The Wages of Obfuscation: Farcism and the AIG Timebomb

By Marla Singer and Geoffrey Batt

One of the central tenants of Farcism as a doctrine is the promotion and use of layers of opacity and complexity to empower regulators via their ability to mitigate red tape and compliance costs and to conceal this power under a cloak of (for example) promoting the "American Dream of Home Ownership."  It will be seen that Farcism has imbued the halls of regulatory power, particularly in financial services, for decades.  Zero Hedge readers are invited to opine on the impact this realization has on prospects for a financial reform bill that puts more power in the hands of these parties.

In this connection, back in November of last year we explored the nuances of the "foreign regulatory capital" credit default swap portfolio of the besieged Financial Products group at AIG.  We pointed out that $172 billion in notional exposure (well, it seemed like a big number for a potential loss before Fannie Mae actually lost $145 billion in eleven consecutive quarterly losses, wiping out its combined profits for the prior 35 years and still leaving about $80 billion in red ink to spare) remained outstanding, that deteriorating credit markets may force AIG to recognize additional losses on the portfolio, but that AIG expected the swaps mostly to be terminated by the first quarter of 2010 (please please please please?).  We also noted that the implicit backing of the Federal Reserve might be one of the key (only?) elements permitting these swaps to perform their desired function: permitting European banks to reduce their regulatory capital requirements (read: boost their leverage).

We had several questions last year.  Including:

1. If the European banks that bought swap protection from AIG are still relying on this protection to meet their capital requirements, and AIG might be unable to make good on the agreements, are these banks actually out of Basel I compliance as we type this?
2. Are the banks still able to use swap protection to reduce their collateral requirements because of the implicit or explicit backing of AIG by the Federal Reserve?
3. If this situation existed in September-November 2008, as it certainly appears to have, how exactly can the Federal Reserve claim in good faith that it lacked the leverage to negotiate with these banks from a position of strength?  (One assumes that many of the same names collecting payment from AIG were also AIG swap protection buyers of the sort mentioned in the SIGTARP report).  Failure to back up an insolvent AIG would have resulted in near-immediate Basel I non-compliance as the protection offered by these swaps, and on which these banks depended for their reduced capital requirements, evaporated- a near death sentence.
4. Or had these banks somehow, and in the middle of the credit crisis, managed to boost their capital to levels that made the swaps unimportant?
5. If so, why keep them on the books now, instead of unwinding them?
6. Since it doesn't seem likely that a teetering AIG could make good on these agreements without substantial assistance is the Fed is currently the ultimate backstop for AIG?
7. Does this mean that the Fed is effectively underwriting these swap agreements?
8. Will the Fed post collateral if deteriorating credit conditions at AIG (today's -$11 billion news suddenly seems especially daunting if the potential insurance shortfall has an effect on credit ratings) or general credit market issues require it?  Or are we missing something significant?  By September 30, 2008 AIG had already posted $974 million in collateral for its "Foreign Regulatory Capital" portfolio.
9. What if European banks are hit with more losses from, oh, we don't know, say... Dubai?  Deleveraging, risk reduction and credit tightening would have an effect on LIBOR, the Eurobond market and, of course, Eastern Europe.  Might not that sort of contagion easily spread to, say, Switzerland, which enjoyed the other side of the carry trade for years by lending Swiss Franc like mad to any Eastern European mortgage borrower who could sign documents?
10. Could it be that the Fed, once again, might have to bail out the world?

So what became of these issues?

Well, it seems most banks managed to skate by without enough realized Dubai exposure to cause problems, but those were the days of the $1.50 Euro.  With nearly a 20% EUR/USD slide since then, perhaps we should revisit the ticking time bomb of AIGFP's "foreign regulatory capital" swap portfolio.

In the spirit of review, recall that the purpose of "foreign regulatory capital credit default swaps" is tied up in the structural rigging of the markets to support a housing market bubble and encourage foreign financial institutions to be among the greater fools when the music stops in the United States.  (Score!)  Perhaps unsurprisingly, the role played by the United States' elite Regulatori caste in detonating multiple 300 kiloton W87 warheards over the American Dream of Home Ownership (in order to save the American Dream of Home Ownership) is almost never reported.  Key to understanding this perverse dynamic is the realization that regulators rarely manipulate bank behavior through the direct prohibition or mandate of certain behavior.  Instead, banks are rewarded, somewhat nefariously, via policies that amount to massive subsidies.  Arguably the two most substantial, and damaging, of these are:

1. The implied and/or explicit guarantee against loss by the United States government or its proxies.
2. Deliberate rigging of capital requirements to manipulate banks to hold assets favored by policy makers.

