Monday, March 9, 2009

The AIG Shell Game – Part 2

If the Government wasn’t at the helm, the SEC would call this a Ponzi scheme

Many of my earlier writings going back to 1998, have pointed to the fundamental “weakest link” in the global capital markets which has been the disconnect between the understanding of collateral and the retail cost of capital leading to precipitous risks to the public and private investor. Long before it was thinkable, I commented to the executives at AIG that their opaque counterparty risk management products were going to result in global market calamity. In contrived bull market enthusiasm, such a warning was unheard. Even now, as President Obama and his team work to stem the hemorrhage of calamity in the markets, there is NO evidence that he or his advisors actually understand where the tumor is that is causing the spreading cancer. So, in an effort to shed some light on this, I’m going to take a basic approach to explain what’s going on and what to do about it.

Philosophically, we need to understand the ubiquitous nature of perceptions of risk and how it has allegedly been managed over the past 75 years. Established in 1933 as part of the Banking Act, the Federal Deposit Insurance Corporation (FDIC) was chartered to shield the public from economic disruption arising from liquidity crises and bank failures. In theory, by building public confidence in bank security, depositors would be comfortable supplying the reserve liquidity (in the form of deposits) to allow banks to issue credit. Sold to the public as a way to insure their safety, the FDIC was and remains, in truth, a tax on the public to incentivize private depositors to fund banks and their operations.

Recognizing how well the “public interest” insurance premium "tax" argument worked to entice depositors to support the U.S. banking infrastructure, other similar structures were equally incentivized. For example, the Pension Benefit Guaranty Corporation (PBGC) formed by the Employee Retirement Income Security Act of 1974, like the FDIC, receives its reserve funding through insurance premiums paid by the public. Like the FDIC, the PBGC is in a position of near illiquidity. While more indirect, federal tax policy has funneled the majority of tax-deferred investments into IRAs, 401(k)s, and other defined benefit programs which have consolidated asset allocations into a very limited swath of financial products – the bulk of which are bonds. This incentive has been used as a way for the Federal government to underwrite corporate and municipal debt without telling the public that they're actually being charged a tax. After all, the theory goes, this is an investment in the future productivity of the country. Which would be great it we had a GDP. This was, at inception, supposed to insure against wild volatility swings in equity markets and other investment products. However, this “risk management”-based-on-insurance strategy built a catastrophic risk overhang into the market which is moments away from full failure.

Heralded as financial market innovation by brokers and academics alike, many saw pools of cash sitting in conservative yield financial products during the bull run of the late 90s and again in the first half of this decade as wonderfully under-utilized. Since most of the public didn't really "need" their money until retirement, the accountability for where it was double and triple leveraged wouldn't really matter, would it? As long as S&P, Moody’s, and Fitch were willing to sell their ratings to prop up unsubstantiated investment products and bless them as investment grade, conservative investment managers of reserve accounts leveraged these public insurance policies against increasingly ephemeral financial products. Among the providers of liquidity were insurance companies (like AIG, MBIA, FGIC, Ambac, and FSA) who used premium deposits (not income) as the collateral for short-term credit guarantees joined by a host of life insurance companies around the world. Also getting in the act were endowments from major universities, sovereign pensions like Singapore’s Central Provident Fund (CPF) or Canada’s Pension Plan Investment Board, and anyone else who had contractual requirements (supported by tax deferral policies) to hold the public’s money for future obligations.

Unfortunately, few people understood that these pension and annuity obligations were being put at risk and, since the managers of such programs were being incentivized to leverage their reserves for promises of short-term gains, they were being seduced into deepening their exposure by providing ever greater amounts of credit insurance. Credit insurance, by the way, is an interesting, Ponzi-like program where to gain investment grade ratings so that fixed income buyers can purchase bonds, other fixed income accounts (pensions, annuities, and insurers) provide balance sheet support for a fee. This fee – a credit insurance premium itself - is then used to support income which, in turn, is invested. Like any Ponzi scheme, the racket works as long as there are buyers and until the risk matures. Then, like every Ponzi scheme, the house of cards falls.

So imagine the irony when the house of cards begins to crumble. Based on their reports today, March 9, 2009, the FDIC has $41 billion. Not to worry. With over half of that set aside for the next 12 months of losses alone, Sheila Bair, the person at the helm of the FDIC has cast any concern for premium collection aside now saying that the FDIC has the “full faith and credit of the United States government”. “We can’t run out of money,” she said in a Reuters report.

On the same day of this announcement, the newly-minted federally insured bank, General Electric corporation, announced TLGP and FDIC backed debt in the amount of $8 billion to add to their existing Aaa (Moody’s) and AAA (S&P) corporate bonds. Why does the U.S. government need GE to originate these products? Well, quite simply, because it’s desperately trying to get someone to plug the gap in investment grade bond instruments to fulfill the quasi-statutory demands of pensions who are now both illiquid and, with the down-grading of credit insurance providers, no longer holding investment grade investments. Bottom line, there is insufficient inventory for annuities, pensions, endowments and other conservative long-term buyers to remain out of default so the government is attempting to shore this up with, you guessed it, a Ponzi-scheme. Is it any wonder that the SEC is making so much noise about the Madoff's of the world to distract from their own more egregious program? In short, the GE deal is part and parcel of the AIG cover-up.

