since the Fed had less than 24 hours to assess the situation and make a decision on AIG -- all while dealing with the unprecedented destruction that Lehman's failure was causing!)

Economics of Contempt said...

"Hey genius, what part of contractual re-negotiation with the threat of bankruptcy behind it don't you understand? If you've never heard of it, just ask GM's bondholders today.

Before calling someone else idiotic take your head out of your ass."


People like you crack me up, because you clearly have no clue what you're talking about, but you're so sure of yourself.

AIG's CDS were collateralized and marked to market every day. All of the collateral AIG posted was either cash, Treasuries, or Agencies. If the Fed offered anything less than par, they'd get a polite "fuck you" from the counterparties. And if the Fed then let AIG fail, the counterparties would seize the collateral and liquidate it for the full value of their marks (or very close to it, since Treasuries and Agencies are extremely liquid). The automatic stay in bankruptcy doesn't apply to CDS, kid.

And even if AIG's CDS weren't fully collateralized, your argument would still be clueless. The government has very clearly demonstrated that it's not willing to let AIG go into bankruptcy, so the idea that the government could renegotiate the contracts with "the threat of bankruptcy" is simply laughable.

Anonymous said...

I think it is you who doesn't quite get it:

1) AIG had no capital to post collateral which caused the problem in the first place

2) Dealers acting as counterparties to AIG had a fiduciary obligation to understand the risks of dealing with AIG.

3) A bank that lends money to a company knowing that company also has borrowed from a dozen other banks and has poor controls over the use of those loans surely lends at its own peril.

4) Dealers pretty much expected the government to bailout AIG in the event of collapse and advanced disaster scenarios to almost guarantee a government bailout.

5) The government would have best served free markets and the taxpayer by allowing AIG to fail. The shareholders at BAC, GS, MS, etc. would have then demanded why such exposure to AIG existed.

5) GS, BAC, MS, etc I'm sure will be most gracious to George W. Bush, Hank Paulson and Tim Geithner in the upcoming years as well as bloggers like you who carry their water.

Anonymous said...

It's clear that the sensible solution would have been to just let AIG fail, let its counterparties take their deserved haircut, let them fail, and then watch the ensuing populist revolution as markets crumble and the heads of the investor class are asked for.

Or we could just pay counterparties 80 cents on the dollar. Your pick.

Anonymous said...

Interestingly you mentioned that CDS is like an insurance contract but is not an insurance contract and you are right legally speaking. But from a financial standpoint CDS are not like insurance contracts, they are insurance contracts. Unfortunately they were underwritten and managed by non insurers neglecting the most basic rules of insurance, hence the current crisis.

Economics of Contempt said...

1) AIG had no capital to post collateral which caused the problem in the first place

As soon as the NY Fed bailed AIG out, all the collateral had been posted. The issue is whether the government, after intervening, could have negotiated haircuts for AIG's counterparties. The answer is a definitive "no," since AIG had lost its rights in the collateral absent a credit rating upgrade. This is the real world, not some simplistic hypothetical.

None of your other points have anything to do with anything I said. Arguing with straw men about how to best serve "free markets" may make you feel good, but it doesn't make you right.

Economics of Contempt said...

"It's clear that the sensible solution would have been to just let AIG fail, let its counterparties take their deserved haircut, let them fail, and then watch the ensuing populist revolution as markets crumble and the heads of the investor class are asked for.

Or we could just pay counterparties 80 cents on the dollar. Your pick."


Or we could, you know, bail out AIG and honor its contractual obligations. Which is, by the way, what we're doing.

If we chose to "just pay counterparties 80 cents on the dollar," the counterparties would seize the collateral, sue AIG, and win on summary judgement. And then we'd end up paying much more than 100 cents on the dollar. I'll pass, thanks.

Economics of Contempt said...

"Interestingly you mentioned that CDS is like an insurance contract but is not an insurance contract and you are right legally speaking. But from a financial standpoint CDS are not like insurance contracts, they are insurance contracts."

Not true.

Standard CDS are collateralized, or "pay-as-you-go," whereas insurance contracts provide for one-off, lump sum payouts. As the CDS spread widens -- that is, as the reference obligation gets closer and closer to default -- the protection seller has to put up more and more collateral.

