Guest Post: Suspicious Timing Surrounding The "De-risking" of AIG's Toxic Obligations

Submitted by David Fiderer, posted originally on the Huffington Post

Suspicious Timing Surrounding The "De-risking" of AIG's Toxic Obligations

Because everything unraveled so quickly, no one scrutinized Standard
& Poor's flip-flop on AIG. On Friday, September 12, 2008, S&P
said it would, "continue discussions with the company over the coming
weeks regarding liquidity and capital plans. Once we have more clarity
on these issues, we could affirm the current ratings on the holding
company and operating companies or lower them by one to three notches."

Of course, that never happened. S&P did not wait, and issued a
downgrade the following Monday. It had at least one conversation with
AIG that day, when only two things were clear: Nothing at AIG was
settled, and the contagion effect
from the Lehman Brothers bankruptcy was huge. The discussions could not
have been especially detailed, since AIG's financial staff was
preoccupied in its negotiations with Hank Paulson's deputy, Dan Jester, Goldman and JPMorgan Chase, who ostensibly were trying to put together a bank deal that would address S&P's concerns.

For S&P, the only way to find clarity at AIG was to peer into
its own reflection. AIG's liquidity was dependent on its credit
ratings, or more specifically, ratings triggers. And AIG's biggest
problem - its unsettled disputes over the valuation of $62 billion
worth of CDOs - was traceable to the reliance on AAA credit ratings of
those CDOs.

For a financial company like AIG, liquidity is like oxygen; it can't
live very long without it. To take the analogy a bit further, solvency
is more like food; you'll die without it, but your lack of nourishment
won't be apparent for a while. Around 6:40 p.m. on September 15, 2008, Fitch announced its downgrade of AIG, and few hours later Moody's
followed suit. Whether or not the rating agencies acted independently,
or in good faith, is an open question. But there is no doubt that they
all knew the consequences of their actions. The rating agencies cut off
part of AIG's oxygen supply.

More specifically, AIG's unregulated subsidiary, AIG Financial
Products, which operated under the financial guaranty of its parent,
had hundreds of billions of dollars of trading positions in all sorts
of derivatives. AIGFP's obligation to post cash margin on those trading
positions was based on its credit ratings. The lower the credit
ratings, the more cash margin required. As of September 12, 2008, if
AIG were downgraded one notch by one credit agency, its expected liquidity drain
would have been about $10.5 billion; if it were downgraded one notch by
two agencies, the damage would have been $13.3 billion. During the
evening of September 15, 2008, S&P downgraded AIG three
notches, from AA- to A-, and downgraded it's short-term rating from A-1
to A-2. Those downgrades, plus the downgrades at Moody's and Fitch,
precipitated a $32 billion liquidity drain by month-end.

On September 16, 2008, when the government hurriedly put together a
bailout package for AIG, everyone was focused on AIG's immediate
liquidity needs. Certain ratings triggers, with 30-day lead times, were
not given top priority. Those triggers had been tripped by downgrades
from S&P, and not by those at Moody's. But 18 days later, after AIG
had become a ward of the state, Moody's decided that it too would start
the 30-day countdown on the ratings triggers of some other CDOs. On
October 3, 2008, Moody's downgraded AIG from A2 to A3.

The timing these embedded rating triggers were part of the backdrop
of Thomas Baxter's testimony for the House Oversight Committee on
January 27, 2010. Baxter, the general counsel for the New York Fed, was
part of the team that oversaw negotiations with banks holding credit
default swaps on $62.1 billion worth of CDOs that the government
purchased at par. Baxter gave some of the most important testimony of
that day's hearings:

First of all, there was a critical deadline, Congressman,
of November 10th. And that was the day that AIG was going to announce a
$25 billion loss in its 10-Q for the third quarter. So we were looking
at that.

And we were being told by the credit rating agencies that unless
something happened with respect to the credit default swaps, on or
before November 10th, that there was a strong probability of a
downgrade.

Now, a downgrade would have been catastrophic. It would have brought
us back to where we were in September, on the brink of an AIG
bankruptcy.

So from those of us who were working on -- at the New York Fed, we
looked at that as a hard deadline. And the execution risk of failing to
get the credit default swaps torn up by that date was -- was -- it
would put us back on the brink of bankruptcy.

So that was -- that was the risk of deal failure. That was the execution risk. So we had to get the deal done.

AIG had been unable, as Mr. [Elias] Habayeb [AIGFP's CFO when a lot of those toxic assets were booked] has testified, to get that -- those credit default swaps torn up.

On November 6th, Congressman, we got formal authorization from
Stasia Kelly, who was then AIG's general counsel, to take over and see
whether we could get those credit default swaps terminated by deadline.

So we were operating against the clock to do that.

Our choices were, should we push for concessions and try to use
whatever leverage we had to get those concessions, or should we simply
go to par, which would apply to every counterparty -- and the way par
works is you offset the collateral that these counterparties had been
pulling out of AIG against you offset that collateral against the par
price of the bonds.

