Follow The Money, as they say in J-school

So everyone around the blogosphere is latching on to this WSJ story that hit the wires late Friday night. The lead:

The beneficiaries of the government’s bailout of American International Group Inc. include at least two dozen U.S. and foreign financial institutions that have been paid roughly $50 billion since the Federal Reserve first extended aid to the insurance giant.

Among those institutions are Goldman Sachs Group Inc. and Germany’s Deutsche Bank AG, each of which received roughly $6 billion in payments between mid-September and December 2008, according to a confidential document and people familiar with the matter.

The commenters at Calculated Risk are infuriated: “Once AGAIN America is bailing out the Europeans, all the while they bad mouth us. What’s wrong with this picture?”

Yves at Naked Capitalism is indignant: “wake up and smell the coffee. The public purse is being looted”.

The FT’s Willem Buiter is “speechless and weak-kneed with rage”, and clearly needs a cup of tea and some mellow jazz to calm himself down.

(Update: Barry Ritholz of The Big Picture says “[T]his is a giant FUCK YOU to the American taxpayer”. Language, people, please. Someone, please think of the children!)

Only Dealbreaker has the right idea: “oh wait. We kinda knew that.”

This story is a beat-up.

The “scandal” revolves around a list of counterparties that have received payments from AIG since the first round of bailouts. The WSJ makes it sound like these are under-the-table subsidies to tottering banks that would collapse without them.

This is wrong.

(Now, I’m not a CDS trader – if any CDS gurus are reading this, shoot me a mail and let me know if I’ve screwed anything up.)

Let’s imagine you’ve sold a credit default swap to AIG – let’s say it’s a 5yr $10 million notional on Acme Corporation, and let’s say the price is 100 basis points.

Each year, AIG pays you 100bp (1%) of the notional: $100,000, in two semiannual payments of $50,000 (why semiannual? Just because). In return, if Acme Corporation defaults on its debt (because of too many liability claims from Wile E. Coyote), you have to pay AIG the losses on $10 million of Acme Corporation’s bonds (which could be anywhere from zero to 100% of the $10 million notional).

So: as long as AIG’s still in business, it’s contractually obliged to keep sending you those semi-annual cheques for $50,000. The only way to stop it is for Acme to collapse, which stops the semi-annual payments and triggers the default payment, or for AIG to collapse, which would leave you as an unsecured creditor for the market value of the CDS.

All of these payments flowing out of AIG are contractual obligations. Whether they’re CDS payments, IRS payments, collateral adjustments, spot FX settlements, repo payments, or FX option premiums, AIG has no choice in the matter – it’s required to pass on this bailout money to its counterparties. It’s not Goldman’s fault that it was the right way round on all of its trades with AIG.

And if anything, they’re missing half of the story. AIG’s Financial Products unit was massively short credit – that’s what blew them up – so they should have been net receiving payments in anticipation of paying out on eventual defaults. Why doesn’t the WSJ chase that side of the story – “the banks that are propping up AIG”?

Update: another thought. What if these mysterious “payments” included collateral exchanged under CSAs?

Under a collateralisation agreement, the counterparty on the losing side of a transaction (in this case AIG) has to give money to the counterparty on the winning side of a transaction. The collateral’s exchanged every day as the market value of the contracts changes, and is designed to cover the winning bank in the event of the losing bank defaulting on its obligations. (It works exactly the same way as posting margin on a futures position.)

Again, this is a contractual part of doing business between larger banks. AIG has said it has CSAs in place with its larger counterparties.

And part of a collateral exchange process is that if the price of the derivatives bounces back, the winning counterparty returns the money to the losing counterparty.

If that’s the case – if this $50 billion figure includes CSA collateral – then this story is even more of a shameless beatup. Not only is that money a contractual obligation, it’s money that could come back at any time (if markets eventually rebound, that is). Call off the mob you’ve raised, WSJ.

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