US taxpayers paying off AIG's gambling "losses" before they're losses

The US government is funneling at least $50 billion through AIG to banks (many foreign) and refusing to say who’s receiving taxpayers' cash. Even worse, they’re paying off bets that counterparties haven’t even won yet!

The insurance claims were paid off in full, even though widespread defaults on the underlying debt have not occurred. Why, many people wonder, did the Fed make A.I.G.’s counterparties whole on losses that have not happened yet? Why didn’t it force these financial companies to close out the contracts at a discount, making them take what is known on Wall Street as a “haircut”?

Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn., and an expert in insurance… said it is not clear that the government had to pay out 100 percent of the contracts’ value to all the counterparties. Healthier institutions could have been persuaded to take a haircut, he said. “That is what tough negotiators do,” he added.

Imagine you’re at a racetrack and bet the trifecta and then the horse you predicted to win wins. You wouldn’t expect the racetrack to rush over and pay off your entire bet even before the other horses finish the race and you see whether the #2 and #3 horses finish in the order you bet they would. And you certainly wouldn’t expect a bankrupt racetrack to be irrationally eager to pay off your bet even before you’ve won. What is our government’s motive?

I’m bothered by this part of the New York Times article:

AIG… sold contracts to these sophisticated counterparties that theoretically protected them from losing money if the debt they had purchased defaulted. Known as credit default swaps, the contracts offer the same kind of protection a homeowner receives from an insurance policy against fires and other unforeseen calamities.

If AIG had only insured parties against losses they would otherwise have sustained, AIG’s situation (and taxpayers') would be far less dire. The biggest problem is that government allowed AIG to take bets from anyone. Many of the CDSes were bought by speculators, effectively like low-cost options. Many have called for government to pay off only CDSes taken out by parties that actually were insuring something they already owned. Many CDSes were really low-risk, high-reward gambles.

Posted by James on Sunday, March 15, 2009