In the first case, government guarantees can be seen as a combination of price fixing and subsidies.  Price fixing in that the intent of the guarantee is to pull the perceived risk out of the asset and lower its price.  Subsidies in that the government does not extract a fee from the investor in exchange for assuming the risk.  Amusingly, while commentators are prone to liken guarantees to put options, they are more properly described as default swaps.  The government is assuming (swapping) the risk of loss or default in the instrument.  In this context it is beyond comic to watch some of the most profligate used car salesmen of government guarantees denouncing the sinister and evil nature of, for example, credit default swaps.

No one expects to pay a guarantee when it is made.  That's why it is made.  It is a bit of "free" political payoff for loyal supporters.  The more cynical among us might point out that the maturity mismatch between guarantees and their potential implosions (political capital right now, outsized loss in many decades time after elected official has retired to the private sector) is probably seen and leveraged by the more clever and greedy political animals.  But this is the siren song of taxpayer funded subsidies.  They look "free."

Of course, any Zero Hedge reader with even a passing understanding of options understands that a guarantee against loss is valuable, and that when such guarantees are made without compensation the recipient is getting a subsidy and taxpayers get to carry the risk (read: pay for it).  In fact the risk need not even materialize for taxpayers to have been cheated here.  They have given something (the security of risk mitigation) for nothing.

The situation is nearly identical when the FDIC so radically underprices deposit insurance premiums to member banks that it chronically bankrupts the DIF and regularly has to go to the taxpayer well to make up the difference.  This, of course, is a subsidy from taxpayers to banks in the form of underpriced insurance.  How free do those subsidies look now?

In the second case, the power to reduce the capital requirements for financial institutions permits a small and mostly obscure group of the Regulatori to wield control over literally trillions of dollars.  Lowering capital requirements on banks has the immediate and naturally consequent effect of boosting their available leverage.  This, of course, permits banks to boost their profits and thereby looks like a bit of "free" graft.  Of course, to the extent these banks are insured by underfunded depository insurance schemes designed to keep premiums low rather than to build appropriate reserves for resolution, taxpayers are footing the subsidy bill, even before any failures crash the scheme.

Add failures in a "too big to fail" environment and the subsidy looks larger still.  With GSEs and FHA now backing 96.5% of all mortgages in the United States (that's not a typo... and the figure approaches 100% of US 2009 GDP- let that sink in for a minute) sketching out the nature of this subsidy is left as an exercise for the reader. 

In addition, and often overlooked, complex, interlocking and even Byzantine regulatory mazes provide ample opportunity for a bit of taxpayer funded, no-control-group sociology experimentation by elected representatives who are about as likely to have spent time in the private sector as Robert Byrd.1

It should come as no surprise at all to the astute Zero Hedge reader that foreign banks investing in United States treasuries and certain (favored) mortgage backed securities (guess which ones) received favorable treatment with respect to the capital requirements (read: allowed leverage) imposed on them.  Further, it should surprise such readers exactly "not at all" to learn that European banks in particular (but also US banks with international presence) could use provisions of Basel I to duck the 8% of "risk weighted assets" capital requirement by using credit default swaps to insure MBS and other securities against loss.  Using this method, banks could reduce their effective capital requirement to below 2% of risk weighted assets, provided they held the right assets. 

Obviously, being able to control the list of "favored assets" entitled to preferential treatment permits regulators to funnel massive amounts of capital into risky assets out of all proportion to their actual economic value.  AIGFP's "foreign regulatory capital" portfolio of credit default swaps served exactly this market by writing billions of dollars in notional credit default swaps that created trillions of dollars in additional leverage.  Suddenly, the foreign appetite for U.S. MBS securities seems just a bit less a consequence of the "invisible hand" and a bit more related to the "political handout."

