Or, "what should have been done with AIG and why". No, not the bonuses. I mean the original response by Geithner, Paulson and Bernanke on September 16th 2008. George Santayana's phrase "those who cannot remember the past are condemned to repeat it" is unfortunately applicable to this situation. As will be described, the lesson that was forgotten was the Long Term Capital meltdown in 1998. Their confusion in understanding the approximation which is mark to market accounting, their failure to understand a financial market "squeeze", their failure to not compare mortgage values to actual housing values in the real housing market, their crony identification with the very firms they were regulating, their failure to realize that derivatives are a "cash zero sum" transaction, and their inability to be calm under fire and rise above the cacophony of screaming Wall Streeters, all lead to the unnecessary cash bailout of AIG. And all that has followed. They were in their positions to understand just these issues, but they did not, or did not care.

OVERVIEW 

What, ultimately, was the nature of the AIG debacle? Entities---predominantly banks and investment banks-- which either owned mortgages/mortgage backed securities, or wished merely to short them, “sold” them to AIG largely from 2005-2007. They did this through a type of derivative called credit default swaps ("CDS"). If the capital and cash requirements for derivatives had been the same as the underlying securities they replicated, AIG would never have gotten as large as it did in this market and their insolvency would not have happened. A good argument can also be made that the "mark to market" meltdown would never have occurred to the degree it did in the mortgage market. The over-the-counter derivatives market should have been using the same or similar rules as the listed derivative exchanges require. In practice they usually do. In the case of AIG, they did not. However, even given these irresponsible circumstances, the debacle could still have been mitigated and been largely contained.

Derivatives are often misunderstood. Their apparent complexity belies their actual simplicity. All derivatives are simply cash zero sum bets. What is a cash zero sum bet?  You are in Atlantic City and go to the roulette wheel. You bet on red and win. The casino pays you cash. Their loss is your gain. This is a "cash zero sum" bet. All derivatives are bets of this nature. Any market view can be expressed using derivative contracts. Derivatives create market efficiency as long as the users know what they are doing. Derivatives can be used to replicate cash transactions. Instead of selling a security or a commodity to another buyer, one can enter into a derivative trade that replicates the underlying economics of such a sale. Derivatives were first used as "insurance" in the agricultural futures market, not unlike what AIG was doing in the credit market. Derivatives are more easily traded than securities. Occasionally, they were used to close "arbitrages" that existed between different financial markets. It is not derivatives which are the problem, it is the incorrect use of them which is.

In the case of AIG, derivatives were used by Wall Street Firms and others to replicate a "sale of mortgages" to AIG. But there were other features too. Rather than precisely replicating what is done in the underlying securities markets, they were used on the part of AIG's counterparties to increase their own leverage, versus what is permitted and/or practiced in the securities markets; and they also provided AIG greater leverage than is standard practice in the securities markets. The regulatory rules as well as market practices are often different for derivatives than for securities for the exact same risk. This, of course, is absurd. How did this happen? Derivative individuals took over the capital markets businesses of the leading financial institutions and were, and are, the primary people interacting with the various "oversight" bodies (internal to their firms as well as external) on capital and mark to market rules. This seems bizarre, but it is true.  These are not necessarily conspiratorial behaviors. Many derivative people are simply "hopelessly talented". They can be talented in that they truly understand a tree's nature. They can be hopeless in that they often never realize they are in a forest.

THE LEVERAGE OF WALL STREET AND AIG

How were the "sale of mortgage securities" to AIG structured? In a securities based world, the standard way to sell a security is to sell it outright for cash, or more often, by lending the money to the buyer for the purchase. This is done through what is jargonistically called the "repo" market. A repo, or  a "repurchase agreement", is really just an overnight loan collateralized by the very security the buyer is buying. In order to borrow money to buy the security, firms require a partial cash down payment by the buyer, called a "haircut" (more jargon). These loans tend to be rolled over daily and have protective provisions. They have what are called maintenance provisions. A maintenance provision requires the borrower to post more cash daily if prices go down. These loans are also immediately callable. This means the seller can simply unwind the trade at any time for any reason and take back the securities that were sold. Wall Street's financial lifeblood is the repo market. They are virtually the safest kind of loan that can be made. In fact, almost all derivative trades mimic this model in some way. This is why "trillions" of assets and derivatives can be traded daily among financial institutions and there is rarely if ever a serious financial problem. 

However, this is not how the AIG deals were negotiated. The "street" made the same error with AIG that it did with Long Term Capital in 1998. Compared to normal practice, the "purchases" of mortgages by AIG; 1) were 100% financed---there was no cash downpayment required; 2) there were no maintenance provisions as long as AIG remained AAA. If prices declined AIG was not required to post further cash; and 3) the CDS were "term contracts". This means they could not be unwound by the “sellers” accept under certain conditions. This is remarkable. Every safety feature that is normally and universally employed was ignored. Why in the world would "sellers" agree to these terms? AIG was AAA and used to getting their way on issues involving posting cash. After all, they had the best credit in the world. It was as simple as that. Sellers were so desperate for the "sale", they simply caved. This is exactly what happened with Long Term Capital. No one was around who remembered. As a side note, Warren Buffet, on a much smaller scale, has been able to to demand the same terms in his equity derivative trades with the street.

When the final tally was calculated in September 2008, AIG “owned” about $600 billion of mortgage related credit instruments through this method. Ironically, there were provisions  in the CDS agreements which did require AIG to post cash. But the way it was structured required them to post cash exactly at the point in time when they would be unable to do so; when their credit rating declined from AAA. I say ironically, because arguably we would have been better off if there had not been a "ratings trigger" requiring them to post cash at this juncture (again, as an aside, Buffet refuses a rating trigger). It does little good to demand cash at just the exact point in time it cannot be posted. But Goldman was leading the charge to demand cash be posted. Here was the point in time where intelligent clear eyed thinking was now crucially needed by the regulators. And here is when they failed.

