AIG was a ponzi scheme for risk transfer and, IMHO, should be treated accordingly. We (meaning myself and the rest of the current and future taxpayers of the United States) should no more be bailing out AIG and its counterparties than we should be bailing out Bernie Madoff and his institutional counterparties.* And it, if the hints in the Institutional Risk Analyst article are to be believed, there is a paper trail to prove this.

I read yesterday (I forget where, I’m sorry to say) that the Madoff investigation is now widening to include his institutional counterparties who, basically, were either incompetent to possess their licenses or knew he was running a fraud but decided to ignore it so long as he continued to produce excessive returns.

Anyway, where I started was with a pair of fairly technical articles about risk transfer and re-insurance that summarize quite nicely what was really going on with AIG in particular and risk layering in general with regards to reinsurance and Credit Default Swaps during the past five years. Eventually, the transferred-but-not-really risk blew up and took everyone left holding it along with it.

Robert Waldman set me off about all this by leading me to this article, “AIG: Before CDS, There Was Reinsurance”

One of the first things we learned about the insurance world is that the concept of “shifting risk” for a variety of business and regulatory reasons has been ongoing in the insurance world for decades. Finite insurance and other scams have been at least visible to the investment community for years and have been documented in the media, but what is less understood is that firms like AIG took the risk shifting shell game to a whole new level long before the firm’s entry into the CDS market.

In fact, our investigation suggests that by the time AIG had entered the CDS fray in a serious way more than five years ago, the firm was already doomed. No longer able to prop up its earnings using reinsurance because of growing scrutiny from state insurance regulators and federal law enforcement agencies, AIG’s foray into CDS was really the grand finale. AIG was a Ponzi scheme plain and simple, yet the Obama Administration still thinks of AIG as a real company that simply took excessive risks. No, to us what the fraud Bernard Madoff is to individual investors, AIG is to the global financial community.

As with the phony reinsurance contracts that AIG and other insurers wrote for decades, when AIG wrote hundreds of billions of dollars in CDS contracts, neither AIG nor the counterparties believed that the CDS would ever be paid.

As Waldman cogently observes in his post

Contingent liabilities appear on published balance sheets (I mean Q-10s) at market value and without details. So on the assets side, a CDS has an effect which depends on its notional value and on the liabilities side at it’s market value.

Now I’d guess that regulators can detect and disallow regulatory benefits from positions which exactly cancel by definition. However, different CDSs can be very close substitutes without being identical. If I buy and write CDS on similar tranches of similar pools, I am not running (or insuring) much risk. If one counts at nominal value and one at market value, can I claim that I am insuring a lot of risk ?

No. And don’t let anyone convince you differently because they’re an “expert.” While I’m generally a fan of expertise, I’m an even bigger fan of evidence, and the evidence of unmanaged risk has now been spread across the front page of the paper for six months.

* While I’m moderately sympathetic to the individuals who lost money when Madoff’s fraud unwound, they ultimately need to realize that they were victims of their own greed. Excessive returns always come with excessive risk. In this case, the risk happened to be that the ponzi scheme would end before they pulled their money out. Just because they didn’t know the nature of the risk does not entitle them to be made whole beyond what can be recovered from Madoff and his wife, cronies, etc. I can only think of one case (the guy who tried to get the SEC to investigate Madoff) where anyone said, “This guy is beating the market so much that he can’t be on the level.”

As to participants in the banking system, I’m even less sympathetic. Nationalize, re-capitalize as-necessary, wipe out the equity holders. Again, you didn’t hear them crying when they were seeing excessive returns while things were going well. And I include myself in the group who will be hurt by this move–I still own a few shares in my former employer.

I take great exception to your negative comments about the everyday Madoff investors, conveniently couched in your comment about being “moderately sympathetic” towards them. Madoff investors are indeed guilty about believing in a corrupt SEC that first stated that they suspected in 1002 that there was a Ponzi scheme going on, then 2 weeks later stated that Bernard Madoff was the money manager and that he was investigated and was clean. We are guilty of believing that the securities industry could elect as the Chairman of the Nasdaq exchange a man who could be guilty of running the largest Ponzi scheme in history. We are guilty of believing that since Ponzi schemes never last for more than a couple of years at most that Madoff, in business since 1960, could possibly be doing this also, especially in view of the SEC “blessing.” And lastly, though it is not a crime to be “greedy,” a word tossed around a lot these days, most Madoff investors were very satisfied in receiving 12 to 15% steady returns, certainly not “excessive” when the general stock market was returning 20 to 40% each year during the 1990’s, and thought of ourselves as having a conservative investment. We are fighting a long uphill battle to get back from the governemnt our own income taxes paid on phantom income, which the recent IRS guidelines will help some of us. We are fighting against SIPC, an agency funded with brokerage money, not taxpayers, that has decided not to follow their own guidelines to deprive investors of monies due them, and to threaten to clawback money that they withdrew from Madoff, thinking it was their own, money that they no longer have. Yes, thank you for your being “moderately sympathetic,” but being understanding and supportive might go a lot further for our cause.