When last we left our heroes at AIGFP, they expected a large portion of their foreign regulatory capital credit default swap portfolio to be subject to early termination by counter-parties (as the phase out of Basel I removed the incentives to maintain the swaps).  The SIGTARP report on AIGFP quipped:

AIGFP’s COO informed SIGTARP in July 2009 that they expect that most of these swaps will be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II.  Currently, financial institutions are required to hold a certain level of capital against their assets, and one way for a financial institution to reduce the amount of capital is to purchase swap protection on its assets.  However, new requirements decrease the level of capital required for such assets and, in most cases, there will be limited capital benefit to holding on to the existing swaps. Nonetheless, AIG warned in a June 29, 2009, SEC filing that if credit markets deteriorate, the company may recognize unrealized losses in AIGFP’s regulatory capital credit default swap portfolio.  AIG could continue to be at risk if the swaps in its regulatory capital portfolio are not terminated by the end of first quarter 2010 as expected.2

So how's that working out for them do we think?  Well, fortunately we have AIG's latest quarterly to give us timely updates:

The regulatory benefit of these transactions for AIGFP's financial institution counterparties is generally derived from the terms of Basel I that existed through the end of 2007 and which is in the process of being replaced by Basel II. It was expected that financial institution counterparties would have transitioned from Basel I to Basel II by the end of the two-year adoption period on December 31, 2009, after which they would have received little or no additional regulatory benefit from these CDS transactions, except in a small number of specific instances. However, in 2009, the Basel Committee announced that it had agreed to keep in place the Basel I capital floors beyond the end of 2009, although it remains to be seen how this extension will be implemented by the various European Central Banking districts. Should certain counterparties continue to receive favorable regulatory capital benefits from these transactions, those counterparties may not exercise their options to terminate the transactions in the expected time frame.

[...]

In addition, as of March 31, 2010, AIG had expected $304 million of Regulatory Capital CDS transactions to terminate early between April 1, 2010 and April 30, 2010. Of that amount, none had been called. The counterparties to these transactions continue to receive favorable regulatory benefits as a result of the extension of the Basel I capital floor. Since all of these counterparties retain the right to terminate the transactions early, the expected maturity for these transactions has been extended by one year.

[...]

Regulatory capital portfolio: In the case of credit default swaps written to facilitate regulatory capital relief, AIGFP estimates the fair value of these derivatives by considering observable market transactions. The transactions with the most observability are the early terminations of these transactions by counterparties. AIGFP continues to reassess the expected maturity of the portfolio. AIGFP has not been required to make any payments as part of terminations initiated by counterparties. The regulatory benefit of these transactions for AIGFP's financial institution counterparties is generally derived from the terms of the Capital Accord of the Basel Committee on Banking Supervision (Basel I)....3

To summarize:

• The regulatory capital portfolio (politically renamed from the "foreign regulatory capital portfolio" in this quarterly) simply isn't shrinking as fast as AIG hoped.
• The only input to their model valuing the instruments in this portfolio seems to be the early cancellation of swaps, which is simply not happening at the rosy pace AIG predicted.

Ouch.

Another otherwise obscure detail caught our attention.  Of about $7.6 billion in net notional credit default swaps in AIGFP's "multi-sector CDO" portfolio, some $1.5 billion are on "physical settlement terms."  This means that, in the event the credit default swap is triggered by default or other credit events, AIGFP will pay the counterparty the protection (in cash) and the counterparty will deliver the debt instrument covered by the protection to AIGFP.  Of these physical settlement swaps, more than 80% are Euro denominated.4  This means that while AIGFP must deliver cash to the counterparty, all it gets in return are increasingly worthless debt instruments denominated in a crashing currency.  Not only is this a major drain on cash, but the instruments would also have the effect of loading up AIGFP's balance sheet with more deteriorating sludge.  Of course, cash settled swaps are 80% dollar denominated, meaning that the decline in the Euro hits AIGFP's portfolio coming and going.

Ouch.

