There’s an interesting article going around which notes the widespread use of side-letters in the insurance industry. Side letters were used to say “even though you’ve said that you’ll take on X amount of risk on this insurance policy, we won’t hold you to that.” The letters were generally buried off to one side, only to come to light if things did go wrong. Insurance companies did this because if they bought say 1 million of reinsurance for $100,000, they freed up $900,000 of regulatory capital which they could continue to use for further insuring or lending and so on.
Think of this as essentially the same as fractional lending. Insurers have to have enough assets on book to cover their liabilities—policies they may have to pay off on. If somene else is going to pay off on that risk because you bought reinsurance from them, you don’t need that capital. So buying reinsurance frees up capital. As for the seller of reinsurance, they get money in exchange for no risk, if there’s a side letter. Win, win.
The article goes on to suggest that many Credit Default Swaps (CDSs) AIG sold may have had similiar side letters, which since AIG was never seized, may have been destroyed. I don’t know if such side letters existed, but my take is that neither side, in many cases, expected to every have to collect on CDSs, or pay on them.
But when everything went to hell, they certainly tried to. The key fishy problem with AIG wasn’t the bonuses, it was that counterparties were getting paid 100% of the value of CDSs with government money, something they had no right to expect from what amounts to a bankrupt company. In such a case, either as AIG or the counterparty, why would you bring up the side letters, if they exist? The counterparties are getting money and AIG is paying out with money that isn’t theirs anyway.
As for the government, the reason all that money was given to AIG was specifically so they could pay off counterparties—it was a way of getting money to various damaged financial firms, including overseas ones, who needed the money, without it being obvious that the government was giving that money away, especially to foreign firms, which would have caused a firestorm
So, I don’t know if these side letters existed, and it’s worth finding out because if they did, that makes all the transactions fraudulent and we can insist on all the money back and prosecute. But the bottom line is that the government, AIG and the counterparties all wanted the money to be paid out, whether there was a legal obligation or not. So don’t expect anyone to look too hard, unless Congress really gets the bit between its teeth.
senecal
This is a job for Eliot Spitzer! He knows more about AIG than anyone, which is probably why he’s out of office now.
lambert strether
One thing I like about this theory is that it gives a clear reason for the otherwise incomprehensible* refusal to treat AIG and GM in the same way. If GM goes bankrupt, the resulting court cases don’t cause the entire financial class to get arrested to face a few months playing golf at Club Fed. Not so with AIG. Everything resolves around making sure no transparency exists, and no accountability is done. There are, no doubt, good reasons for that.
Hillsfar
So basically we’re all paying for the financiers’ mistakes and greed. But like no one is gonna bring Bush or Rove or Cheney up on trial, so also will no one bring Geithner or Paulson or Bernanke up on trial. Instead, kids go hungry, poor people get worn to the bone, and the middle class continues to fume while running at the treadmills that they are tied to with golden handcuffs.