AIGFP’s derivatives portfolio stands at about $1.6 trillion and remains a significant risk. Failure to pay the required retention payments therefore could have very significant business ramifications.
For example, AIGFP is a party to derivative and structured transactions, guaranteed by AIG, that allow counterparties to terminate in the event of a “cross default” by AIGFP or AIG. A cross default in many of these transactions is defined as a failure by AIGFP to make one or more payments in an amount that exceeds a threshold of $25 million.
In the event a counterparty elects to terminate a transaction early, such transaction will be terminated at its replacement value, less any previously posted collateral. Due to current market conditions, it is not possible to reliably estimate the replacement cost of these transactions. However, the size of the portfolio with these types of provisions is in the several hundreds of billions of dollars and a cross-default in this portfolio could trigger other cross-defaults over the entire portfolio of AIGFP.
There are also substantial risks related to the hedging of AIGFP’s various books. Although we view the large-market risk books at AIGFP as generally well hedged, the hedging is dynamic – that is, it must be monitored and adjusted continuously. To the extent that AIGFP were to lose traders who currently oversee complicated though familiar positions and know how to hedge the book, gaps in hedging could result in significant losses. This is driven to some extent by the size of the portfolios. In the interest rate book, for example, a move in market interest rates of just one basis point – that is 0.01% or one-100th of one percent – could result in a change in value of $700 million dollars if the book were not hedged. It has virtually no impact on the hedged book. There are similar exposures in the foreign exchange, commodities and equity derivatives books.
What does this mean: Bankruptcy, nationalization, the abrogation of any AIG contract worth over $25 million are all unthinkable. Why? Because the changes to the bankruptcy law that were enacted between 1982 and 2005 have privileged derivative counterparties to such an extent that any default will allow counterparties to terminate the derivative contracts.
While the laws imply that termination will involve careful netting of contracts (that is both contracts that are in the money and those that are out of the money will be terminated and then offset against each other), it is not clear to me that under ISDA protocols a derivative counterparty is required to terminate all contracts. For example, the wording above implies that AIGs counterparties have the right, but not the obligation to terminate derivative contracts. If this is indeed the case, then these counterparties are likely to argue that they have a duty to shareholders to selectively terminate those contracts that are in the money, while leaving contracts that are out of the money in place. In this circumstance the value of AIGFP's assets are likely to fall well below zero for the simple reason that AIG will be stripped of its hedges, except where they are losing money.
The preceding analysis may be wrong because I have never read the ISDA protocols. However, even if the ISDA protocols force each counterparty to either terminate all derivatives contracts with AIG or none of them in the event of a default, such a termination would strip AIG of its hedges with a potentially devastating effect on its balance sheet. (Recalling however that AIG's insurance subsidiaries may well be protected by strict regulation from the debacle.)
Why are regulators and policy-makers behaving as though firms such as AIG are holding a gun to their heads? Because the US bankruptcy law has been rewritten so that every big derivative trading financial firm is a time bomb waiting to explode. Somebody needs to defuse these bombs -- and I suspect that the only entity with that authority is Congress. The law needs to be revised so that the only circumstance in which a counterparty is granted the right to terminate derivative contracts in the event of a cross default is when this right is granted under the rules of an exchange regulated by the CFTC.
Let us not forget how these new bankruptcy laws got passed. For the most part our Congressmen and women felt that the regulation of derivative contracts was such a complex problem that only a limited group of experts could understand it. Unfortunately our regulators never really got up to speed on derivatives and also trusted the judgment of a limited group of experts. Who were these experts? Members of the financial industry itself. In particular the ISDA weighed in in support of every single one of these bankruptcy amendments.
In other words financial industry experts used their expertise to convince Congress to pass laws that gave their firms extraordinary privileges under the new bankruptcy law, in every instance resulting in a de facto taking of property from bond investors who would otherwise be senior to the derivative counterparties. Now these same experts are claiming that the government needs to go into debt to the tune of multiple trillions of dollars in order to protect the sanctity of contracts. Clearly legislative takings are okay only if they affect Main Street investors, not if they affect Wall Street.
It is time for someone to call bullshit and put an end to the extortionate scam that underlies the modern American financial industry.
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