GREENSPAN VERSUS GEITHNER/PAULSON

Those are approximately the details of what lead up to AIG's demise. It was going to be a crisis under any circumstances, but why one so large? Let's stipulate it as obvious that a dollar of investment can only be lost once. If these CDS represented, for example, mortgages on defaulting houses in California, then the decline in the value of those houses is the true, or fundamental, loss the financial system experienced. No more, no less. The banks of the world believed it had “resold” the risk of these mortgages to AIG. But, lo and behold, that turned out to be an illusion. AIG could not afford to "buy" the mortgages after all. They had no cash, and never had to post it. This means the credit risk of the mortgages reverted back to the original sellers like Goldman Sachs, Deutsche Bank, J.P. Morgan, etc, etc. It was as if the trades never happened.

But in a world of contracts and property rights AIG was still properly on the hook. What should have happened? The closest analogy to the AIG situation was Long Term Capital. What happened with Long Term Capital?  Alan Greenspan, in a then controversial move which was criticized as encouraging moral hazard-–how innocent and ludicrous that seems by the standards of today--met with Long Term Capital's counterparties and basically said “it is in your interest not to force these guys to post collateral”. Why? Because that would have set in motion an even larger wave of selling thus driving down prices further. One might call Greenspan's arm twisting, “collateral posting forbearance”. He convinced them it was in their own interest to do this. An orderly unwind of Long Term Capital, rather than panic selling caused by LTCM's need to raise cash, was in every one's best self interest. However, in order to do this, LTCM had to be put into bankruptcy proceedings. Greenspan told the Street their money was at risk. If they wanted to not lose more of it, they should stop any action which would require panic selling. What is interesting about AIG is we get to look at what would have happened had Greenspan not intervened with LTCM. An interesting accidental social experiment.

Why did this not happen with AIG? We can speculate based on what we know.The most obvious answer is that Greenspan had a clue and Paulson, Geithner and Bernanke did not. Greenspan lead, he did not follow. In a world where we tend to superstitiously believe in impersonal deterministic forces, it is easy to forget that one man with an idea can sometimes make all the difference in the world. He called the meeting among the banks. He strong armed them to do what was in their best interest. He basically told them not to panic right when they were in a state of panic. It worked. Conversely, when Goldman saw their gains were going to be partially wiped out, they persuaded their former comrade, Henry Paulson, and his senior associate, Tim Geithner, that the world was going to come to an end if Goldman did not get their cash now. The world was also misled by Paulson and Geithner. They created the perception that somehow AIG's real insurance contracts were at risk. But their global regulated insurance entities had nothing to do with the CDS contracts. They might as well have been another company. The derivative contracts were obligations of the holding company, a separate legal entity which owns the insurance companies. The insurance companies were never at risk.

THE "LONG SQUEEZE" AND THE MARK TO MARKET ILLUSION

When AIG was unable to come up with cash collateral when their credit rating declined, what should the regulators have done? They just let Lehman go under virtually the same day, didn't they?  That is what they should have done. While many look back at Lehman's bankruptcy as some watershed event, the fact is the unwinding of Lehman was a non event. Another irony is no one would roll over their short term loans to Lehman, but it was Goldman who was really up sh....ts creek without a paddle. AIG did not owe Lehman money, they owed Goldman money. But Goldman had their men in DC and Lehman did not. Lehman should have been unwound. Those are the breaks. But nothing happened when they were. They still exist; they are called Barclays. 

AIG's market value in 2006-2007 was $180 billion. Virtually all of that was related to their insurance businesses which could have been sold if put into receivership. We don't know what Wall Street Firms would have had to merge or been taken over if AIG had not been bailed out. But like with Lehman, it is likely nothing would have happened. Instead of leading calmly, Paulson joined the rush to escape from the theater after Goldman yelled fire. This helped trigger a giant “long squeeze” and eventually an entire money market collapse.

The Government, like a bull in a china shop, rushed in a panic to provide AIG with cash. The world followed suit as they saw the giant AIG stumble. Effectively, the market began to "squeeze" AIG. They knew AIG was going to have to cover. They knew the government had little to no patience. The world shorted CDS.  There was enormous short selling in the CDS market—creating widening spreads and declining mortgage values. The world did what it always does when a financial institution is in trouble. They opportunistically looked for ways to benefit. If AIG was going to have to unwind, i.e. "sell" their positions, the market was going to make sure they would sell at the lowest price possible. Hence, they shorted CDS in front of them.

The sizes were large enough to have caused the rapid decline in mortgage values we saw. The William Lucy study (UVA professor William Lucy), which I have referenced in my last 2 essays, demonstrates that the magnitude of market decline in mortgage values could not have possibly been based on fundamentals. This information was apparent to anyone with an internet connection, let alone the government. Anyone doing a simple set of calculations and scenario analysis could have seen that. The participants in the financial markets were shorting both out of self protection and opportunity. They drove down the financial prices of mortgages. But these prices were completely disconnected from the underlying value of the housing assets they represented. But Geithner, Paulson and Co. either never realized this or thought their job was simply to get Goldman its cash when they demanded it. Again, if they were not practicing crony capitalism and if they simply provided leadership to the market place, the panic would have gradually subsided, just like it did in 1998. This eventually lead to Paulson's view that we needed $700 billion of TARP money to bid up the prices of mortgages they just drove down. He and his sidekick, now successor, tax idiot Tim Geithner, created chaos. Their future supreme leader, the "laughing president" got just what the doctor ordered, a "crisis" which cannot go to waste, as he creates his "statist" regime.  What a nightmare.