Moral Hazard? Slabbed wipes our a$$ with Moral Hazard (Part 1)

Friday afternoon I decided to take on the broad topic of Moral Hazard, the concept for which this blog is unpinned. I collected links and research and then promptly experienced writers block for which even my gratuitous bashing of Rossie could not break. Then as per normal (and in true Talebesque fashion) Russell serendipitously emails me a link that ties things together. This becomes part 1 because there is no way I can tackle the topic in one post and do it justice. The bonus is I get to indulge a personal interest in Game Theory and of course poke some fun at what one observer calls moral hazard lite which represents the intersection of politics with the calamity that has shaken our banking system to its core. Let’s start with a quick definition of Moral Hazard:

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.

How does this “different behavior” that results from having no ri$k play out in the financial markets? We have a case study in progress commonly known as the bailout that provides some clues. Russell knows me as an intuitive trader when it comes to individual issues and I’ve been casually telling people this current rally in the financial services sector is an illusion in respects. We’ll have to retest our lows and that could happen as many as three times between now and Q4. Tyler Durden at Zero Hedge gives us a 2009 example to the old Wall Street saying, “Sell in May and go away” as he details why banks as a whole were surprisingly profitable the past two months. Hopefully this will stick with us when the bank execs collect their bonuses from these “results” down the road. Here are some snippets from the Zero Hedge exclusive: AIG was responsible for the bank’s January and February profitability:

Zero Hedge is rarely speechless, but after receiving this email from a correlation desk trader, we simply had to hold a moment of silence for the phenomenal scam that continues unabated in the financial markets, and now has the full oversight and blessing of the U.S. government, which in turns keeps on duping U.S. taxpayers into believing everything is good.

I present the insider perspective of trader Lou (who wishes to remain anonymous) in its entirety:

“AIG-FP accumulated thousands of trades over the years, all essentially consisted of selling default protection. This was done via a number of structures with really only one criteria – rated at least AA- (if it fit these criteria all OK – as far as I could tell credit assessment was completely outsourced to the rating agencies).

Main products they took on were always levered credit risk, credit-linked notes (collateral and CDS both had to be at least AA-, no joint probability stuff) and AAA or super senior portfolio swaps. Portfolio swaps were either corporate synthetic CDO or asset backed, effectively sub-prime wraps (as per news stories regarding GS and DB).

Credit linked notes are done through single-name CDS desks and a cash desk (for the note collateral) and the portfolio swaps are done through the correlation desk. These trades were done is almost every jurisdiction – wherever AIG had an office they had IB salespeople covering them………..

During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent – these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were “we have never done as big or as profitable trades – ever”.

As these trades are unwound, the correlation desk needs to unwind the single name risk through the single name desks – effectively the AIG-FP unwinds caused massive single name protection buying. This caused single name credit to massively underperform equities – run a chart from say last September to current of say S&P 500 and Itraxx – credit has underperformed massively. This is largely due to AIG-FP unwinds.

I can only guess/extrapolate what sort of PnL this put into the major global banks (both correlation and single names desks) during this period. Allowing for significant reserve release and trade PnL, I think for the big correlation players this could have easily been US$1-2bn per bank in this period.”

For those to whom this is merely a lot of mumbo-jumbo, let me explain in layman’s terms:

AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

In simple terms think of it as an auto dealer, which knows that U.S. taxpayers will provide for an infinite amount of money to fund its ongoing sales of horrendous vehicles (think Pontiac Azteks): the company decides to sell all the cars currently in contract, to lessors at far below the amortized market value, thereby generating huge profits for these lessors, as these turn around and sell the cars at a major profit, funded exclusively by U.S. taxpayers (readers should feel free to provide more gripping allegories).

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner’s (and thus the administration’s) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

For banks to proclaim their profitability in January and February is about as close to criminal hypocrisy as is possible. And again, the taxpayers fund this “one time profit”, which causes a market rally, thus allowing the banks to promptly turn around and start selling more expensive equity (soon coming to a prospectus near you), also funded by taxpayers’ money flows into the market.If the administration is truly aware of all these events (and if Zero Hedge knows about it, it is safe to say Tim Geithner also got the memo), then the potential fallout would be staggering once this information makes the light of day.

The fact AIG stock still trades, albeit around a dollar, also speaks to Moral Hazard. In simpler times, say like 2004, equity in common stock of a insolvent company would largely be flushed in bankruptcy court. The evidence is mounting that the taxpayers have gotten swindled with this AIG bailout.

Next up contract sanctity.


14 thoughts on “Moral Hazard? Slabbed wipes our a$$ with Moral Hazard (Part 1)”

  1. I’ve read this three times now, still not believing anyone would do this – or let anyone get by with doing this. Noticing the lack of comments, am I the only one that finds this incredible?