When can we expect Basel II?  Suffice it to say that, just like it was a year ago, the one year delay predicted by AIG seems quite silly.  Already by late 2009 Italian banks were screaming bloody murder at the prospect of complying with Basel II.  The tougher requirements would, they credibly complained, likely slap all of Italy with a massive credit crunch.  None other than the Telegraph's Ambrose Evans-Pritchard quoted Giampaolo Galli, director-general of Italy’s business lobby Confindustria thusly:

“We must convince the authorities that it is not only necessary to postpone the changes until 2011-2012 but also to soften them,” he told Italy’s financial paper Il Sole.

“There are going to be very serious difficulties. Firms have a great need for credit and they are going to reveal awful books for 2009, with the result that their access to credit will suffer,” he said.5

If it sounds like Galli is bemoaning the impact real disclosure would have in revealing the sludge hidden beneath the AstroTurf and calling for its continued concealment, well that is because he is.

It is difficult to imagine, given the kind of panic that prompts short-selling bans, Basel II seeing implementation in the next twelve (or twenty four) months.  For perspective, the original deadline was in 2004.  Indeed, the Committee itself seems vague on this point.

The fully calibrated set of standards will be developed by the end of 2010 to  be phased in as financial conditions improve and the economic recovery is  assured, with the aim of implementation by end-2012. The Committee  will put in place appropriate phase-in measures and grandfathering arrangements  for a sufficiently long period to ensure a smooth transition to the new  standards.6

So:

1. The end of 2012
2. Never

This makes it rather difficult to gauge the risk of AIGFP's swap portfolio, the likelihood that AIGFP will have to post additional collateral, or the possibility that technical insolvency at AIG or AIGFP will invalidate the beneficial effect of the swaps on foreign capital requirements- instantly branding these institutions as "undercapitalized" and (in some jurisdictions) legally mandating authorities to put them in receivership.7

Ouch.  Ouch.

Then remember that AIGFP is only one of these Farcist enablers that we are fortunate enough to have discovered.  What other nastiness lurks beneath CDO^3 structures and SPVs?

The reality is that until transparency of the sort that casts the brightest sunlight on earmarks, guarantee giveaways, accounting games, dumbed down capital requirements and the kind of legal structure that expects subjects to comply with 150,000 pages of federal regulations on top of state and local statutes, effectively causing the average citizen to unwittingly commit three felonies per day,8 the Wages of Obfuscation (read: Farcism) will drive the United States.

Get down with the sickness.

This is Part III of a multi-part series on global rise of Farcism.  Part I, "The Silver Curtain" can be viewed here. Part II "On the Pensioning of Roman Veterans" can be viewed here.

• 1. Total tenure, 57 years, 142 days, 9 hours and is (at the sprightly age of 92) third in the line of succession for the presidency. (Sleep well, dear readers).
• 2. Special Inspector General for the Troubled Asset Relief Program's (SIGTARP's) November 17, 2009 report "Factors Affecting Efforts to Limit Payments to AIG Counterparties".
• 3. American International Group Form 10-Q, United States Securities and Exchange Commission (May 7, 2010).
• 4. American International Group Form 10-Q, United States Securities and Exchange Commission (May 7, 2010).
• 5. Ambrose Evans-Pritchard, Italian Banks Fear Crunch from Basel II, (December 16, 2009).
• 6. "Consultative Proposals to Strengthen the Resilience of the Banking Sector Announced by the Basel Committee," Bank for International Settlements (December 17, 2009).
• 7. Cf. Sheila Bair's assigning responsibility for enacting "Prompt Corrective Action" to this year's winner of the FDIC's Jeff Spicoli Award for Industry in Financial Regulation.
• 8. Did you make a personal call at work today?  Are you going to declare that income from your employer to the IRS?  If not, you too might be a felon.

Comments

[Conrad Murray]

"This means that, in the event the credit default swap is triggered by default or other credit events, AIGFP will pay the counterparty the protection (in cash) and the counterparty will deliver the debt instrument covered by the protection to AIGFP.  Of these physical settlement swaps, more than 80% are Euro denominated."

Yikes.  http://media.ebaumsworld.com/picture/stpdrckr420/DEPENDS.png

[mikla]

+1

This is a "Holy Sh*t!" statement.

One of the best precursors to Weimer-style hyperinflation is to denominate your debt in a foreign currency that you can't control, nor debase.  I've been carefully watching that the US does *not* denominate debts in Yuan, or Yen, or any foreign currency.  Of course, through these swaps, the US is on the hook for Euro.  Crap.

