AIG's tangled web unwinds slowly
A look at AIG's complex derivative business shows why it's difficult to take apart these bets.
By Lauren Tara LaCapra, TheStreet
Drilling down into the terms and details of American International Group's (AIG) massive derivative book shows why unwinding thousands of these bets has been so difficult and time-consuming.
AIG's financial products division has made incredible strides in whittling down its often-complex trades. Progress has sped up since the markets have recovered and the firm has been standing on more solid ground, both managerially and operationally.
As of March 9, AIG had reduced the notional value of its derivatives book to $800 billion, with 14,800 trades outstanding. That's $140 billion less exposure and 8% fewer trades than at year-end alone, and less than a third of the $2.7 trillion in exposure at its 2007 peak.
"The trades that are left today are not only fewer in number, but they are also less complex, involve fewer counterparties, are much simpler to hedge or defease and pose dramatically less of a risk than the book did 18 months ago," says spokesman Mark Herr.
In a typical deal, AIG provides insurance against losses by issuing credit-default swaps. The CDS are supported by securitized debt, such as mortgages or corporate bonds, while other contracts protect bets on the direction of equities, bonds, commodities or currencies. Counterparties pay monthly premiums for the protection. They receive payments from AIG if borrowers stop paying en masse, if underlying assets lose market value, or if ratings downgrades occur -- all of which happened in 2008.
As a result, AIG has been forced to make good on others' bearish bets, with more than $100 billion in cash collateral coming directly from the Federal Reserve to firms like Goldman Sachs (GS), Bank of America (BAC), Morgan Stanley (MS), JPMorgan Chase (JPM), Citigroup (C) and other big banks in Europe.
The insurer has been trying to "unwind" the rest of the trades -- whether through natural expiration, or outright purchase of underlying assets. But that task hasn't been easy, says hedge fund manager Ralph Nacey, who actively bet against the subprime housing market in 2007. AIG's protection isn't on a single item in most cases, but on pools of thousands of loans or trades. For instance, the average pool of small-to-medium sized corporate debt that AIG insures is backed by 6,500 loans.
"The way these underlying securities take loss, they're not binary events," says Nacey, who is now managing principal of WestSpring Advisors, a credit-focused firm. "In corporate credit, there's a default and that's an event. With these securities, it happens over time, by not paying interest or not paying principal or a combination of both."
As credit quality continues to degrade, AIG is responsible for additional payments over the life of the contract, unless it is extinguished. However, the loan pools have been packaged and sliced up into securities with different levels of risk, sometimes more than once, creating confusion at times over who even owns the underlying assets. Furthermore, if AIG approaches a counterparty to exit a trade early, it can be difficult to come up with a price tag that satisfies both sides.
"It's not like the underlying securities are trading day to day," says Nacey. "It's not as simple as, 'Let's see where this is trading in the market,' because it's not trading in the market."
As a result, AIG can be locked in tough negotiations with holders of toxic debt for months or years, staring down two choices that appear equally bleak: The insurer can make payments on money-losing assets, hoping they retain or recover some value; or, it can purchase the assets, try to sell them into a still-icy market, and take a related loss.
Outcomes can be wildly different -- depending on market conditions, the horizon of a contract, and a counterparty's willingness to negotiate.
In one case last year, AIG took a charge of nearly $200 million related to guarantees on office-space leases it entered back in 2002. In two other residential-mortgage trades, AIG posted an unrealized gain of $137 million because it believes it will receive premiums even after the underlying assets mature. In yet another case, AIG purchased $1.5 billion worth of debt that is heavily weighted in subprime real estate in Spain. AIG believes it will lose less by selling or holding onto the assets than continuing to make contractual payments.
Complicating the situation further, some transactions are tied to more than one level of a debt structure, and AIG can't extinguish one bet while another is still in place. To hedge against losses on less-healthy, "mezzanine-level" debt, AIG has at times purchased CDS from third-party issuers to offset losses on its own CDS.
When asked to discuss what it takes to unwind a typical contract, Nacey responded: "You're kind of opening Pandora's Box."
Overall, AIG's trades have lost a significant amount of money, because the insurer had been very bullish about a financial market that was soon at the brink of destruction, and an economy that would soon be in a recession. Most deals were set up so that AIG protected the top-level, "super senior" layer of risk -- meaning it only needed to pay out funds once lower layers of equity and debt had accrued losses.
Yet, most of the trades were linked to subprime mortgage bets, and as that market collapsed, losses soon ate through riskier tranches. As a result, AIG's capital-markets business posted $40.5 billion in pre-tax losses in 2008.
"A lot of people are basically equating these problems to credit default swaps [by saying they] are like insurance," says Edward Grabeck, a debt-market strategist and CEO of Tempus Advisors, who has worked with structured vehicles at JPMorgan Chase (JPM) and General Electric's (GE) GE Capital division. "Well, I say they aren't. The people who say they are like insurance are usually the people who mispriced them in the first place."
The complexity of these trades is part of CEO Robert Benmosche's battle with the Obama administration over employee compensation. AIG says its financial products employees know contract terms, market conditions and hedging strategies, as well as AIG's complex proprietary trading systems, better than anyone else. The firm also argues that the departure of key traders and executives would make unwinding contracts more difficult because counterparties in negotiations with them would be spooked by signs of instability.
Financial products employees earned $98 million last year, or 19% of operating expenses. Another $153 million was paid out for pre-existing retention plans and related expenses.
"AIG financial products not only had numerous trades on its books, but extraordinarily complex trades, a substantial number of which were long-dated, making for a daunting challenge on its face," says Herr. "Layer onto that unprecedented market conditions and we faced a tremendous challenge. Despite all of this, the men and women at FP were persistent, diligent and, most important, committed to seeing the unwind through, and we have achieved, by any measure, remarkable success."
Though AIG isn't expected to recoup all of its subprime losses, its capital-markets business showed muted signs of improvement last year, earning $180 million in pre-tax income as the markets improved. If borrowers start repaying overdue debt, or if market values gain more ground -- both big "ifs" -- AIG will be reimbursed a requisite portion of its counterparty payments as well, for contracts that are still active.
Gerry Pasciucco was brought on in October 2008 to wind down the FP division in its entirety. But rather than race to extinguish all of the unit's positions, he now plans to retain $300 billion to $500 billion in derivative trades.
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