On Fri, 27 Nov 2009, Doug Henwood wrote:
>>> I got it from the "SIGTARP" audit.
>>
>> Fair enough -- can't get a more reputable source for criticizing the
>> Fed than that. So then it's their logic I don't quite get.
>
> Rescuing AIG meant, in large part, paying off the holders of its credit
> insurance. The Fed could have said, hey, your hair's too long, it'd look nice
> a little shorter. Instead, because Goldman et al whined, the man a friend
> calls Timmee! decided to pay them in full. He claimed he had no negotiating
> leverage, which is absolute nonsense.
Okay, here's the part I don't understand. They were unwinding default swaps, which is essentially haircut insurance -- the more you haircut, the more the default swap pays. In the event, IIUC, Goldman had bonds whose value was 65 cents on the dollar, and they also had 35 cents of collateral from AIG. Treasury bought the bonds for 65 cents and cancelled the swap contract.
So first point is that the bonds have already been severely haircut -- they are being bought at their market value. The only way to cut hair here seems to be to buy the bonds for say 50, which is below their value. I got no problem with that. But then the default swap obligates AIG to pay 15 more cents, so it's a wash.
Which brings us to my problem: if AIG doesn't cough up that extra 15%, it's defaulted on the contract. In which case its rating will go down several notches. Which will induce massive contractual collateral calls on the whole bazillion dollar of outstanding contracts. Which call will itself lower the rating again. And presto, in one or two quick bounds AIG goes down the default death spiral that they did all this to avoid. We could have done that for free and saved $200B.
I can see how you could apply the strong arm on the banks to make them accept partial payment of the default swaps as full settlment so that technically it wouldn't be default. But if you can't control the rating agencies, I don't see how that helps you.
So what am I missing?
Michael