  2. I think there will be many “snakes in the woodpile” as this whole deal unfolds. AIG was complicit in the Marsh Mac scandal a few years ago with “rate rigging”. This was a disgrace.

  3. Don’t you know that’s true, Sup, So do we just get rid of the woodpile snakes and all? Disgrace doesn’t even begin to describe this.

  4. “Well you know Mr CLS some contracts are more sacred than others right?” SOP

    Sums it up in one succinct sentence.

  5. When discussing our research with a federal judge friend of mine a few years ago he noted it was reminiscent of the decline of the Roman Empire. I agreed. This Rolling Stone article reflects what we have been observing from the internet for years—-

    It’s over

  6. A great post Steve. Being in the insurance industry, if it was AIG it was solid. Unfortunately, we did not know the other shenanigans that was going on with them. The Marsh Mac scandal got the attention of some in the industry something might not be right.

    Their Lexington brand has been writing a lot of coastal business. In fact the company would write “Wind” coverage where other carriers would exclude the wind and it would have to be written in various wind pools. Those of us in the industry questioned the business model, but it was backed by AIG. The agents using Lexington felt they had more money than anyone, even though, they usually operate as a “non-admitted” carrier and not covered by state guaranty funds.

    In my humble view, this company has no value on the open market. Why would a carrier buy coastal business? If there is an appetite for coastal business by a carrier a company does not have to buy a book. Any carrier can write all the coatsal business they wish and apply their own selection standards.

    We are in a critical situation. It is time for the government to remove itself from all this “help” they are giving private enterprise. We still have a lot of smart people in our country who will see the opportunity of failures in our economy. Let these folks take over and allow the free market to work.

    What is the over and under on Senator Dodd surviving?

  7. SOP is hot on the trail of Mrs. Dodd. Dodd’s wife was right in the middle of a snake pit. Why he let her get involved with Hank Greenberg is truely a mystery.

    PS We got the links where Hank is putting the ole gang at Lexington and their AWAC alter ego back together again. Should be interesting. Get caught. Just reorganized under a different name and go back to what you were doing before law enforcement so rudely interrupted you?

  8. Here is a lawsuit in Delaware where Hank and his Band of Brothers are kept in a lawsuit against some of them. Its a long order and this might just define complex litigation? I begin with an apology for ever doubting my Italian classmates that they were unfairly selected for prosecution by the fed’s. This case makes me think they were right.

    INC. )
    Plaintiff, )
    v. ) C.A. No. 769-VCS
    Date Submitted: November 12, 2008
    Date Decided: February 10, 2009

    The Complaint is lengthy and alleges that Greenberg, his Inner Circle, and other
    AIG employees engaged in a diverse array of financial and transactional wrongdoing.
    Most of the misconduct was aimed at concealing AIG

  9. Hank and his Band of Brothers had already suffered this—–eisenhofer-lawyers-for,537809.shtml

    The court filing for this case is great but I have lost the link and can’t find it.

    Here is where there is a court order for records being maintained and not looted. The order might have been too late—

    Staff Reporter of THE WALL STREET JOURNAL
    April 1, 2005; Page A1

    In Bermuda last Friday, a lawyer for American International Group Inc. Chairman Maurice “Hank” Greenberg carted boxes of documents out of an AIG office and into a van, according to people familiar with the situation.

    The next day, lawyers hired by the big insurer to handle a regulatory probe discovered certain records were missing, these people say. Then another jolt: They also learned that an AIG employee had destroyed some computer records and tape recordings of business meetings. There was a confrontation between the lawyers for AIG and their counterparts representing Mr. Greenberg over who should secure the rest of the documents.

    The showdown set in motion a frantic 48 hours that ended Monday with Mr. Greenberg’s abrupt resignation as AIG’s longtime chairman. Before it had ended, New York Attorney General Eliot Spitzer told AIG lawyers he was dismayed over what he called the “document caper,” according to people familiar with the matter.

  10. Why go to Bermuda to open a business?
    Reserve Requirements

    All three have been used by AIG FP and other units to generate profits. I think its more of a regulatory problem in that AIG was so powerfull over regulators that they started using that power to “help” others avoid the three above issues. Did they do it in an illegal manner. I hope we are about to find out. They need to look into the accounting firm over in Bermuda and the shell companies Hank Greenberg used. We can’t continue with the civil path. This has to be a criminal investigation because these guys are already setting up shop again under a different corperate shell to do it again. They won’t stop till they get locked up or killed. Its their life. Someone needs to figure out Hank Greenberg is a sociopath.

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