The Problem With AIG's Credit Insurance Payouts

Every day, insurance companies sell policies to homeowners to cover the cost of damage in the case of fire. Why would those companies agree to pay out in full to a policyholder even if a fire had not occurred?

That is the type of question being asked about the federal government’s bailout of American International Group in which the insurance company funneled $49.5 billion in taxpayer funds to financial institutions, including Deutsche Bank, Goldman Sachs and Merrill Lynch. The payments, which amount to almost 30 percent of the $170 billion in taxpayer commitments provided to A.I.G. since its near collapse last September, were disclosed by the company on Sunday.

The company had resisted identifying the recipients of the taxpayers’ money for months, citing confidentiality agreements.

But instead of quieting the controversy, the disclosure of the amounts paid to A.I.G.’s customers has created still more questions and unease over the insurer’s rescue, arranged by the Federal Reserve Bank of New York and the United States Treasury.

Critics argue that the government’s decision to pay buyers of A.I.G. credit insurance in full and across the board was an inappropriate use of taxpayer money. In addition, these people say, options not pursued by the government could have allowed taxpayers to benefit from future gains or at least have done a better job of limiting the potential for losses.

The criticism surrounds the action taken by the government on credit insurance that A.I.G. had written and sold to large and sophisticated investors, mostly financial institutions. The banks that did business with A.I.G. bought credit insurance to protect against possible defaults on debt securities they held or had underwritten.

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But when A.I.G.’s credit rating was cut last year, the company was required to post collateral on these insurance contracts. The need to quickly deliver cash that it did not have created the downward spiral that brought it to the brink.

What upsets some people is that the government paid the counterparties in full even though the underlying securities had not experienced widespread, or perhaps even any, defaults.

“It is inappropriate to be giving money to A.I.G. for them to give it out to their counterparties equally,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn., and an expert in insurance. “If we decide that another bank will be in trouble because A.I.G. fails, then we should decide explicitly that the bank should be supported. We should not simply give everybody 100 cents on the dollar.”

When the government bought the underlying securities to cancel the insurance, the taxpayer became the owner of these pools of debt issues. Because the government chose to pay par or 100 percent of the face value, the taxpayer has downside risk if the securities lose value but virtually no upside.

Even if none of the debt securities in the pools experience a default, the taxpayer is likely to receive no more than par — what the government paid — when they mature.

Had the government negotiated for a lower price, say 75 cents on the dollar, the taxpayer might have been able to reap gains down the road.

The top three recipients of money from the government related to the credit insurance A.I.G. had written are Société Générale, a French bank, at $11 billion; Goldman Sachs, at $8.1 billion; and Deustche Bank, at $5.4 billion.

A.I.G.’s disclosure of payments to its counterparties did not provide any details of how the government arrived at the prices it paid for the underlying securities. If it overpaid, the taxpayer is at greater risk of loss and the recipients may have received more than they were due.

Another troubling aspect to some is that so many of the counterparties are foreign institutions. Indeed, of the 22 institutions that have received either collateral from the government or cash payments to close out credit insurance deals, 16 are foreign.

“I find it impossible to understand why we as taxpayers are bailing out foreign banks,” said Thomas H. Patrick, a founder of new Vernon Capital and a former top executive at Merrill Lynch. “If the shoe was on the other foot and major U.S. institutions were exposed to those banks, would the U.K. or the E.U. tax their citizens to pay off JPMorgan? There has to be some explanation of why we decided to do that.”

The decision to protect foreign institutions from losses in an A.I.G. collapse may reflect how interrelated the global financial markets have become. That is the view of Adam Glass, a partner at Linklaters in New York and co-head of the firm’s structured finance and derivatives practice.

“It is an interconnected world,” Mr. Glass said. “If UBS or these French banks collapsed, it is not just their problem. It is our problem because world economic activity would have been further impaired.”

Even though A.I.G. finally disclosed the names of the institutions that received so much of the government money that was thought to be going to A.I.G., the idea that it took six months still rankles some market participants.

“The system was undermined by asking the American people, under the veil of secrecy, to bail out one company when in fact they wanted to bail out someone else,” said Sylvain R. Raynes, an authority in structured finance and a founder of R & R Consulting, a firm that helps investors gauge debt risks. “The prospectus for the bailout was not delivered to the people. And it was not delivered because if it had been, the deal would not have gone through.”

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