What Do Pensions Have in Common with AIG?

After rallying for four days, stocks gave up early gains and the rally fizzled this afternoon:

Analysts said Monday's pullback after a four-session surge didn't necessarily signal that traders were reconsidering their newfound optimism about financial stocks, a main driver behind last week's advance.

In fact some viewed the measured easing in stocks as reassuring following a surge of more than 9 percent in major indicators last week, more than the market has moved in some years.

"This is healthy," said Dave Rovelli, managing director of trading at brokerage Canaccord Adams in New York. "The best thing for this market is that we don't go up aggressively. A steady rise of a few up days then a down day would be a lot better than 1,000 points up."

Stocks rose for much of the session as investors snapped up hard-hit financial shares. Comments from Federal Reserve Chairman Ben Bernanke and reassuring news from a British bank eased some worries about the overall economy and prospects for financial companies struggling with bad debt.

Bernanke said Sunday the recession would probably end this year if the government's efforts to revive the banking industry succeed. In an interview with CBS' "60 Minutes," Bernanke said fixing the economy will require getting banks to lend more freely and financial markets to work more normally again.

Financials rallied strongly with AIG (AIG) and Citigroup (C) leading the pack, up 66% and 30% respectively today. And this constitutes a "healthy" market?!?

Hedge funds have been playing the financials using the Direxion Financial Bull 3X shares (FAS), an ETF that seeks to replicate, net of expenses, 300% of the daily performance of the Russell 1000 Financial Services Index. Who said the addiction to leverage is dead?

The big scandal today revolved around the AIG bonuses. By now, everyone knows that Goldman Sachs won big on the AIG bailout. And Goldman was not alone. AIG also paid hedge funds and other banks with taxpayer money:

While the biggest global banks and municipalities topped the list of entities that AIG owed money under counterparty agreements, two hedge fund firms, Citadel Investment Group and Paloma Securities, were also on the list for $200 million apiece. The two firms were owed the money under securities lending agreements with AIG.

A spokeswoman for Citadel said the firm had no comment. A spokesman for Paloma said the payment was part of a securities loan transaction for corporate bonds that was done in the usual course of business.

Indeed, the $200 million to the hedge fund firms was small feed compared to the money that the world’s biggest banks got for different kinds of counterparty agreements.

Goldman Sachs was listed as receiving $12.9 billion, Merrill Lynch got $6.8 billion, Bank of America received $5.2 billion, Citigroup received $2.3 billion and Wachovia $1.5 billion.

Foreign banks who received AIG money included Societe Generale ($11.9 billion), Deutsche Bank ($11.8 billion), Barclays ($8.5 billion) and UBS ($5 billion).

AIG came out with the list in an effort to head off the protest over the news that the company was paying bonuses of up to $165 million for executives in their structured finance group. That was the business that went heavily into collateralized debt obligations and got AIG into its financial mess to begin with.

AIG protested that it had to pay the bonuses because it was under contract to do so. The company also claimed that it had to pay the bonuses to retain those traders in order to unwind the business.

On Monday, President Barack Obama said he was asking U.S. Treasury Secretary Timothy Geithner to find every legal way to block the payments. “Under these circumstances it’s hard to understand how derivative traders at AIG warranted any bonuses, much less $165 million in extra pay,” Obama said. “How do they justify this outrage to the taxpayers who are keeping the company afloat?”

The U.S. Treasury has loaned AIG almost $170 billion in financial bailout money and now owns about 80% of the company.

The pressure mounted on AIG on Monday when New York State Attorney General Andrew Cuomo sent a letter to AIG Chief Executive Officer Edward Liddy about the traders’ bonuses, demanding details about their names, job description and job performance and whether the payments had already been made.

Cuomo said in his letter that if the company did not comply with his request by 4 p.m. (EDT) Monday, his office would issue subpoenas and go to court.

AIG did not immediately return a phone call from HedgeFund.net seeking comment.

Talk about the glue that binds a nation. I agree with Miles Mogulescu of the Huffington Post who writes that the Obama administration must stop bonuses to AIG Ponzi schemers:

It's time for some righteous populist anger from the Obama administration--not just in words, but in deeds--to stop the looting of the Federal Treasury by Wall Street executives using taxpayer money to pay bonuses to the very people who manipulated markets and were instrumental in bringing the international financial system crashing down on the heads of hundreds of millions of people in America and around the world.

If the Obama administration doesn't stop AIG from paying hundreds of millions of dollars in bonuses, it will enable a popular uprising (led, unfortunately, by hypocritical Republicans posing as populist leaders) which will block the Obama administration from taking the actions necessary to save the financial system. It could destroy Obama's presidency and lead to a decade-long depression.

