Branding the situation an 'outrage' for American taxpayers, who control around 80% of the company, the US President said that AIG had fallen into financial distress due to "recklessness and greed" and questioned the justification for paying out staff bonuses. Mr. Geithner was instructed to "pursue every legal avenue to block" some $165m of payments due immediately to members of AIG's London-headquartered Financial Products team, including what are thought to be several multi-million dollar pay-outs for a number of key British staff. In a hard-hitting series of comments President Obama took aim at the Financial Products team, responsible for a $40.5bn loss last year which in large part drove AIG to the brink of collapse, saying "it's hard to understand how derivative traders at AIG warranted any bonuses." AIG intends to pay out $450m within the next few weeks – part of an overall compensation pool of $1.2bn. – UK Telegraph
Dominant Social Theme: Greedy guys at AIG.
Free-Market Analysis: This is pretty incredible. AIG got into trouble playing the derivatives games. It "swapped" risk-based contracts and took fees, but never set aside funds as it would with ordinary insurance risk. Additionally, there is probably nothing wrong with derivatives under a gold standard. But it was "easy" fiat money that allowed AIG to create the derivatives and take the risk in the first place. Derivatives, all US$400 trillion, (most not unwound yet) are nothing but the biggest fiat money bubble of all. Bigger than "tech," bigger than the mortgage bubble – these derivatives are pure speculation, but because they are so contractually obscure, and overwhelming, until they are dealt with, the rest of the financial system will doubtless remain in some sort of paralysis.
Here is how AIG's derivatives business worked, according to an email response to an article on the AIG fiasco in the Dallas Morning News. We don't know the attribution, and we wouldn't ordinarily publish an unattributed email, but it is a good summary that rings true, confirming what we already understand about the way the AIG pursued its derivatives business and why it got into trouble.
The problem [is that] AIG didn't sell "insurance" because "insurance" is a regulated product that requires the insurer (AIG) to maintain a pool of cash to pay out for losses. What AIG sold were contracts that indemnified (mostly) investment banks from losses on certain investments they held (mostly mortgage backed securities, but AIG would sell you a swap on just about anything). These contracts (the credit default swaps) were unregulated and didn't force AIG to maintain any sort loss pool, so they didn't. Money went in to AIG when the banks bought the swaps and instantly fell to the bottom line as profit. Another side effect of the way AIG was selling the default swaps: Once they sold a swap on a set of securities, those securities would have their credit rating raised to match AIG's perfect AAA rating. Because they were indemnifying the underlying securities, it no longer mattered what they were, just the odds that AIG would pay off in the end.
The Dallas Morning News article, not excerpted above, has harsh words for another part of the AIG crisis – the places where the government bailout money went (apparently over US$100 billion by now though it is difficult to keep track.) "Billions and billions of taxpayer dollars went to pay off investment banks — Goldman, JPMorgan, et al. — who bought credit-default swap policies from AIG, which AIG could not pay out on. These are the same firms who spent gobs of cash successfully lobbying Democrats and Republicans for years to keep government oversight of derivatives and credit-default swaps at bay."
OK, so let's take a deep breath and summarize. AIG was a reinsurer of insurers but several years ago it slowed its normal course of business and revved up its swaps business. These swaps were trades in which AIG certified that it would make good on any losses, but didn't put money aside to cover potential losses. When the bill came due, AIG went to the US federal government which basically made good on the promises that AIG had made. Thus the counterparties were made whole – and these counterparties were among the biggest American and European financial entities. As we have already indicated, the AIG bailout was actually a bailout of the larger financial industry. That was the reason for the bailout. Without it, Wall Street, and who knows, maybe London's City big banks would have gone down sooner and harder.
To fulminate about AIG bonuses is to miss the point. There is no way that America's largest insurer could have or would have taken such risks were not the entire system corrupt from bottom to top. AIG's top people were not foolish, anymore than the rest of Wall Street. At this point moral hazard hardly exists. AIG execs probably figured if things soured they would be bailed out. And they were. Now they are busily dispensing bonuses to the same people who made the bad bets. And what can anyone in Washington do but fulminate? It's rank hypocrisy, but that is how the game is played. Return to an honest money system and this sort of nonsense diminishes to almost nothing. Speculation like this is an inevitable side effect of fiat money. Back money with an asset and you won't get it again. The problems have almost nothing to do with regulation and everything to do with a corrupted money supply. Washington probably won't go there, though. It will gladly fix the salaries of corporate America from top to bottom before it will even attempt to deal with root causes. And actually, it likely never will.