Thursday, March 19, 2009

AIG reinvents the trader’s option

In the Financial Times by John Gapper:

If there is one thing everyone should have learnt about Wall Street by now, it is that the financial contract a trader takes the most care to hedge properly – and to ensure is profitable in the long term as well as the short term – is his or her own employment contract.

Tim Geithner, the benighted Treasury secretary, forgot this point when he approved the doling out of $30bn more in US government support to AIG at the start of this month. Hence he is now struggling to survive the Washington maelstrom.

Mr Geithner has excuses for this oversight, since he was trying to save the rest of the financial system at the same time, and has few senior officials in place to help.

Still, as a Wall Street figure – I count him as such because he used to work within a stone’s throw of the Street of Shame at the New York Federal Reserve – he ought to have known better than to overlook $165m in “retention bonuses” AIG has paid to those who made it fail.

From the letters written by Mr Geithner and Edward Liddy, chief executive of AIG, since the affair became a public scandal, one can imagine the tone of the conversation the two men had last week when Mr Liddy told Mr Geithner that he was sending out the cheques.

On one end of the phone was Mr Geithner, stunned to be blind-sided once again by tricksy traders. On the other end was Mr Liddy, irritated at being second-guessed by politicians, regulators and Andrew Cuomo, attorney-general of New York.

My sympathies are with Mr Liddy, who is being paid only $1 a year and is not responsible for the debacle at AIG. He is doing his best to sort out all the mess, while public servants with megaphones bellow into his ear and Chuck Grassley, a Republican senator, suggests bone-headedly that AIG traders should atone by committing suicide.

That said, his reasons for paying the bonuses share the characteristic of being internally logical yet ludicrous when one takes a step back to consider the context.

The first reason is that AIG had to pay the bonuses to 370 employees in its financial products (aka derivatives and funny stuff) division because it foolishly agreed last year to fix this element of their pay for two years. As Mr Liddy put it to Mr Geithner: “Honouring contractual commitments is at the heart of what we do in the insurance business.”

Yes, contracts are important and should be abrogated only under rare circumstances. But be serious. Mr Liddy is there only because AIG could not honour its contracts without going bankrupt. Furthermore, the credit default swaps that failed were written by the same people who want their own contracts followed.

He knows about AIG’s inability to meet its obligations, since he detailed the costs this week. The government in effect ripped up some of AIG’s flawed CDS contracts and paid out its counterparties at par. This act alone required it to hand $5.6bn to Goldman Sachs, $6.9bn to Société Générale and $2.8bn to Deutsche Bank.

Mr Liddy’s second point is that AIG is better off retaining the traders who wrote the disastrous CDS contracts because only they know them well enough to keep them safely hedged while winding them down. Some are so complex and bespoke that an outsider could be stumped.

A lot of people, including politicians who do not care much one way or the other about the truth of the matter, dismiss this as more self-serving Wall Street claptrap. Personally, I think the appalling thing is that Mr Liddy could well be correct.

Consider the implications. We are by now familiar with the trader’s option – that an employee of an investment bank has an incentive to take big risks to make money. If his trading strategy works he gets a bonus but if it fails, the bank (and ultimately the taxpayer) pays.

In recent years, a lot of traders, including those at AIG, exploited this by coming up with derivatives that were very profitable in the short term but had expensive long-term risks embedded in them. That allowed the traders to enjoy several years of large bonuses before the bill for their recklessness fell due.

Now, the ever-ingenious AIG traders have come up with a derivative of the trader’s option. Call it the trader’s option squared.

They had an incentive not only to sell financial contracts that paid out a lot of money immediately in return for assuming a long-term liability, but also to make these contracts very complicated and opaque.

This allowed them to charge big fees (which brought big bonuses) and it also made them irreplaceable at the institution that employed them. If you are the only one who can understand your own handiwork, it puts you in an enviable bargaining position.

Wall Street banks used to believe it was in their financial interest to keep the credit derivatives market as an over-the-counter, high-margin, complex business. It turns out to have been a financial disaster for everyone involved except – surprise, surprise – derivatives traders.

For the taxpayer to be forced to pay additional bonuses to the wreakers of havoc is, of course, a travesty, an outrage, an insult, etc. You can take your pick of the insults being bandied around Washington and flung at Mr Geithner, whose authority is trading in a low band.

But for the financial institutions involved in credit derivatives, it is worse than that. To be taken for such a ride by their employees is a humiliation, one that has been in the making since the old Wall Street partnerships went public in the 1980s (in Goldman’s case 1998).

If this does not compel them to change the way they pay people, I doubt whether anything will.

1 comment:

Pro said...

If you thought it couldn’t get any worse than Bush. The dems are spending more and making grossly incompetent mistakes. Here is the latest (quite shocking) of their trillion dollar blunders:

Cap Schmap: