it is really so widely known
that you are expected to know.
I think i am talking to a
novice. sigh.
The white-hot
furor over AIG's retention bonuses seems to have died down a bit.
Last week the House of Representatives passed a watered-down
version of the bill that was supposed to tax those payments out of
existence. But AIG isn't leaving the bull's-eye anytime soon. The
Government Accountability Office said on Mar. 31 that AIG should
demand concessions from its trading partners and employees. On Apr.
2, deposed AIG Chief Executive Hank Greenberg paid a visit to
Capitol Hill, blaming his successors for the company's failings and
calling its government bailout a failure. And New York State
Attorney General Andrew Cuomo is probing the $165 million bonus
payments and the billions AIG transferred to such banks as Goldman
Sachs (NYSE:GS - News) and Societe Generale
(SOGN.PA).
Amid all this hubbub, AIG's employees plug away, trying to wind
down the beleaguered company's remaining credit default swaps,
which are basically insurance policies purchased against the
default of various forms of debt.
So what's so hard about unwinding a CDS? And does it really take a
financial rocket scientist, chained to a seat by a fat retention
bonus? Or could it be done by some of the vast army of recently
unemployed Wall Street workers?
Large, Complex Web of Derivatives
Part of the problem is that not only are the financial instruments
themselves complicated, but they involve tangled relationships of
companies and investors, each with their own interests. AIG owns
$1.5 trillion in derivatives, including CDSs, interest rate swaps,
and currency swaps, among others. And these trades overlap in a
large web across all its companies. Since everyone knows that AIG
needs to rip up its contracts, its partners are holding out for the
best deal possible.
The nastiest, most complicated, and most controversial types of
AIG's CDSs have largely been taken off the company's books. Those
swaps were customized by the insurance company to protect financial
institutions from default in illiquid pools of mortgage-backed
securities, the now infamous collateralized debt obligations, or
CDOs. When the value of the CDOs tanked and AIG's credit rating was
cut, the insurance company was forced to pay billions of dollars in
collateral to companies known as "counterparties" -- money it
didn't have.
To exit the contracts, AIG used Federal Reserve and Treasury Dept.
cash to pay the counterparties 43% on the dollar for the securities
(which now reside on the Fed balance sheet as Maiden Lane III).
Then the company paid off $26 billion in insurance on the same CDOs
to Goldman Sachs ($5.6 billion) and Societe Generale ($6.9
billion), among others. This cost taxpayers $46 billion.
That's not the end of the story, unfortunately. AIG's remaining
credit default swaps may not be as toxic. Many of the remaining
swaps are, in fact, what the industry calls "plain vanilla" --
fairly standard, liquid contracts. But that doesn't mean they'll be
easy to get rid of.
"Like You're Flying Blind in a 747"
There is no centralized market for derivatives, so AIG's traders in
Wilton, Conn.; London; Paris; and Tokyo can't just look at a PC
screen and see the current price, as a trader would do with a
stock. Instead they look at the available data on such things as
interest rates and the earnings of the companies whose debt is
insured, and then use mathematical models to determine what they
want to pay. Next they reach out to other traders to gauge what
might be a reasonable price. At the same time, the trader has to
figure out the overall impact the trade will have on AIG's
book.
"It's like you're flying blind in a 747," says Marc Groz, a
hedge-fund risk manager who now heads up risk management firm
Topos. "You can only see what the instruments are telling you."
Because they are contracts between two parties, AIG's credit
default swaps can't simply be sold. Some will expire on their own,
like the $234 billion of swaps that are expected to come off the
books in the next year and a half. Others will be terminated at the
request of the owner. AIG can opt to let the contracts expire. But
$34 billion worth of CDSs is set to run down over the next five --
or more -- years, which would seem to run counter to its avowed
plan to wind the contracts down as quickly as possible. If AIG
wants out, it will have to go back to the other side of those
trades and negotiate an exit.
That won't be easy -- or cheap. CDSs are still trading, but the
spreads -- the difference between what dealers are willing to pay
to buy or sell -- have widened, making it more expensive to get
out.
Needed: Steely Nerves and Keen Math
"The Street knows they have to unwind positions," says TABB Group's
Kevin McPartland, an analyst who specializes in derivatives. "It
gives AIG little pricing power."
Working those deals doesn't necessarily require the same hands that
put them together in the first place. But it's not a task for just
any newly minted MBA. Wall Street has largely abandoned the
shoulder-to-shoulder battle of the exchange floor for a more
formula-driven mode of trading. Steely nerves are still required,
but so is an acumen for high-level math.
Such skill sets are not necessarily uncommon on Wall Street but
they're still in demand, despite waves of industry layoffs.
"The vast majority of professionals at AIG are just doing their
jobs," says Rob Sloan, head of U.S. financial services at Egon
Zehnder. "And many could get jobs elsewhere."
AIG declined to make its employees available to walk through its
swap-unwinding operations, which are conducted through the
financial products unit known within the company as FP. The company
also declined to say just how far down it has managed to cut the
pile. "FP's employees have made tremendous progress unwinding FP's
trading positions, business books and lowering its risk," AIG said
in an e-mail. "Despite this progress, the risks in the books at FP
are still large, and require the skills and professionalism of the
traders, marketers and support functions."
