Thursday, March 19, 2009

Is There No One Else to Unwind These Trades?

In the Wall Street Journal's MarketBeat by David Gaffen:

In his letter to Treasury Secretary Timothy Geithner explaining why massive bonuses would have to be paid to those responsible for American International Group’s meltdown, the company’s CEO, Edward Liddy, trotted out the argument that the expertise of said employees was needed in order to wind down positions in an orderly fashion.

The bonuses, of course, are ridiculous. But amid calls for the recipients’ heads (or for them to commit seppuku), many have questioned whether there are no other sentient, able-bodied people out there that could handle the job of unwinding the messy derivatives portfolio at AIG’s financial products unit, estimated by Mr. Liddy in testimony to Congress at a notional value of $1.6 trillion — which is at least down from $2.7 trillion.

It isn’t an easy answer. “I would think that others could unwind the books, but I’m guessing the bigger problem is keeping the guys from leaving for other banks or funds where they could try to trade against AIG’s positions in fairly illiquid markets that can be manipulated without needing large amounts of capital,” said Mark Dow, portfolio manager at Pharo Management LLC in New York. He added, “we are all flying blind to a large degree.”

While it seems preposterous that anyone would offer a job to those responsible for AIG’s current status as a ward of the state, 11 people who have been given bonuses of more than $1 million have already left the company, including one who received more than $3 million. And a well-capitalized firm (and these do exist) would be happy to pay good money — albeit at less lofty levels than in the past — to take on those who knew the weaknesses of AIG’s books best.

For an outsider to take on the job of unwinding such a portfolio is a thankless task at best. The pool of people in this unregulated market — one that does not have an exchange or central clearing mechanism — who could handle such an undertaking is limited, said Jim Bianco, president of Bianco Research LLC. There are plenty of people who trade structured products but AIG, he said, needs managing-director types — “someone that is qualified to maximize value when liquidating the book … that can restructure the entire department to self-liquidate in an orderly fashion.”

That still then leaves the knotty problem of unwinding this massive portfolio of credit-default swaps for which the primary benchmark — Markit Group’s ABX Index — has been discredited, at least to some extent.

Markits AAA index has deteriorated in recent months from already-distressed levels. (Markit Group)

The triple-A index, which measures a basket of asset-backed securities with high credit ratings (for whatever that is worth), was lately trading at 24 cents on the dollar. Lower-rated triple-B and single-A indexes were worth about three cents on the dollar, due in part to fears of large losses in the underlying loan pool that was purchased and packaged into collateralized debt obligations, as well as a momentum trade that saw fund managers continue to push those indexes lower.

“The ABX was completely decimated so it’s not a fair benchmark to assess a structured product,” said Mel Harris, market strategist at ACM, and a former trader of structured products. “I don’t think it should be left to the AIG guys at al l… but there are very few experts out there.”

But others argue that such an unwind could be handled by anyone in the business. “There are many CDS and CDO traders/risk managers that could manage/hedge/unwind a book such as this,” said Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research. “In fact given the layoffs, I would suspect that supply is large. While the guys at AIG may know the book the best, there is little that is not understandable or hedgable in those portfolios.”

Mr. Harris argues that those who have been out of work for a few months would face difficulties in getting up to speed with AIG’s portfolio. Those that do have the expertise, in the meantime — those at other institutions — are unlikely to want to step into this situation.

“There are people that make big bucks at Pimco, Goldman, BlackRock, etc. that are qualified to unwind AIG’s book,” Mr. Bianco says. “Why in god’s name would they leave a managing director position at one of these firms to go to AIG? What is their upside?”

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