Moody's announcement,
contemporaneous with the November 10 deadline, backs up Baxter's
testimony. AIG's A3 rating, which had been under review for possible
downgrade, was affirmed, following the government-supported
restructuring plan, which included "de-risking" the CDO exposures.

The dates are critical. The New York Fed was first authorized to
negotiate on behalf of AIG on November 6th, 2008, which was a Thursday.
And the New York Fed believed that the absolute deadline for setting
everything with 14 different banks was the following Monday, when AIG
was required to file its 10-Q with the SEC. That might have been
possible if the banks were motivated to cooperate. But, as The New York Times
reported, one of the largest CDO counterparties, Goldman Sachs, "did
not own the underlying bonds. As a result, Goldman had little incentive
to compromise."

If people have little incentive to compromise, they don't make
themselves available over a four-day holiday weekend. It's a safe bet
that most senior bankers and bank regulators in France took that
Monday, November 10, as a vacation day to segue into Armistice Day. The
same was true for a lot of bankers in the U.S., where Veterans Day is a
bank holiday.

There's another reason why a banker would be disinclined make
himself available over the weekend. He would need to assemble a group
of very a senior executives in order to say, "I need an emergency
approval to agree to something that will force us to write off billions
of dollars on a deal that's been the subject of contentious
negotiations for the past fifteen months. And the reason why I need an
answer right away is because..." If you convene such a meeting, you
need to be prepared for tough questions, which may include, "Are we
legally required to do this?' or "Are the other banks also taking a
comparable haircut?" If you value your career, you'd better have some
good answers to show that you are acting on behalf of the bank.

On Friday, November 7, 2008, a subsidiary of Societe Generale,
another large CDO counterparty, put AIG on notice that it had defaulted
on the swaps of several CDOs. And those defaults could not possibly be
cured. Those defaults were triggered by the S&P and Moody's
downgrades.

Trust Company of the West, an SG subsidiary, was the collateral
manager for Davis Square Funding I, Davis Square Funding II, Davis
Square Funding III, Davis Square Funding IV, Davis Square Funding V,
Davis Square Funding VI, and West Coast Funding I. All of those deals,
with the exception of Davis Square Funding II, were originally
structured and underwritten by Goldman.
Each of those deals is a separate legal entity. Each of those entities
had entered into one or more swap agreements with AIG Financial
Products. Under the various swap agreements, if AIG were ever
downgraded below certain levels, AIG had so many days to find a
substitute swap counterparty, with a higher rating, to assume AIG's
contractual obligations. Of course, in the fall of 2008, no substitutes
were not easily found, since only a handful of parties understood these
very complex CDOs.

If 30 days had passed following the downgrade, and AIG had failed to
find eligible substitutes, the entities were entitled to terminate the
swaps. But Trust Company of the West did not deliver those notices of
termination on October 15, or November 3, when those rights first
became effective. Only after the New York Fed took over negotiations
did TCW deliver that notice on Friday, November 7, the last business
day before AIG was required to file its 10-Q, and the day after the New
York Fed took over the process. At the Paris headquarters of TCW's
parent, the business day is over by noon, New York time.

When testifying before Congress, Neil Barofsky, the Special
Inspector General for TARP, said, "I think very much these negotiations
could have been conducted in a different way, a more forceful way."
Yes, the negotiations might have been very different, if the New York
Fed had more than two business days to wrap up a a contentious 14-bank
negotiation that had dragged on for 15 months.

The deal with the banks was twofold: terminating the credit default
swaps which insure the banks' investments on these CDOs, and also
turning over the underlying CDO investments. The unexamined part of the
negotiation pertains to the other ratings triggers embedded in the CDO
documentation. Under some of the CDO documentation, if AIG were ever
downgraded below A-, some of some of the banks could terminate their
credit default swaps, hold on to the cash collateral that it held, sue
for the difference, and also keep the CDO. That's one reason, in
addition to the collateral calls on the hundreds of billions on others
derivatives, that a further downgrade of AIG would have been
catastrophic. In addition, if the CDOs terminated the interest rate
swaps, because of their rights under earlier downgrades, AIG's sundry
interest rates swaps with the CDOs, which were all in the money, would
have effectively become unhedged, losing AIG billions more. On March 6,
2009, TCW went to court, seeking a declaratory judgement to terminate
all the relevant swaps. AIG was eventually able to find substitute
counterparties to take over the CDO interest rate swaps, but the
November 7 notice signaled that TCW wasn't going to make things easy
for AIG. On March 6, 2009, TCW went to court, seeking a declaratory
judgement to terminate all the relevant swaps. It's an issue that has
not been adequately examined by Barofsky, Congress or the press.

As with everything related to the backdoor bailout of the banks,
timing and dates are critical. In the weeks and months following the
de-risking of AIG's CDOs, the ratings of those seven deals were slashed
severely. The ratings agencies are regulated by the Federal government.
There is no way that Congress can understand the AIG bailout without
carefully scrutinizing the decision making process behind these
specific ratings and subsequent downgrades.

