AIG and Credit Default Swaps

The Ethics of AIG’s Commission Sales
1
American International Group (AIG) had been a big player in the financial crisis of 2007-2009. The company had been selling credit default swaps and making a commission on the sales (Brooks & Dunn, 2018). AIG had not expected the market to turn south in subprime lending as quickly and devastatingly as it did. The result was disastrous for the global economy as many were left holding toxic debt.
The credit default swaps (CDSs) were like insurance on the bundles of home loans sold to investors. Investors would buy the mortgages for the fixed return and then savvy investors would buy insurance on the investments (the CDSs) in case the mortgages were not repaid. The bundles of loans were supposedly mortgages of home owners who were unlikely to default, according to their AAA-rating. However, many of the bundles consisted of tranches that were full of sub-prime loans with a high default risk. Investors who saw this immediately starting buying up CDSs anticipating a huge default blow-up.
AIG was mostly oblivious to this and did not mind collecting the commission sales on the CDSs. As far as it was concerned, it was selling insurance on something that would never be needed. Then the bottom fell out and suddenly a flood of defaults came in, starting right with the sub-prime mortgages that filled up all the bundles of loans that were being sold. Those with insurance now wanted to sell back the CDSs but just at a higher price. This in essence was their “big short” play, which Lewis (2010) describes in detail in his book by the same name.
The biggest buyer of AIG’s CDSs was none other than Goldman Sachs—and Goldman wanted to make sure it got paid, so that is why AIG got a bail-out from the government: Goldman always has friends in high places—like Henry Paulson who was former CEO of Goldman and served as U.S. Treasury Secretary at the time of the economic crisis—so he made sure to see to it that AIG could make good on its CDSs sold to Goldman (Taibbi, 2010).
AIG’s sales agents didn’t mind one way or another—they got to collect their commissions on the sales of the CDSs that ultimately blew up in their faces—and then they got a bail-out from taxpayers so they were never really held accountable. In their eyes, all’s well that end’s well. AIG lived to see another day, and they still made a lot of money.
2
The top two who were affected by AIG were Goldman Sachs and the taxpayers who had to foot the bill for TARP—the Troubled Asset Relief Program—a “$700 billion stimulus package” (Brooks & Dunn, 2018, p. 89). Banks all over the world were affected by the subprime mortgage debacle, but in the U.S. the two most affected were Goldman and the people on Main Street. TARP would eventually be repaid—but the banks were never really penalized for their practices. The worst part of it was not even the bailout but the Fed’s role in all of it. The Federal Reserve began buying the mortgage-backed securities that no one wanted and the treasury bills the U.S. needed to sell in order to pay for TARP, etc. The Fed’s money helped inflate asset bubbles all over the place, pushing the stock market to all-time highs and then some (Houston & Spencer, 2018). As Milton Friedman has pointed out, the Fed was creating an inflationary bubble (StatelessLiberty, 2013). Thus, the common worker saw the value of his dollar drop substantially over the past decade as hedges like gold soared. And while Goldman and all the other banks of the world were affected, like Deutsch and Swiss Bank and other central banks, the Fed was the one that really got the ball rolling on saving the world from the bankers’ and lenders’ and credit rating agencies’ blunders.
3
The moral and ethical problem here was that a) lenders were handing out loans hand over fist just to collect commissions on loans originated. They did not care that they were handing out bad loans that would have repercussions all around the world. The requirements for handing out loans had been loosened considerably by the government because the government wanted more people to have the opportunity to buy a house, so the lenders could originate loans with little to no paperwork; b) the loans were then carved up and bundled into tranches which were sold to investors as being A-grade investments when they were actually full of sub-prime—and anyone who bothered to look would have seen this; c) AIG did not bother to look and instead sold insurance on the mortgage backed securities; d) instead of insisting that the banks liquidate their assets to cover the insurance they sold, the government allowed them to get back to business as usual by taking out a huge loan and lending it to the banks so that they could pay their customers like Goldman Sachs. It was one giant incestuous, unethical business scheme in which there was no accountability for anyone because the bankers were in control at all levels. That is one reason for the populist blowback seen around the world today.
4
My own personal reaction to this is that the system itself is highly flawed. There are too many ways in which it can be gamed. The banks should not be allowed to have their own people (former workers or top level executives) working in government. Paulson and today Mnuchin are just two examples of former Goldmanites directing the U.S. Treasury (in case something bad happens, they have one of their own in there to make sure they are protected).
AIG should have been forced to liquidate—like Lehman—to cover its costs. Instead, it was allowed to keep going. Therefore, the question is what sort of special relationship did it have that the others did not? Lehman collapsed along with Bear Stearns. But AIG was too big to fail? It sounds suspicious to me. The reality is probably that when Lehman collapsed and Wells-Fargo bought it up, Wells-Fargo was pulling strings to make a play that it thought it could benefit from, while when AIG was set to fail, Goldman made a play that it thought it would benefit from. Both were running different plays but both were essentially using the same playbook called, “How to Win the Game if You’re a Big Bank.”
5
What I would have done in this situation would have been to let AIG fail and I would have gone after the credit ratings agencies that were giving the bundles of loans high credit ratings. They were in on the take as well. All of them were acting recklessly and criminally, including the credit ratings agencies. They definitely should have known better. I would also make it so that no former Goldman executive or high ranking worker in Goldman could ever hold another post in the federal government again. The same would go for all banks. If they want to be bankers—fine. But they should not be allowed to them act like they are public servants later: there is an obvious conflict of interest on their part as a result of their past careers.
6
· Home mortgage lenders were lending subprime borrowers more money than they could possibly repay to buy homes.
· These loans were then sold to investors. The originators of the loans thus had no skin in the game after making the loan.
· The bundles of loans were carved up and tranched in a way that masked their actual nature.
· The bundles were full of subprime loans—but the ratings agencies said they were mostly AAA-rated, meaning unlikely to default.
· Investors bought mortgage-backed securities for their fixed return not thinking that they would default soon and be worthless.
· Some saw the problem and bought credit default swaps, a new product that essentially allowed them to “short” the mortgage-backed securities that were full of subprime.
· AIG sold a bunch of credit default swaps both to retailers like the guys featured by Lewis in The Big Short and to banks like Goldman Sachs.
· When, sure enough, the loans began defaulting, the demand for credit default swaps surged. Those who shorted the mortgage-backed securities by buying credit default swaps early on made out like bandits.
· AIG could not cough up enough money to cover the insurance they sold without liquidating. Goldman had Paulson in the Treasury, so Paulson got AIG a nice big bailout that allowed them to pay up to Goldman
· No one was punished or held accountable.
· The Fed stepped in to pump trillions of dollars into the economy, which inflated asset bubbles all over the place.
References
Brooks, L. & Dunn, P. (2018). Business & Professional Ethics for Directors, Executives
& Accountants. Cengage.
Huston, J. H., & Spencer, R. W. (2018). Quantitative easing and asset bubbles. Applied
Economics Letters, 25(6), 369-374.
Lewis, M. (2010). The Big Short. NY: W. W. Norton.
StatelessLiberty. (2013). Stagflation was not caused by Cost-Push factors—Milton
Friedman. Retrieved from https://www.youtube.com/watch?v=qQjAbHR40nk
Taibbi, M. (2010). Griftopia. New York, NY: Spiegel & Grau.