On the bright side, it looks like the Euro detonates before the US dollar, so we might have dodged that bullet.  Doesn't bode well for European states that denominated some of their bonds lately in US dollars, though.

However, the original article's assertion is still true:  "Hey everybody, the US taxpayer will co-sign any loan/backstop you want, FOR FREE.  Don't forget to lever up before you take out that loan/backstop!"

Marla:  Fantastic article.  I've been wondering what was going on with these AIG swaps since "back then" they were portrayed as expiring Q1 2010 (Liars!).  Media outlets can't produce stuff this good (factually correct using terms the author actually understands).  The fact that it's well written (grammar, style, presentation) is merely a big bonus.

[Paladin en passant]

There are times in history when only a firestorm can clear out enough underbrush to allow freedom room to flourish.

[chinaguy]

Many thanks Marla, excellent as always.

[heyligen]

We're still living in Plato's cave. What we're allowed to see is not what is.

Transparency, will we ever have the opportunity to welcome you?

Not, I think, if history is a  guide.

[anarkst]

Technically, Farcism includes all things intellectual.

[Problem Is]

Except Mental Masturbation
You know... Thinking about thinking about thinking...

[blindman]

http://verbewarp.blogspot.com/

.

[Implicit simplicit]

If all the poor people with low income that were sold mortgaqges that they couldn't afford started asking to see the paper trail of their mortgage before they agreed to let the bank foreclose, the banks could have real problems.

 The CDO tranches were set up to get AAA ratings by packaging good morgages with very bad with myriad levels of risk in between.

If I was being foreclosed on, I would demand to see the paperwork. I bet some of it doesn't even exist anymore. The CDO writers could have had the evidenced destoyed or altered to avoid being  implicated for fraud for packaaging that crap and conning everyone from the unqualified buyer to AIG.

[Conrad Murray]

There was a judge in Ohio that did that to DB in early 09.  He dismissed over a dozen cases.  Not sure how it went from there.

[Bolweevil]

I understand that is why some are not foreclosed on or why it takes months (years?) to do so; there is no paper trail.  

[JohnKing]

Banks must prove ownership to foreclose homes:

Partly responsible: a new Florida Supreme Court rule that requires lenders to verify they are the actual owners of a home before making the initial case for foreclosure.

"The original note is something very significant, and they just seem to have lost thousands of them," said Boca Raton attorney Marlyn Wiener, who handles real estate cases. "Nobody knows where the stuff is."

http://www.sun-sentinel.com/business/fl-foreclosure-court-20100524,0,479...

[Alexandre Stavisky]

This system is one where those who have no "gift" or cannot be productive are able to access the gain of those with good providence.  Expropriation has been the antediluvian blemish .  Envy, strife, and malice of those jealous of the material acquisitions of their peers.  Cain murdered Abel for it--desired his wealth and preference before "the Man".  Even more delicious it the ability to plunder secretly by incremental dilution.  Add fractional banking, ability to issue checkbook money, and having monopoly power over money supply and credit aggregates and you have the most seductive fusion of money and power.  None derived from the true fountain of abundance and prosperity.

Real wealth comes from the organic explosion of labour and innovation of the common men using available resources of the earth and sun. Banking and monetary slave runners are a bleak shadow of the former.

Fraud is the peaceable means to expropriate, uncomfortable--yes.  Causative of social rebellion, no.  When it no longer works, players move farther afield or move to Force.  Expropriation by war or physical strife, ruling over with rigour and death.

Were these same men who worship money to spend their energies creating productively, instead of feeding their idleness with other's break and ever conceiving new intrigues to deprive their neighbors, AND lend on sustainable, equitable terms--then we would have an economic model of longevity.

But where men lend in a systemically destabilizing, usurious way, or seek to obtain through any means except participation in honest labour and production, we will always have boom/bust and eventually war.

Fraud and Force.  Stains of CAIN.

[Bolweevil]

Bravo Alex!

[Miss Expectations]

Second that.   Well said.

[Tapeworm]

We sow, they reap.

[Dirtt]

So we sow the seeds of political revolution and they reap the sharp end of the guillotine?

Sure. Why not? I'm game.