Comments

[Anonymous]

the more that comes out the more fucked as a taxpayer you feel

the beneficiaries, jpm and gs and some big others had to know all of this in spades and that they would be backstopped to save the world

in the end 1/2 a depression and these guys are bigger and badder than ever

i'm not portending to some co-ordinated blah blah blah during the downtrend, yet, at the end all these guys were inside and knew what to do and when to do it too benefit tremendously, buffest loan looks more and more suspicous each day imho, he says oh buy low, which if you know anything about him is total bs at times, he was being spoon fed as much as anyone

[glenlloyd]

True, we don't have all the information about what was happening, and I'll be the first to admit that I don't know much of what transpired, but then again very little information, or transparency if you will, allowed the tax payers, those who had to backstop this disaster, was utilized.

The fallback position on the bailout of AIG has always been that the economy would have collapsed. Unfortunately there's no way to prove that, yet it's always paraded about as the excuse. My guess is that it probably would have collapsed but we won't ever know.

The big question is though whether it had to be done, and I would argue that regardless of TBTF or the "economy collapsing" that it's not the government's job (tax payer) to backstop a private sector entity with tax payer dollars, especially when the tax payer is saying don't do it. There's no justification in my book, none whatsoever, there have to be consequences for your actions otherwise no one fails and no one learns and the system becomes worthless.

My understanding is that the insurance side of AIG would have remained untouched, regardless of what Timny G blithered on about at the hearing, so who did this actually protect? Did it do nothing but protect AIGFP? Did the backstop / bailout protect the parent? If so then how and why was it necessary. in the grand scheme of things this will be remembered as the biggest failure of rational minds, when Paulson / Bernanke et al succumbed to the idea that they needed to do something at all.

[Anonymous]

It was a zero-sum game. Period. There would of been very little effect on the economy.

[Dirtt]

"There is no way that Congress can understand the AIG bailout without" Without admitting what? That they should be sharing the prison cell or standing in line before the firing squad. I have ONE WORD in response to everyone and everything. RICO. It's a racket. Ergo The Racketeer Influenced and Corrupt Organizations Act covers what happens next. Send in the US Marshals boys....come November. RICO. Its that easy. And then they'll all start singing like the greedy song birds we all know so well.

[foxmuldar]

I agree, Buffett isn't as squeaky clean as we are led to believe. he's been in bed with GS and their ilk for a long time. You can get he got the inside information on the Fed bailout prior to it going to the press. Buffett was ahead of the crowd when the buying began. Big spenders like Buffett get info that the small guy never has access to. Its all a sham. 

Wouldn't it be nice if the Fed came to our houses and said ok so you can't pay your debt. Don't worry, we'll pick up the tab at the expence of your neighbor. Well thats what they did for AIG and GS and others.  

[Anonymous]

Paulson and his bazooka, lol.

Get the feeling his bazooka pointed at congress. "Listen, like Warren, said derivatives, of which we got 500T in existence are weapons of mass wealth destruction. AIG is a nuclear warhead that must be de-fused, any way possible."

glassy eyed stares all around the table

"Listen, you got a choice. Rule of CONTRACT LAW, if you rip up alot of these bad CDS's, and save AIG, another warhead will start too tick, tick, tick. We have no idea which one, where, how do you de-fuse that. Then we're all dead. Here with AIG, we stop it all. And men, life will go on. There will be ups and downs, you must do better, but, life will go on, I guarantee you that, above all else."

grimaced lips, slowly nodding heads

one lone low voice, "Won't this happen again, can't it be wrose."

Paulson, looks around, squints, stutters several times, "No. Not really, this will contain it, most of these CDS's are hedged neutral, there's just a fraction that are bad" he says, with hands behind his back fingers crossed.

[bugs_]

So much there to be flushed out.  Greater

than all prior 'gates.  AIGgate.

[BlackBeard]

Still a cesspool.  Nuff' said.

[spekulatn]

Warren B ain't alone. 

http://philanthropy.com/blogPost/AIG-BailoutEli-Broad/9872/

The AIG/GS saga will never be explained/exposed.

Bummer.

[Miles Kendig]

I wonder how much of the "untapped" AIG lines of credit at the FRBNY have to do with resolving the swap and related products that have been deployed to assist sovereigns in moving present liabilities to the future and off the balance sheet for the Club Med nations.... and perhaps more?  And perhaps these arrangements and the likelihood of failure formed an underpinning of the AIG support structures and the inclusion of DB, SocGen & Barclays in the mix along with the 500 billion in currency swaps through the FRB...

[Anonymous]

Another tentacle detected. All Mother, inbound.

[Zippyin Annapolis]

The taxpayer will take it in the shorts--count on it--to the tune of $80B.

[artcash (not verified)]

rom as early as first quarter 2008 it was possible to predict the overvalued Euro, always able to gain from intrinsic US dollar weakness, was itself heading for a fall. Through 2008-2009 this was delayed, with speculators first making unsurprising bets on the traditional hedges, Gold and Oil, rather than mount direct attacks on the Euro.

moron... I can't believe it

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