Institutional Risk Analytics published this piece a few days ago comparing AIG’s CDS business to AIG’s reinsurance business. They’ve laid out an interesting, scary and plausible thesis for fraud and fail. Hard to make this one funny but I thought it worth posting, nonetheless.
Reinsurance is a good way to get risk off your books, and generally, a legitimate one. As background, though, understand that in the reinsurance business, there was a type of fraud that involved issuing reinsurance with a “side letter” attached. Basically, it’s a wink-wink-nudge-nudge agreement that allows a company to say their risk is hedged, while the “side letter” – named such because it is kinda hidden on the side, like in someone’s secret wall safe somewhere – specifies that both parties involved know damn well that in the case of a default, nothing is ever actually going to be paid. It makes a company look better on paper only, and yes, it’s illegal:
First, they are a criminal act, a fraud that usually carries the full weight of an “A” felony in many jurisdictions. Second, once the side letter is discovered by a persistent auditor or regulator examining the buyer of protection, the transaction becomes worthless. You paid $6 million to AIG to shift risk via the reinsurance, but the side letter makes clear that the transaction is a fraud and you lose any benefit that the apparent risk shifting might have provided.
Emphasis mine… fraudulent contracts have to be written down as worthless. Mark it zero. Remember that.
AIG got in trouble for writing agreements to transfer risk with side letters attached more than once (showing they have experience in applying the concept when dealing with institutions other than insurance companies). The SEC fined them $10mil in 2003 for using this craftiness to help a communications company called Brightpoint inflate its earnings, and AIG-FP was investigated in 2004 for helping PNC Bank shift bad assets into a special-purpose entity (this ended in a deferred-prosecution agreement). Anyway, around ’04 they decided the side letter jig was up… and AIG entered the CDS markets.
And, allegedly, they pulled the same crap there.
Indeed, our sources as well as press reports suggest that the CDS contracts written by AIG may have included side letters, often in the form of emails rather than formal letters, that essentially violated the ISDA agreements and show that the true, economic reality of these contracts was fraud plain and simple.
If, somewhere in the unwinding of AIG, these “side emails” can be uncovered proving that any of the CDS contracts written by AIG are fraudulent, that means two kinds of trouble for our favorite banksters on the other sides of these contracts: they’ll be guilty of fraud, and they’ll have to write down these contracts to zero.
The Office of the Comptroller of the Currency’s Q4 report shows you on page 13 which are the top five US banks by commercial derivatives holdings, and the percent of their total credit exposure to risk-based capital. I could rubber-stamp FAIL all over it but you probably see the possibility for insolvency without needing that.
If there is truth to this, it won’t end well for the names you see on there:
Only when we understand how AIG came to be involved in CDS and the fact that this seemingly illegal activity was simply an extension of the reinsurance/side letter shell game scam that AIG, Gen Re and others conducted for many years before will we understand what needs to be done with AIG, namely liquidation. Seen in this context, the payments made to AIG by the Fed and Treasury, which were then passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be reversed once the US Trustee for the Federal Bankruptcy Court for the Southern District of New York is in control of AIG’s operations.
Insolvency and prison bitches, ahoy! IRA warns that much of the evidence may have been fleeting (calls and emails), or destroyed, but who knows what will turn up in The Great Unwind.
h/t on this one to Stephanie at FedUpUSA and to Erik Skiles who also pointed out the OCC chart.