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September 23, 2008 01:55 AM UTC

Bailout IV: AIG, CDS and the insurance regulators

  • 10 Comments
  • by: Danny the Red (hair)

( – promoted by Colorado Pols)

Insurance is a state business-there is no real federal insurance regulator.  This is the reason the Fed had to work through the state insurance regulators in the bailout of AIG.  Insurance regulators in the several states are of varying quality (which is one of the reasons the GOP pushes intrastate insurance competition-so that insurance companies can base themselves in weak regulator states).  Fortunately, the New York state regulator has stepped in to bailout AIG.  Why?

Let me state for the record, I’ve always hated AIG.  I always thought Greenberg was a pirate and never abided their “we’re smart and have a AAA rating so we don’t need to tell you hat” attitude.  “Trust me” has never gone very far with me.

But why “must” we bailout AIG :  Credit Default Swaps.  

Credit Default Swaps are not “securities” and have never been regulated as such.  There was an attempt in 2000 to regulate them, but McCain economic advisor Phil Gramm in what one legal textbook called “a stunning departure from normal legislative practice,” the Senate tacked on a complex, 262-page amendment at the urging of Texas Sen. Phil Gramm known as the Commodity Futures Modernization Act which specifically defined them as “not securities”.  Right now no US regulatory agency claims oversight jurisdiction for credit-default swaps. Not the SEC. Not the Commodity Futures Trading Commission. Not the Treasury Department. Not the Federal Reserve.

This is how CDS work: a bond investor is worried about the solvency of a corporation (agency or loan portfolio) whose bonds he holds. The investor buys an insurance policy on the bonds with terms that require the insurance counterparty to pay the claim if there is a loss event. That transfers the default risk to an insurer, who might be another institutional investor, bank or trader.

On the other hand If an investor is more optimistic about the issuer than others, he might sell an insurance policy on the bonds, pocketing a premium or even create a synthetic bond.

One problem with the CDS is that other than the contract there is no guarantee the counterparty on the other side of the contract will make good on the contract when it comes time to pay.  Just like when you make a claim against your insurance, there is no guarantee they will pay.  Hence, CDS traders pick up an additional risk Counterparty Risk in addition to the underlying credit risks.

But it doesn’t end there. The person who takes out insurance must not only worry about the strength of his counterparty, he must worry about the strength of his counterparty’s counterparties. The credit swaps market is no regulated. As a result, many contracts can be traded – or swapped – from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends – the insured and the insurer.  And here is where AIG comes in.  AIG was one of the biggest counterparties, but was often laying off credit on less credit worthy parties that were highly levered hedge funds.

A subsidiary of AIG wrote insurance in the form of credit default swaps on corporate credits, but more troubling on even the most esoteric asset-backed security pools .  When the housing market collapsed, imploding home prices resulted in precipitously rising foreclosures. The mortgage pools AIG insured began to fall in value.  2007 progressed, so did the losses on AIG’s books and credit default swaps.   Once the value of AIGs collateral fell they began to be hit with margin calls from their strong counterparties through the spring.   When rating agencies lowered the firm’s ratings last Monday evening, it triggered an additional $14 billion collateral call as margin against AIG’s credit default swaps. AIG was done.

The argument is that giving the breadth of AIGs roll in spreading credit risk around the system, AIG’s failure would have pushed weakened institutions into bankruptcy.

Verdict

At first I did’t buy it.  AIG is important, but they have been run as a criminal enterprise for years.  Prison not bailout is a better solution.

Failure to do due diligence or correctly provision for counterparty risk is not a failure of the system.  Push the losses down and give forbearance on the back side.  AIG needs to go down.

But then I looked at the details.  The government is may be getting a pretty good deal and could end up making money.   AIG has some great assets and government is getting an ownership stake.  In addition the senior management is out.

My biggest problem with the bailout in general is that the taxpayer is just a wallet, we do not get what other providers of capital get-an equity stake.  I don’t want to fully nationalize these institutions, but taxpayers should receive something for their capital infusion.  It can be sold later once we have a new modern regulatory regime and people have confidence in the system.

CDS are a useful tool, but the fact that they were unregulated was ridiculous and the fact that institutions were allowed to ignore counterparty risk has been one of my major complaints for years, but truthfully I like the AIG bailout more than the “management keeps their job, shareholders get nothing” Paulson plan.