[Hulk]

You have my vote....

[Mitchman]

Marla, you should submit this to the likes of Forbes, Fortune or some other publication with a huge distribution.  This is incredible work.  One of the best pieces of research and analysis that I have ever read.  Congratulations.  

[Tapeworm]

I will second that.
For many years- going back to 1997, we on the old Kitco board discussed this rush to usage of derivatives to junk the capital reserve requirements of banks. As a lowly manufacturer I was not up to speed on just what was happening, but I knew that it was being used by gombits and the banking system to game everything, and especially the rules for entry into the Euro. If a mundane like me knew of it, of course all in the goomint financial systems knew of it too. Yet they went ahead and wrecked everything.
I have to say that this essay is tops in explaining how it fits together. Getting this message out to the few that will bother to come to understanding the how and why, is our last chance.

[Mitchman]

I agree.  The only chance we have is to fight the lies with the truth.  I honestly believe that there are people out there who want to be led, but also people out there who want to lead.  But this is the type of information that is a weapon in the hands of the right people.  I am not one of those nor do I have access to the people who can spread the word.  But I will do what I can to support the effort.  It beats agreeing with one another here on ZH.

[Mercury]

Zero Hedge has a much larger distribution than Forbes or Fortune or at least it has the potential to instantly far surpass theirs...especially when people like you and me do the responsible thing and forward pieces like this to those who can make an impact and to those who could stand to benefit.

Forbes and Fortune should be aspiring to ZH's level at this point, not vice-versa.

[b_thunder]

8. Will the Fed post collateral if deteriorating credit

Of course they will!  What a silly question!  With Fed you can even have a choice of wire transfer, or pallets of new, crisp, freshly printed 100, 1000, and 10000 dollar bills!

Nothing can be easier and more desireable for the Fed than increase money supply and to give all that "supply" to their favorite (beggest) shareholders (banks)

[Rusty_Shackleford]

Hey, there's no birthday party for me in here.

[Mercury]

Happy birthday Rusty:

http://www.spooncraft.com/wp-content/uploads/2009/08/beer-maid.jpg

(sorry, I profiled)

[Hephasteus]

Happy birthday!!

[Rusty Shorts]

Happy Birthday Rusty !!

http://www.youtube.com/watch?v=gIb70a1ZY7Y

[Gold...Bitches]

How can you not click on a post that has a pic of Spicoli?

[Bolweevil]

I read "Silver" just wanted say, "My Dad's got an awesome set of tools." I'll be back after reading "Rome". 

[Duuude]

Expect QE Majorem.

[williambanzai7]

"It remains to be seen if these revelations will have any impact or if, in fact, the great power of Farcism (denial) will overcome enlightenment until utter collapse finally takes hold."

Unfortunately, it does not appear that Farcism will be defeated by enlightenment any time soon.

But the struggle must go on!

Spicoli: All I need are some tasty waves, a cool buzz, and I'm fine.

[sangell]

Maybe we should just 'give' AIA to Prudential if they agree to take the rest of the carcass.

[williambanzai7]

THE POLITICAL HACKOIDS:

http://williambanzai7.blogspot.com/2010/05/political-hackoids-banzai7-wa...

[FASB 666]

Avarice and greed are gonna drive you over the endless sea 

[Clycntct]

Damn you Marla. Now another dumb ass knows the truth.

Thanks for the great display.

[Alexandre Stavisky]

Row, my countrymen, row well. And live
Our captain, a bilious over-consumer
Doth require our forced labour
to transport overseer officers restive.

They, glutton become, swallowing ample
while we thin and muscled, have but maggot and gruel,
And mark our happy station that tramples
a birthright of freedom, and marks us fool.

They stride a bridge and deck, companion to wind and sail,
We heave daylong with rats and fear the flail,
Our ration accounted to this raft's propulsion,
Theirs to birth, privilege, and dominion.

How came we to submit to our tethers?,
Where, in this hull, is a sharpened edge,
Wherewith to smite the "others",
Or push our blood past its ledge.

Pull, bonded brothers, pull and be.

This is the order and will ever be.

Ships like pyramids require blood,

and ours, whether in mortar or bilge, serve the greater good.