Instead, while AIG prepares to use hundreds of millions of dollars in taxpayer money to pay bonuses to the very executives at AIG's Financial Products Unit who designed, managed and marketed the credit default swaps which were little more than a Ponzi scheme, the Obama administration sends out Tim Geithner, Austan Goolsbee, and Larry Summers to lamely express fake anger to the media while defending the payments on the grounds of the "sanctity of contracts".

As Larry Summers timidly told George Stephanopoulos, "The easy thing would be to just say...off with their heads, violate the contracts. But you have to think about the consequences of breaking contracts for the overall system of law, for the overall financial system."

Even first year law students in Contracts 101 learn that there are numerous exceptions to the "sanctity of contracts". As any working lawyer will tell you, contracts are legally abrogated every day--a big part of our court system is given over to litigating disputes over the enforceability of various commercial contract provisions. If Treasury Secretary Geithner is rolling over and passively taking the advice of lawyers hired by AIG's Chairman that there are no legal defenses and counterclaims to paying the executive bonuses, then he's talking to the wrong lawyers. He and President Obama need to bring in the best litigators in the country and give them the mandate to find every available legal argument for not paying the bonuses, and then force every employee of AIG's Financial Products Unit who is unwilling to give up their bonus to hire expensive lawyers to sue for it, and vigorously defend these lawsuits through trial and up the appeals ladder, if necessary, for years, before even considering paying any such claims.

Let's clearly understand what the executives of AIG's Financial Products Unit did: As several commentators have noted, AIG's Financial Products Unit is a hedge fund grafted onto an insurance company. I would go even further--It's all-but a Ponzi Scheme grafted onto an insurance company.

AIG's principal business is selling insurance including casualty, auto and life insurance. In fact it's the largest insurance company in the world. Insurance is a highly regulated business. When a company sells insurance, government regulators require it to set aside financial reserves to pay claims. For example, if an insurance company sells fire insurance, it uses actuaries to calculate the amount of fires which are likely to occur and the likely costs of paying claims on these fires, and is required to set aside enough money to pay these potential claims. It also invests these reserves and profits from these investments. AIG's regulated insurance business was profitable and would not require AIG to take $170 billion and counting in Federal bailouts.

AIG's Financial Products Unit was instrumental in creating and marketing a new type of insurance product which purported to insure investors in mortgage-backed bonds and derivatives against losses to their investments if the homeowners who took out these mortgages defaulted on their payments. Only AIG didn't call these products "insurance policies". They called them "credit default swaps," instead.

Because AIG and other big financial institutions claimed that credit default swaps were not insurance but a form of financial security like a stock or a bond, they were not required by regulators to put aside reserves against losses.

This worked out pretty well for AIG and its high-paid executives during most of the past decade while the real estate bubble kept home prices rising, allowing homeowners to continually refinance their mortgages and make their payments--AIG profitably collected billions of dollars of premiums on the credit default swaps it sold, hardly ever had to pay any claims, and gave executives hundreds of millions of dollars in bonuses for keeping the circus operating.

(It worked out pretty well for Bernie Madoff, too, who could continue to pay earlier investors from the proceeds paid in by new investors, until the financial markets crashed and investors started asking for their principal back.)

In fact, credit default swaps were little more than an (arguably) legal Ponzi Scheme which, because reserves against losses were not set aside, relied on a constant flow of new premiums to pay-off any potential losses, as well as to pay the oversized bonuses to the executives who created and sold them. In selling credit default swaps, many of which insured sub-prime mortgages, AIG executives did not perform due diligence on the viability of the underlying mortgages to determine the actual risk that mortgagees would default if the housing market stopped rising.

As a result, last September, when the housing bubble burst, and increasing numbers of homeowners stopped making their mortgage payments, the counterparties to AIG's credit default swaps demanded that AIG post hundreds of billions of collateral to secure the counterparties against the potential losses to their insured bond and derivative portfolios. AIG didn't have the money, because it had failed to put aside adequate reserves and because it had already paid out the premiums it had received in the form of bonuses to its executives and as dividends to its shareholders.

Because these counterparties were some of the largest banks, investment houses and hedge funds in the world, the Federal Reserve under Ben Bernanke and (then) Tim Geithner, and the Treasury Department under Hank Paulson and (now) Tim Geithner, decided that AIG was "too big to fail" since AIG's failure to pay-off the losses on its credit default swaps to these other "too big to fail" financial institutions would lead to a cascade of huge bankruptcies which would bring down the international financial system.

So far the Federal government has given AIG $180 billion to back up its credit default swaps to these counterparties, with no end in sight, and we, the taxpayers, now own 80% of AIG. Meanwhile, the AIG executives who created this disaster demand hundred of millions of dollars in bonuses and the Obama administration throws up its hands and says there's nothing it can do, as though it is powerless but to listen to AIG's Chairman and his lawyers that the bonuses must be paid.

Under these circumstances, I have no doubt that smart lawyers, hired by the Obama administration, can find numerous legal arguments for refusing to pay the contractual bonuses to AIG executives.