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10 thoughts on “Bailout IV: AIG, CDS and the insurance regulators”

  1. Apologies for the extensive quoting, but as Danny the Red (hair) made clear above, this is a complex issue.  Full article here, except follows:

    Insurance is terribly simple, as long as you follow the Three Rules:

      1. Price your risk correctly.

      2. Invest conservatively so you can pay out claims when they come due.

      3. Don’t do anything else.

    Sit back and collect the spread. That’s it, folks.

    Seriously, that is it. Ask Warren Buffett, and he’ll probably tell you that if you follow those three rules, you’ll be fine. You won’t be the biggest or fastest grower, but you’ll be absolutely fine.

    The problems come when you get greedy and aren’t satisfied with the spread. And your greed can lead to certain actions that aren’t stated anywhere in the rules, including:

      1. Diversifying into fast-money proprietary trading.

      2. Leveraging your company 11-to-1.

    Neither of these is a goal of a well-run insurance company, yet AIG embraced both with open arms.

    …

    The “L” word

    As in “leverage,” the sharp knife in corporate seppuku dramas. Leverage is, by my estimation, the No. 1 reason why companies fail.

    And compared with its peers, AIG had one of the sharpest knives around. Here’s how its leverage (assets to equity) stacked up against other insurance operations as of December 2007:

       * AIG: 11 to 1.

       * Markel (NYSE: MKL): 4 to 1.

       * Berkshire Hathaway (NYSE: BRK-B): 2 to 1.

       * Montpelier Re (NYSE: MRH): 2 to 1.

       * Travelers (NYSE: TRV): 4 to 1.

       * White Mountains Insurance (NYSE: WTM): 4 to 1.

       * Chubb (NYSE: CB): 4 to 1.

    I would love it if someone gave me a rational, believable explanation of why leveraging your equity 11-to-1 is a good thing for an insurer. The sole job of an insurance CEO is to ensure that his or her company stays in business; the CEO’s job has nothing — absolutely nothing — to do with growing profits every year in a steady, smooth line.

    Surprises in insurance are almost always negative, so simply staying solvent is the overriding priority. A company can do just that by following the Three Rules.

    Two years ago, a few of my Fool colleagues had an interesting conversation with Chris Harris, the chief investment officer at reinsurer Montpelier Re. Harris noted that Montpelier invested its float primarily in U.S. Treasuries, Fannie and Freddie bonds (back when they were considered safe), and the like.

    When asked why he didn’t invest more aggressively, Harris said the company believed that it got all the risk it could handle on the other side of the fence, insuring against megacatastrophes.

    Even if you disagree, as an investor you have to recognize the judiciousness in this way of managing one’s business. An insurer that has to pay big claims from hurricanes Ike and Gustav and Typhoon Sinlaku — and additionally worry about the rapid decline in its investment portfolio as a result of the higher level of risks it has taken on — has a big problem.

    That insurer, folks, is AIG. And that big problem is now yours and mine.

  2. Well some people will go to jail but don’t count on any executive.

    The problem with no bailout is the ripple effect bank failures. I’m sure that you are aware.

    Rep. Barney Frank thinks the government will make money in the long run.

    The Ambak corporate murder job on Friday by Moodys has resulted in complaints in NY state. AG Cuomo has indicated that he will take action on hedge fund abuse and the NY dept of insurance is advisng that complaints be snail mailed or faxed and they have received some from some influential constituents of Sen. Dodd.

    The SEC is already backing off the short sell restrictions for market makers and hedge funds that it announced mostly for show last week.  

    The sad truth is that bribery costs will be going up with an election approaching.

  4. Does this deal insulate the reinsurance providers or could Buffet and the other re-insurers be next?

    Buffet has been quiet, I am nervous. Your thoughts please.

      2. http://www2.goldmansachs.com/o…

        Very similar to the Deal Level3 did with Buffett a few years back.

        New York, NY – September 23, 2008 — The Goldman Sachs Group, Inc. (NYSE: GS) announced today that it has reached an agreement to sell $5 billion of perpetual preferred stock to Berkshire Hathaway, Inc. in a private offering. The preferred stock has a dividend of 10 percent and is callable at any time at a 10 percent premium. In conjunction with this offering, Berkshire Hathaway will also receive warrants to purchase $5 billion of common stock with a strike price of $115 per share, which are exercisable at any time for a five year term.

  5. I should clarify: My experience in the brokerage community sadly reflected that both government officials and brokers were used to corruption. It doesn’t appear ot have changed. It’s just moved to be mainstream on the NYSE, the rating companies, and the Market  makers.

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