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.

OCC Quarterly

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.

Man, they’ve got such good slogans. Thursday morning’s entertainment will be brought to you by GE, whose illustrious AA+ finance arm will be reporting on its commercial real estate holdings. (Light bulbs + real estate = synergy!)

An idea of what we’ll be looking at:

Other companies have been clobbered by steep declines in the value of office buildings, apartments, stores, hotels and other commercial property. The Dow Jones REIT index has slid 60% in the past 12 months. Private-equity firms that specialize in real estate are reporting losses of as much as 60% for funds invested recently.

GE has been much more generous in its approach to its holdings. So far, GE has said its $34 billion in property could fall in value by about 1.5% this year, amounting to a pretax loss of as much as $500 million.

Hmm. 60%… vs 1.5%.Wut?

Well, we’re comparing it to the market. GE has always held that its properties are long-term investments, and thus should not be subject to the mark-to-market whimsies of everyday investors who have cut and run from everything that smells like fail. However, if you’re not marking to market, you’re marking to a model that includes free cash flow – which you’re not getting from those empty offices and retail stores. Just a wild guess, that’s probably down a little bit more than 1.5% (see also: Ackman, Bill). Also, in moves sure to bolster the bottom line, GE added a net of $9.7 billion worth of r/e to their portfolio near the top of the market in 2007, and had been snapping up Eastern and Central Europe property left and right over the last few years.

It’s enough to make a girl wonder why their stock has rebounded 80 or 90 percent in the last couple weeks, for sure. Pledge: If GE sees a 5 handle again by the end of Q2, I will mail Jeff Immelt a ShamWOW. It’ll be up to him whether he wants to use it as a crying towel or try to see if it will absorb some of GE Capital’s losses.

- Today on Wall Street, the Dow climbed to new heights.  Wait, what?  Upside-down?  Oh.  Nevermind.  Epic, epic failing.  It’s May 1997 all over again, the last time the index saw such a number.

- Speaking of failure, AIG ran out of crack money and wants more, even though it literally cannot do anything more degrading than it already has.  Last time?  Some Requiem For A Dream stuff.  If you don’t remember, and AIG apparently does not, the company has already been lent over $150b.  The company is expected to post a Q4 loss of $60b, mostly from massive writedowns.  Sixty billion dollars, in three months.  Yep.

- Microsoft laid off a lot of employees last month, accidentally overpaid some of them, and sent letters to them saying they wanted that money back.  But then one employee posted his letter to the internets, and suddenly they get to keep the money.  The end.

From the “Maybe I should’ve settled for a firm handshake” department, Credit Suisse announces all bonuses will be paid in illiquid assets:

Dec. 18 (Bloomberg) — Credit Suisse Group AG’s investment bank has found a new way to reduce the risk of losses from about $5 billion of its most illiquid loans and bonds: using them to pay employees’ year-end bonuses.

The bank will use leveraged loans and commercial mortgage- backed debt, some of the securities blamed for generating the worst financial crisis since the Great Depression, to fund executive compensation packages, people familiar with the matter said. The new policy applies only to managing directors and directors, the two most senior ranks at the Zurich-based company, according to a memo sent to employees today.

The incentive to use an approach like this is overwhelming, and you wonder why nobody thought of it before. First, your employees don’t have to walk away absolutely empty-handed; second, it transfers some of the risk, even though the garbage stays on Credit Suisse’s books, and third, it’s more memorable than handing out homemade fruitcake:

“It’s monstrously clever,” said Dirk Hoffman-Becking, an analyst at Sanford C. Bernstein Ltd. in London who has a “market perform” rating on Credit Suisse stock. “From a shareholders’ perspective it’s great because you’ve got rid of some of the assets and regulators will be pleased because you’ve organized a risk transfer.”

BUT WAIT! THERE’S MORE!

CS provides leverage to the facility (because we’ve proven again and again that leveraging toxic assets is a brilliant move). Oh, and YOU… yes, YOU… may even be able to get in on this action.

Outside investors may also be permitted to invest in the facility, according to the people familiar with the matter, who declined to be identified because the plan hasn’t been made public. The bank will boost the potential for returns by providing leverage to the facility, and will be paid back first, according to the people.

Operators are standing by… call now! Once the value of these assets drops to zero, this offer can no longer be extended!

[h/t to Carsten Maybach for the link to this epic strat.]

Wachovia made a play for captain of the failboat, posting an impressive $23.9b Q3 loss.  Twenty-three-point-nine billion dollars, lost.  In a quarter.  That’s three months.  Wachovia lost $265,555,555 a day in the last quarter, or $184,413 every minute.  All that can really be done at this point is congratulating Wachovia for this staggering achievement.

(Warning: Boring technical content ahead)

The loss included over $18b in a “goodwill” writedown.  When a company is bought, as Wachovia is in the middle of right now, a purchase price is given.  That number is then divided up among the company’s various components.  Often, the valuation of a component will exceed its current value – if the company’s assets were worth what they said they were, the company likely would not have been bought.  That difference, combined with the differences from the other business components, is lumped together and written down all at once in what’s called a goowdill writedown.  In this case, Wells won’t be buying up a bunch of bloated assets; it will be buying up a bunch of assets valued at close to their current worth.  In time, as those assets appreciate, that appreciation will be booked as profit.  Writedowns are now required by law to be recorded all at once, rather than amortized over a period of decades, so they really do look a lot worse than they actually are.  It’s still bad, though.

Companies are required to go through the goodwill process annually, but since such leeway is given in the valuation of assets, goodwill writedowns are usually very small, if they exist at all.  About the only time a company can get a solid real-world valuation of its assets is when it’s being bought.

So realistically, aside from the giant writedown, Wachovia’s losses were still just north of $4b for the quarter, still way more than the roughly $600m that analysts were expecting, and surely enough to make Citi think it ultimately won in the fight with Wells Fargo.