[Mercury]

Zero Hedge readers are invited to opine on the impact this realization has on prospects for a financial reform bill that puts more power in the hands of these parties.

I think I've mentioned this before but the elephant in the room that is still not being publicly addressed is: Does the government intend to continue to regard credit, especially mortgage debt as an effective civil right and if so who exactly is expected to bear the reciprocal risks and under what conditions?  Coming out of a government abetted debt/real estate bubble all other "reform" is kind of beside the point.

Of these physical settlement swaps, more than 80% are Euro denominated.4  This means that while AIGFP must deliver cash to the counterparty, all it gets in return are increasingly worthless debt instruments denominated in a crashing currency.

Well AIG would be covering the default in the same crashing currency too...no? 

In fact...remember that many retail equity portfolios got annihilated during the "flash crash" when market stop-loss orders on stocks were triggered on the way down, locking in losses and preventing recovery of portfolio value during the market's subsequent snap-back minutes later.  Surely some similar event could be engineered whereby the Euro suddenly nosedives vs. the dollar which somehow (insta-mark-to-market?) bam! triggers debt defaults which triggers AIG's obligation to cover in Euro's which their waiting way-below-market bids buy for them. The Euro then snaps back when someone's "elbow" comes off the keyboard and *presto* AIG has flattened it's swap position(s) for a fraction of what it would have cost five minutes ago.

Just trying to think like the bad guys of course;{

[StychoKiller]

Stop, Stop!  Ya got my head spinning so fast, I just saw the back of my Brain!

How many times can you pull the handle, get three lemons and expect a payout?

It's no wonder I sold all my mutual funds and stocks (except for Newmont Mining).

[onlooker]

----It should come as no surprise at all to the astute Zero Hedge reader that foreign banks investing in United States treasuries and certain (favored) mortgage backed securities (guess which ones) received favorable treatment with respect to the capital requirements (read: allowed leverage) imposed on them.  Further, it should surprise such readers exactly "not at all" to learn that European banks in particular (but also US banks with international presence) could use provisions of Basel I to duck the 8% of "risk weighted assets" capital requirement by using credit default swaps to insure MBS and other securities against loss.  Using this method, banks could reduce their effective capital requirement to below 2% of risk weighted assets, provided they held the right assets. -------

Well, not all of us may have remembered this, and surprised I am. Lord have mercy, your AIG article is again stunningly brilliant. If you can continue this, you may just end up being a top writer/analyst of your time. However, I know nothing about writing or analyzing.  But, for the reader, you do it right. I am going to reread and email it.

[Miles Kendig]

Farcism = Faith based governance gone to the Neo-Liberal extreme of limitless printing backed by the power of judicial exclusion.

Great read Marla & Geoffrey.

[carbonmutant]

Nice piece of steak Marla...

[strannick]

 On behalf of dumb schmucks everywhere, I thank the Fed and the banking lobby for guiding the hand of congress when drafting the financial reform bill since it all seems so darn confusing.

It feels safe to have delegated the economic welfare of the nation to congress who then operates under the gentle tutelage of the Banking elite, unobfuscating all the hard-to-understand parts for our elected officials.

I delegate this authority to them, so I can focus on my job, while they do theirs.

[Dr Hackenbush]

Deleated -- sounded wierd in hinesight - no charge this time, next time I do better! 

[Escapeclaws]

"We pointed out that $172 billion in notional exposure (well, it seemed like a big number for a potential loss before Fannie Mae actually lost $145 billion in eleven consecutive quarterly losses, wiping out its combined profits for the prior 35 years and still leaving about $80 billion in red ink to spare) remained outstanding, that deteriorating credit markets may force AIG to recognize additional losses on the portfolio, but that AIG expected the swaps mostly to be terminated by the first quarter of 2010 (please please please please?).  We also noted that the implicit backing of the Federal Reserve might be one of the key (only?) elements permitting these swaps to perform their desired function: permitting European banks to reduce their regulatory capital requirements (read: boost their leverage)."

I had to do some serious parsing to understand the above sentence. Which made me wonder if Marla is actually a German for whom English is his second language. I could see Mark Twain's "haben werden koennen sein" fitting in very nicely if this were in German. Not intended as criticism, by the way--this is a great article and greatly appreciated.