Without having seen these contracts, here are a few legal arguments off the top of my head: Most executive contracts provide that the executive is in breach if s/he engages in gross negligence or willful misconduct. According to the New York Times, most of the AIG executive contracts under which the bonuses are to be paid were entered into in early 2008, after the real estate bubble had started to burst and subprime mortgages started to default in large numbers.

There is a strong argument the AIG executives responsible for designing and selling credit default swaps were grossly negligent (if not willful) in failing to perform due diligence on the risk of loss that the underlying bonds would default and setting aside sufficient resources for paying claims if defaults happened. Instead, they pocketed hundreds of millions of dollars in bonuses off of the premiums from prior-year's credit default swaps and made no provisions for setting aside funds for paying potential claims. This may not only have constituted gross negligence or willful misconduct--It may even have constituted criminal negligence or fraud.

If President Obama wants to avoid a populist uprising that could sink his administration, he needs to tell Geithner and Summers to stop defending the legality of the AIG bonuses and bring the full force of the federal government down on the heads of any executives of AIG's Financial Products Unit who have the nerve to claim a bonus. (As Robert Kuttner has pointed out, "the outrage over the the AIG bonuses is a sideshow. The larger problem, both financially and politically, is the entire strategy for rescuing the banks." But if Obama doesn't act forcefully to stem popular outrage by halting the AIG bonuses, he may never have a chance to get the policy right on the financial rescue.)

Obama should go on national television, explain to the American public how AIG executives used the phony insurance policies of "credit default swaps" to game the financial system, and announce that any executive of AIG's Financial Products Unit who claims s/he's entitled to a bonus will have to hire a lawyer and sue for it--and that the government will insist that every such suit go to trial and if the government loses at trial, be appealed for years before any claims are paid.

Moreover, the government will require AIG to countersue every executive that claims a bonus for gross negligence and/or fraud and will seek damages and a refund of prior year bonuses. In addition, Obama will instruct the FBI to investigate the AIG executives for criminal fraud. And he will instruct the IRS to conduct full-scale audits on the last 7 years of their tax returns to insure that they properly paid the government everything it was due on their huge incomes. He will use every legal resource at the disposal of the Federal government to make their life a living hell if they continue to claim bonuses on their ill-gotten gains.

Rhetoric denouncing the bonuses is not enough. Decisive action by the Obama administration to stop payment of the bonuses is required. Anything less threatens to destroy the credibility of the Obama administration with the American people and derail Obama's efforts to prevent a depression.

UPDATE: President Obama has just released a new statement on the AIG bonuses and unfortunately, he's blowing it by failing to express a sufficient level of populist anger which reflects the anger of the American people, or definitively state that the bonuses will not be paid, period. He follows Larry Summers and Tim Geithner by expressing faux outrage: "How to they [AIG] justify this outrage [of the bonuses] to the taxpayers who are keeping the company afloat?" Then Obama says the Geithner is "working to resolve this matter with the new CEO, Edward Liddy, who came on board after the contracts that let to these bonuses were agreed to". (Liddy is the CEO who already told Geithner than he's legally obligated to pay the bonuses.) Obama says that he's asked Geithner "to pursue every legal avenue to block these bonuses".

Not good enough. Obama has to stop being polite. He needs to proclaim that the full force of the Federal government will be brought down on the heads of any AIG executive who tries to claim a bonus.

I would throw all the crooks who ran AIG's Financial Products Unit in jail and prosecute them under the full extent of the law for criminal negligence that has caused irreparable damage to the U.S. and global economy.

But if you think AIG took enormous risks allowing their executives to reap huge bonuses, then what do you think about a public pension fund using the government's balance sheet to sell CDS? I would say that borders on criminal negligence too and it all goes unnoticed because nobody has a clue as to what these mega funds are doing behind closed doors.

Worse still, the global Ponzi scheme unraveled fast since last August, closing the curtains on private markets, exposing the bogus benchmarks that were governing them and ending the great pension con job.

What do pensions have in common with AIG? It turns out a lot. Both were claiming to run a core business when in reality they were fueling a Ponzi scheme using "sophisticated instruments" or "alternative investments" that threaten the security of the global financial system. That's why AIG's dismal results back in August spelled trouble for pension funds.

Just like AIG, most pension funds lack transparency, allowing them to operate beyond the reach of regulators. Moreover, there is no accountability or serious risk management taking place at any of these large pension funds, allowing senior managers to reap huge bonuses for taking excessive risks (typically by beating bogus benchmarks in private markets).

And just like AIG, when their financial solvency eventually reaches a breaking point, these pension funds are going to require billions, if not trillions, in bailout funds to allow them to meet their pension obligations.

You'd better get ready because Uncle Scam wants your money and there is nothing you can do to stop him.