If you buy fire insurance, and then your neighbor's house catches on fire, you can't call up the insurance company and demand that they post 60% of the payout in collateral to reflect the increased chances that your house will catch on fire.

CDS are not insurance contracts either legally or financially.

Anonymous said...

Collateralization of CDS contracts is about as realistic as the Easter Bunny.

1) How do you collateralize a CDS on ABS or CDO? Who determines the mark?

2)Why do you think the ICE hasn't started 'clearing' single name CDS?

CDS are nothing more than insurance contracts on defaults. They can't be hedged. They can't be priced through any normal arbitrage mechanism.

A client had sold a brace of CDS on CDOs back in 2006. The collateral they posted (which they only began posting in 2008) against their position was about 15% of notional Needless to say the writedowns reached 100% in one month.

The American taxpayer was cheated by the Bush Administration and the Obama Administration is compounding that crime.

Economics of Contempt said...

"Collateralization of CDS contracts is about as realistic as the Easter Bunny."

Huh? The dealers have been posting collateral on their CDS positions every day since 2004. It's not just realistic, it's been very real for several years.

"How do you collateralize a CDS on ABS or CDO? Who determines the mark?"

CDS on ABS and CDOs are inherently collateralized, as the dominant template is pay-as-you-go. Whoever is designated as the Calculation Agent determines the mark. Usually it's the dealer, but not always.

"Why do you think the ICE hasn't started 'clearing' single name CDS?"

Because they were waiting for the Big Bang to standardize contracts with fixed coupons, no restructuring CE, updated cash settlement auction procedures, etc. Strict standardization is a prerequisite to central clearing.

To say that collateralization of CDS is "as realistic as the Easter Bunny" is literally to deny reality. I've never argued that the CDS market is perfect, or that collateralization makes the CDS market super-efficient or anything. I've simply been pointing out that, like most CDS, AIG's CDS were in fact collateralized, which makes the notion of "tough negotiations" with AIG's counterparties laughable.

If you're unwilling to distinguish between positive and normative statements, then we can't have a serious conversation.

Anonymous said...

For some pretty assertive, you seem pretty ignorant of some basic concepts which does make it difficut to have an intelligent conversation.

PAUG in CDS on CDO and ABS refers to the fact that payments are made over the life of the asset -- not just once as in a CDS. It has noting to do with collaterlization.

The Calc Agent computes the balances on the reference assets but the writedowns on the CDS are computed via ISDA formula (which itself is very vague). The Calc Agent does not compute the mark-to-market on the CDS.

Economics of Contempt said...

"For some pretty assertive, you seem pretty ignorant of some basic concepts which does make it difficut to have an intelligent conversation."

OK, I apologize if I was overly aggressive before. With everyone commenting anonymously, it's hard for me to differentiate between the people telling me to "take [my] head out of my ass" and the non-crazy people.

"PAUG in CDS on CDO and ABS refers to the fact that payments are made over the life of the asset -- not just once as in a CDS. It has noting to do with collaterlization."

Clearly we're using different definitions of "collateralization." Floating Amounts are reversible, which makes paying them economically identical to posting collateral. Making payments over the life of the contract rather than in one lump sum is "collateralization" of a CDS. You may have a different definition, but everyone in the CDS market refers to CDS on ABS/CDOs as "collateralized" for this reason. How are you defining collateralization?

"The Calc Agent computes the balances on the reference assets but the writedowns on the CDS are computed via ISDA formula (which itself is very vague). The Calc Agent does not compute the mark-to-market on the CDS."

The Calc Agent also calculates the asset value of the underlying for purposes of Implied Writedowns, which, as (optional) Floating Amount Events, necessitate additional collateral from the protection seller. That's what I meant. Given our different definitions of "collateralization," we were clearly just talking about different things here.

No hard feelings. We were obviously just arguing past each other.

Anonymous said...

I too apologize if I was strident -- it was Saturday morning. I enjoy coming to your site.

The problem is that the 'floating payments' are both unknown and can be massive.

A realistic,albeit simple, example might illustrate the problem.

A bank buys protection via CDS on a $100MM face of CDO Tranche. The seller, a monoline insurance company, is required to cover any interest shortfalls and principal losses.

In return, the bank pays $50,000 monthly to the insurance company.

