AIG executives to blame for "liquidity events"?

With the recent public outcry over bonuses paid to AIG derivatives traders, another issue has been raised: is it possible that those bonuses, representing about 0.1% of the total federal amount poured into the troubled giant, are actually veiling a larger problem? And do the derivatives traders deserve sole blame for the financial meltdown, or were AIG executives aware of what was happening some time ago?

Let’s begin with an overview of AIG, whose primary businesses include general insurance, life insurance & retirement services, financial services and asset management. For insurance operations, AIG charges premiums and deductibles to customers and in exchange provides payments for certain health-related costs based on the individual insurance policies, which are contracts between AIG and its customers. As with any business, AIG must bring in enough revenue to cover expenses and hopefully generate an acceptable profit margin. So when AIG receives premiums, it doesn’t just have extra cash sitting idly around somewhere – it can either place the proceeds into an interest-bearing bank account, or invest in securities or other financial instruments, in order to obtain a return from available cash while it pays out insurance-related expenses.

Why would AIG, or any other business, invest cash into securities instead of simply keeping it in a bank account? Shouldn’t the company focus on achieving profits from its core operations, and not on financial instruments? This could be the subject for an interesting philosophical or regulatory debate, but in truth this kind of investment happens with all manners of companies, from aircraft manufacturers to commercial banks. Such companies shouldn’t receive a large portion of their profits from investing cash into securities (lest equity research analysts become alarmed), but it is commonplace for many business to participate in such investments – and by investing in securities the companies hope to attain a greater return than from simple bank deposits.

Of course, whenever a company invests cash into securities, liquidity (the ability to convert an asset into cash) becomes an issue. It’s all well and fine that firms are trying to realize a larger profit, just so long as they can continue to fulfill their contractual obligations to customers. And because those obligations require cash, investment in securities could become problematic the value of those securities declines. To further complicate matters, AIG had “loaned” its securities to other parties in exchange for cash collateral, and then invested that cash into residential mortgage-backed securities (i.e., AIG owned the rights the payments from certain pools of mortgages). When the market for those mortgage-backed securities evaporated, AIG was left devalued assets and an inability to repay the investors under the securities lease program.

Enter the derivatives traders. AIG had taken a short position with respect to its credit default swaps (CDS), meaning that AIG received regular payments from the CDS, but in return would have to make payments if defaults occurred. So if the housing market had remained strong, AIG would have profited both from the rising value of the residential mortgage-backed securities and from not having to pay under the terms of the CDS – but this is the exact opposite of a hedging position. So the derivatives traders in AIG Financial Products were not hedging to safeguard against risk in the AIG investment portfolio; rather, they were speculating and hoping for the best.

Why would the derivatives traders place AIG in such a precarious position, one which had little to do with the company’s core operations and in fact posed a threat to ongoing operations? The answer may very well be that AIG had already been facing liquidity problems, and the executives engaged in a gambling scheme in an attempt to avoid difficulties and cover the liquidity issues from a probing media. According to its 2008 Annual Report, AIG had raised $20 billion by issuing common stock and subordinated debt in May 2008, and raised another $3.25 billion from more debt issued in August 2008. Why would a healthy, prosperous company need to issue additional stock and debt in order to raise capital, unless it was not nearly as prosperous as we were led to believe? One cannot blame derivatives traders for registering stock and debt with the SEC and then issuing the securities in the market to obtain cash, and it is entirely possible that AIG executives either knew about or instructed the derivatives traders to engage in their speculating activities in order to raise short-term cash to cover liquidity difficulties.

Some Protection for Madoff Victims

When Bernard Madoff plead guilty to eleven criminal counts in federal court on Thursday, many of the victims of his Ponzi scheme were present in the courtroom. And although there was applause and satisfaction from the investors present, it does not necessarily improve there future prospects. While estimates of the exact amount of total losses vary from a few billion to $65 billion, depending on how one accounts for the fraud, there is no doubt that many individuals have been emotionally scarred and left in a precarious financial situation.

With so many government dollars invested in bailing out the financial and automotive sectors, and additional federal assistance approved for the unemployed, is there any recourse for not only the Madoff victims but also other sophisticated or high net worth individuals? Federal securities laws, namely the Securities Act of 1933, Securities Exchange Act of 1934 and Investment Advisers Act of 1940, were passed with the goal of protecting investors from fraud. But there are also exceptions to these laws, designed to allow certain individuals to make investments without having to register their securities and fully disclose the nature of their operations in order to hopefully achieve a greater return on a particular investment. The investors in the Bernard L. Maddof Investment Securities LLC would have (or should have) fallen into this category, so what federal protection is available for these individuals?

Enter the Securities Investor Protection Corporation (SIPC, http://www.sipc.org). Created in 1970 under the Securities Investor Protection Act, this is actually a non-profit corporation, somewhat akin to the FDIC, who charges member investment firms a certain fee to maintain a small security blanket for investors. Unlike the FDIC, which guarantees deposits up to a certain amount regardless of how a bank loses the money, the SIPC does NOT grant relief for normal investment losses. But the SIPC does provide relief in the event that a brokerage firm fails and the cash/shares are missing from an investor’s account, which is what happened for the Madoff victims whose investments were not used to purchase stocks or other legitimate investment instruments but went instead to pay other investors.

For the Madoff victims, the SIPC has granted a waiver to allow for the maximum $500,000 claim. In combination with the fraudulent transfer laws incorporated into bankruptcy law, it might be possible for the victims to receive a more equitable portion of their original investment, but undoubtedly the measures will not provide full compensation. Investors looking into any brokerage or investment firm would be well advised to ensure that the firm is in fact a member of the SIPC, and to consider the maximum amount of coverage available when deciding how much to invest in any one financial institution.

Concerning the SEC, was it negligent of not pursuing the matter further, considering the reports of tips of possible fraud it had received about Mr. Madoff’s operations? While it is true that securities laws in general allow for sophisticated or high net worth individuals to invest in firms which do not have to fully comply with all aspects of securities laws, the intent being to allow for such individuals to invest without having to deal with the costs of reporting and to prevent others from duplicating their methods of attaining high returns, it is also true that the securities laws contain anti-fraud provisions which can never be waived. In fact, on the same day federal agents arrested Mr. Madoff, the SEC filed a civil suit against him accusing him of violating the anti-fraud provisions of the securities acts and seeking an injunction to cease Mr. Madoff’s operations (http://www.sec.gov/litigation/litreleases/2008/lr20834.htm). So there were in fact provisions in the regulatory framework which the SEC could have invoked to initiate an investigation against Bernard Madoff years ago, meaning that there does not necessarily have to be any change in the regulations, but there does have to be enforcement of the existing laws to ensure protection for all classes of investors.