AIG Mystery Trades - Who Knew?

I follow AIG stories. On March 11th I read an interesting piece regarding AIG in blog called Zero Hedge.

The essence of this blog was that AIG went to a number of big Street players and unwound significant amounts of outstanding CDS swaps. The suggestion was that these ‘unwinds’ were done at fire sale prices and that the banks involved got fat on the trades.

There were aspects to this story that I found to be very ‘plausible’. It occurred to me that if this were true it might give the bank stocks an opportunity for a dead cat bounce. I checked around with a few journalists and some friends in Town. Several had heard the same thing, but no one that I talked to could confirm it. I let it slide. Too bad for me, The BKX is up 50% since then.

This weekend, no less than the Barron, Alan Ableson brought up this story in his weekly column. Here are Mr. Ableson’s words:

As Zero Hedge explains, AIG, desperate to hit up the Treasury for more moola, decided to throw in the towel and unwind its considerable portfolio of default-credit protection. In the process, the badly impaired insurer, unwittingly or not, "gifted the major bank counterparties with trades which were egregiously profitable to the banks."

If Mr. Ableson is comfortable with this story then so am I. Unfortunately it does not matter any longer. The move in the BKX is over. I missed it. Now that the confirmation on this story is out, the market will finish the cycle and ‘sell on the news’.

Assume for the sake of discussion that the story is true. There is some related information. Mr. Liddy, the AIG CEO said before Congress in mid March, "The CDS book is at $1.6T, and it will take four more years to unwind." That struck me odd at the time. At one point the CDS book was reported to be as large at $2.7 trillion. Did Liddy confirm that as much as $1 trillion of the CDS book was eliminated?

In the absence of facts let me speculate. These large unwinds must have taken place early in the year. Probably January, possibly it started in December. If this took place it happened on direct orders from Washington. If my sense of timing is correct then Paulson was still involved. His role was transitional however. The decision makers on this had to have been Geithner, Bernanke and Summers. It is not possible that AIG would have done something this significant without the advice and consent of the Federal Reserve.

It is possibly that the DC foursome were looking at an AIG black hole. AIG was ‘too big to fail’ but its CDS book was sucking up huge amounts of liquidity. Potentially an amount greater than Congress was prepared to pay. A choice was made. The order to AIG was given: “Reduce the portfolio by 40%”.

One can imagine the conversations that must have taken place between AIG and its CDS counterparties:

AIG: “We need a price to close $150 billion of CDS on your books”

Counterparty: “Gulp. I will call back shortly with a very stinky price.”

If this story is true it will explain some of those mystery profits the banks have been reporting. There is a broader context in which this should be considered.

The credit markets have been contracting for nearly eighteen months now. The contractions have come in waves. Each wave has been more destructive then the last. It started with something relatively minor called Sub Prime loans. The subsequent waves caused by BST, FNM, FRE, LEH and AIG each caused another contraction of credit and an associate drop in equity values.

The CDS market facilitated the expansion of credit in the good times. CDS created the opportunity for low risk investors to fund high-risk pools of mortgages. Unwinding the large AIG CDS positions had to have a contractionary impact on the total market capacity to absorb credit risk. At its peak in 2007, the shadow banking system was $10 trillion. If it is correct that the AIG unwinds totaled as much as $1 trillion it would constitute a significant portion of the off balance sheet debt market. A contraction of this magnitude in a short period of time would, by itself, result in significant market volatility as the underling ‘risk’ is repositioned. Yet another wave.

If the AIG unwinds were responsible for the great ‘sucking’ noise of credit that we heard in January and February then it is also likely that the big swoon in equities prices during that period were a consequence as well. The move down in stocks during this period caused a drop in values of $2.5 Trillion in less than 60 days. No one factor was responsible for that decline. However, it is possible that an unintended consequence of the AIG unwind was that it caused/contributed to/accelerated the broad decline in global equity prices.

At this point there are a handful of people out there who have the answers on this. They know if this happened, when it happened, what assets were involved and how big this was. There are large group of folks, including Mr. Abelson, and myself that do not have these facts.

It makes sense that the Fed and Treasury keep some of their activities out of the public domain. Tipping their hand would just cost the taxpayers more money. At this point the deals are done. The quarter has passed. The story in Barrons makes it half public. The Fed and or Treasury should clarify the facts on this matter. I, for one, would like to know if our leaders in DC inadvertently triggered a 20% hiccup in the global equities markets.