Each month the Calc Agent computes both the expected pricipal and interest payments as well as the actual princiapl and interest payments. Each month, the bank will send a 'claim' to the monoline asking for coverage of any deficit in principal or interst (sending along a copy of the calc agent's report. I mean the analogies to an insurance claim are amazing.)

The bank is clearly at risk that the mononline can't satisfy a monthly claim.

However, how does the bank make the monoline put up collateral to cover future claims?

Let's say the monoline agrees to put up $10MM. What if the principal shortfall next month is $75 million next month and the monoline can't pay.

The bank only has $10 million. Can the bank reasonably expect the monoline to post $100MM?

I've seen dozens of CDS on CDOs that have had sudden 1 month writedown of 100%

Economics of Contempt said...

"The problem is that the 'floating payments' are both unknown and can be massive."

Oh yeah, I agree that this basically nullifies the "collateralization" effect of the PAUG format for CDS on mezzanine CDOs, since the Floating Amounts can easily be over 75% of notional. And I have absolutely no sympathy for the monolines in this situation, because back when we were drafting the original PAUG CDS template in 2004/05, they cried like little girls about the physical settlement option for Implied Writedowns. Something about "liquidity risk." They finally got their way when they introduced their own "pure PAUG" CDS on CDO template. So it's amusing when, even with their own PAUG template, the CDS they wrote on mezzanine CDOs suffer one-month writedowns of 100%.

AIG, on the other hand, wrote CDS on super-seniors almost exclusively. And since those super-senior tranches all represented ~90% of the CDO issuance, the PAUG format actually did manage to collateralize those CDS. By the time the NY Fed bought the underlying CDOs from AIG's counterparties and cancelled the CDS, AIG had already posted $35 billion in collateral on those contracts. It was AIG's CDS that I was referring to earlier when I was talking about CDS on ABS/CDOs being collateralized.

Rhodo Zeb said...

Its a good discussion in here, please keep it up.

EoC sometimes reminds me of the early battles between heavyweights like Brad Delong and Billmon and maybe a couple of others.

What would happen is that one person would say the other was wrong. Completely wrong. Clueless, even. And it would come off a little harsh, kind of uncool.

There is always another angle, and it is easy to 'argue past' each other, as EOC says.

Dialing down the certainty and contempt, if you will, might be in order.

Anonymous said...

And your example highlights the shabby manner in which the Bush Adminsitrattion and Tim Geithner dealt with the taxpayer.

A bank that bought 'insurance' from AIG on CDO tranches knew (or should have known) that under certain scenarios AIG would not be able to make good on those claims.

The banks made a bet that that outcome would not occur.

When the bad scenario happened, the banks (GS mainly, I suspect) leaned on Paulson/Geithner and had the taxpayer bail them out.

There was probably minimal collateraliztion of the CDS exposure prior to that point.

When the 'extreme event' happened, GS was able to get the taxpayer to post the collateral that AIG was not able.

The taxpayer provided cash to meet the the obligations of future floating payments and also provided cash so AIG could buy the CDO tranches from the banks.

GS stock has risen nicely thanks to the munificence by Hank Paulson and Tim Geithner.

Anonymous said...

i have read that AMBAC, MBIA and other financial guarantors have arranged for commutations of structured credit policies at 20-25 cents on the dollar. I believe Dinallo was involved; he apparently threatened to declare the guarantors insolvent, and make everyone wait 20-25 years for the last muni bond to pay off, to make sure there were no fraudulent conveyance payments made beforehand to any one class of creditor. Since structured credit and muni bonds were underwritten in the same subsidiary, that's the most credible threat he had (i understand that he claimed that CDS is subordinated to other guarantees, but lawyers at Linklaters and other firms disagree). It appears to have worked.

Anyway, with that backdrop, I dont think its idiotic to wonder why AIG might not have tried to pursue the same strategy. Whether its LBO companies, auto companies, households talking to banks, etc., this is the era of paying off liabilities at less than par (and also being able to defer the resulting capital gain). That's why everyone is surprised that AIG went and paid everyone at par.

If the whole bailout exercise, by the way, was to ensure that european banks (whose capital was insured by AIGFP, i think for around $300 bn) did not fail, the Fed should have disclosed that, dont you think?

qadi said...

This happened because AIG had a bullshit AAA rating.

They were a deadbeat bookie, and so to hell with their counterparties.

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