The cover-up is quite simple and profound. Few, if any tax deferred pensions, annuities or endowments now have the funds to redeem their current or future obligations. If the public were to find this out, it would be a disaster far worse than we’ve already seen. Imagine a Depression-era run on pensions. Foreign investors, as evidenced by the Saudi Arabian, Singaporean, and other sovereign funds’ losses in the Citigroup bailout, no longer have an appetite to buy U.S. government debt so the U.S. government is pulling out its last chip before complete insolvency – shore up pensions with faux corporate debt. The problem with this strategy is simple. As soon as we see that the insurance liabilities at present outstrip the U.S. Government’s “full faith and credit”, the collapse is visible and there’s nowhere to hide. The very companies that were put in place to protect the investments of the public have long ago placed your deposits at risk, taken their fees, and are, by and large, in technical or actual default to you, the private citizen. Now, your pension fund is trying to buy FDIC-backed bonds and other fixed income products with your money. This is another bailout tax and you should not participate in it.

What can one do? Quite simply, an immediate review of tax-deferred investments is of immediate import. And by immediate, I mean today. Any investments that are covered under credit insurance programs should be carefully considered and probably re-rated as speculative. At this juncture, it appears prudent to review all equity investments which have balloon maturity debt (many companies financed acquisitions from 2002-2005 with short term maturing bonds and commercial paper) and exit them in favor of equities issued by companies which have reproducible revenue coming from essentials for health, food and food security, and logistics and an innovation pipeline supporting future efficiencies. And finally, realize that all of this problem grew out of the fear of the 1930’s and anything built on a foundation of fear will not yield good fruit. It’s time that we look forward, not at a fix of the old, but at the new. We are beginning to build the Idigna network which will allow the reintroduction of commodities and essentials as well as the introduction of innovation futures which will pay premium prices for creative new production into the new economy that is coming. We would love to enter into a dialogue with you on how these new (albeit inspired by ancient approaches) products can help you weather the storm.


  1. Sadly, your analysis appears both coherent and complete. I wonder what will be the real-life event that triggers the run on the pension funds. I wonder if it delays through Q2 or Q3?

    I appreciate your writing and your lectures posted with Arlington Institute. Thanks for sharing your insights

  2. The actual timing of the defaults already happened. Just this morning (3-10-09), the Washington Post reported that the state insurance regulators have allowed life insurance and annuity managers to restate their assets to over-report liquidity. My timing was off by one day.

  3. Prescient...simply prescient. Now what?

    GE stripped of triple-A rating
    By Justin Baer in New York
    Published: March 12 2009 14:08 | Last updated: March 12 2009 14:29

    General Electric lost one of its triple A credit grades on Thursday, capping months of speculation that an economic downturn and the deteriorating prospects of its finance arm would cost the conglomerate the pristine debt ratings it had safeguarded for more than half a century.

    Standard & Poor’s, which first assigned GE a triple-A in 1956, dropped the company and its lending division, GE Capital, one notch to AA-plus.

  4. How any corporation which needs both FDIC and TLGP backing to issue commercial paper can still be viewed as "investment grade" is beyond the edge of reasonability. This rating bump may be an attempt by S&P to give them partial cover if these issuances go under but it's a rather diaphanous veil at best. In the end, the public will need to know that rating agencies are beholden to fixed income inventory demands and sellers and have little concern for the buying public. Congress must force this dynamic to change through regulatory review.

  5. How many times has China expressed privately their concerns about the safety of their US Treasury holdings before expressing it publicly? Also, the decision to boost the FDIC reserve fund to 500B telegraphs serious problems for the future of the banking system. I feel like we are closing in on a point of no return.

  6. Location, location, location. But real estate has been in the crosshairs...and so now is dead to any part solution.

    Innovation, innovation, innovation must be the solution. But if the dark ages were the result of the status quo fearing change (destruction of its monetary franchise), certainly the modern day purveyors of our new dark age must capitulate at some point. After the Madoff lynching has lost its luster? The Chinese jawbone an impossible threat to sit out of the next reasury actions? Pensions default on redemptions of what's left of the citizenry's (!) assets? G-20 will debate the next move on enforcing (denying) the next banking reserves unltimatums. Oh, sorry, I get it, the modern day "Church" (Read: super sovereigns) will NEVER capitulate.

    We must create our own reformation. So then the question: where is the foundation of new confidence? So simple and so hard.

    OInnovation, innovation, innovation. Only from the very old can come truly new for today.

    Dr. Martin?

    401K's? , , . .

  7. From Raymond Learsy's article "Billions for AIG to protect the speculative profits of Goldman Sachs/Morgan Stanley"

    Goldman Sachs and Morgan Stanley are being covered 100 cents on the dollar on their speculative positions of intrinsically flawed CDS derivatives on which they gorged themselves to the bursting point. It is past time that a distinction be made between that part of AIG's business that was a "large and stable insurance company," and that part that was a "hedge fund," or better put, a casino. So the big question becomes, why should AIG's CDS be paid down 100 cents on the dollar when the rest of the country is taking at or near 50% haircut on the value of its assets?

  8. One more observation on AIG. The combination of the congressional bailout and AIG's pre-February contracts has created a legally solid "wormhole" conduit of billions in tax payor dollars to other national and international banks/investment houses. We are being distracted by the press with the $150M+ bonus issue when they could be focused upon the multi billion dollar losses.

    Is there any good news out there?

  9. Thoughtful.

    Are cash and cash equivalents a necessity for social exchanges of value or are they the reductionist efficiency for power structures to maintain control (and taxation basis)?"

    If money didn't exist, it would still need to be invented. Having a medium of exchange is beneficial to most parties. Yes, it can be abused, but so can fire, water, sex, beauty, force, etc.

    - G Miller

  10. Mr. Miller, while I support the hypothesis that value exchange is necessary in a non-subsistance reality, there is no evidence that currency is the sole answer. Bear in mind that the challenge of trade credit offsets, non-cash counterparty transfers is not the willingness of "buyers" and "sellers" to see value but the absence of the state's capacity to tax and control such transactions. Counterparties do not need to be reduced to a reductionist model unless there is a contravening interest and the interest should be disclosed.


Thank you for your comment. I look forward to considering this in the expanding dialogue. Dave