It takes two whole days’ worth of posts to document, in excruciating detail, just how asinine was the grandstanding taking place in Washington last week as first Ed Liddy and then every TARP recipient was skewered by an outraged Congressional mob. 

Citizens united for shibboleths!

As I keep listing the wrongheadedness, I’ve been using multiple sources, as follows:

Washington Post (indigo text)

The Business Insider, John Carney (red text)

The Business Insider (green text)

Wednesday Op Ed by AIG CEO Edward Liddy (black text)

So far we’ve seen that:

1.  The people Congress is flagellating aren’t the ones who wrote the dangerous CDS’s

2.  Those being excoriated could leave tomorrow

3.  If they people go, the CDS’s could explode worse

4.  The bombs are still live …

5. … so we need the world’s best bomb-defusers

You’d think Congress wouldn’t need a primer

[Editorial note: Not everyone on the committee took gratuitous potshots at Mr. Liddy.  Distinguishing themselves by behaving like adults were Rep. Paul Kanjorski, Rep. Spencer Bachus, Rep. Jeb Hensarling, Rep. John Campbell, and Rep. Joe Donnelly.]

House Subcommittee Chair Paul Kanjorski

Spencer Bachus and full committee chairman Barney Frank

6.  The bonus agreements were made with full knowledge of the situation

Much of the outrage, real or feigned, is misdirected, since nobody at AIG was keeping this a secret:

AIG disclosed its retention-payment program more than a year ago, and the amount of the bonuses — more than $400 million for Financial Products alone — had been widely reported. But as the payments were coming due in recent days, the White House began to express its indignation.

The Administration’s decision to lead the charge, coupled with the massive TARP capital injections provided to AIG, seemed to set off the firestorm.

“No prisoners!”

7.  Even if you’re outraged, these people have rights …

These are contracts, after all – and while you and I may think the compensation sums are astronomical, there’s no hint of fraud:

Attorneys working for the Fed had been examining the matter for months and determined that the retention payments couldn’t be touched because AIG would face costly lawsuits and be subject to penalties from states and foreign governments.  Administration officials said over the weekend that they agreed with that assessment.

Even as the Administration was fulminating against AIG, it was conceding the bonuses were legitimate:

At the Federal Reserve Bank of New York, which has directly overseen AIG since its federal takeover in September, officials have studied the possibility of rescinding or delaying the bonuses. They even brought in outside lawyers for advice. The conclusion: If the bonuses weren’t paid, the AIG staffers would be able to sue the company and probably would win, not just what they were owed but also punitive damages that would make the ultimate cost perhaps two to three times as high as the bonuses themselves.

8. … although the circumstances are exceptional

Are the contracts solid?  John Carney of The Business Insider makes a nice argument they could be rescinded:

I worked as a corporate lawyer for half of this decade, and my practice was largely devoted to writing and negotiating contracts of various sorts (mostly merger agreements, loan agreements, security agreement and bond prospectuses but also a few employment contracts). I know how difficult it is to negotiate a contract under business uncertainties, and can appreciate concern over the cost of introducing political uncertainty as well.

[Snip]  The key to understanding the AIG bonus issue is that AIG would be bankrupt and in the process of a court supervised liquidation but for the extraordinary government action that has kept the company afloat. If not for the government bailout, the contracts would be worthless because the employees would be unsecured creditors in a company worth less than zero.

As a matter of bankruptcy law, he’s dead-on accurate as far as I know.

Great logic so far

To put it differently, the abrogation of the contracts is just a normal form of counter-party risk run by anyone entering into a contract. All contracts are at risk that the other party will go broke before they can perform.  [Snip]

Nothing about the introduction of a government bailout should be seen as changing the situation of the AIG Financial Products employees. There’s simply no reason that a bailout meant to support the company because of systemic risk from failure must also mean that other aspects of AIG’s operations cannot be treated as if the company actually were broke. We’re in undiscovered territory here, it’s true. But I don’t see a reason why the situation of AIG employees should be improved simply because they got a bailout.

In the abstract, I like this argument, and believe it would or will be interesting if tested in court. 

Essentially, the employees receiving bonuses are being treated as super-creditors, immune to the counter-party risks that most employees in the market assume. It rewards, essentially, working for a company that is likely to be bailed out rather than one that will not.

This turns on its head the usual argument for paying bonuses at bailed out companies. Instead of worrying about allowing them to retain “the best and the brightest,” we should be worried about the perverse incentives we create by guaranteeing the income of employees at bankrupt firms posing systemic risk. Do we really want to encourage the creation of systemic risk in this way?

Perverse

It seems likely to me that the costs of bailing out AIG’s bonus pool actually exceed the costs of abrogating the contracts. Just tear the damn things up.

That for your employment agreement

Against that:

Liddy acknowledges that “contracts can always be altered” if both parties agree to it, but the company made the decision to keep them to give the company a “fighting chance” of surviving.

9.  A year ago, they could have walked away clean, and been handsomely rewarded for doing so

After Carney posted his novel-but-logical theory as to why the AIG incentive payment contracts could be set aside, he posted a followup with a reader’s rebuttal:

A friend who used to work at a major Wall Street investment bank writes in to say we’re wrong on the AIG bonus issue. While he hasn’t convinced us, we think he makes some powerful arguments and wanted to share them with you.

Dear John:

The way I figure it the AIG traders REALLY deserve those bonuses.  First let’s remember that largest bonus was $6.4mn which while a lot of money, pales in comparison to what John Paulson was able to generate with a few well placed CDS contracts. 

[I've corrected typos in the original email – Ed.]

John Paulson (no relation to former Treasury Secretary Hank) was the first of the bear raiders, who made money betting against companies and then hoping the stampede would trample them under.

No relation to Hank!

Will he never tire of using my picture?

These guys at AIG saw shit unraveling; they knew where the bodies were buried.  By staying with AIG, these guys were passing up some serious opportunities. 

Turmoil creates opportunities, particularly for smart people.

Second, did you notice the timing on these bonuses?  The one-year anniversary of the Bear implosion? 

As I wrote then:

If Ben Bernanke and the Fed are right, their moves will unjam the gridlock and get capital moving again.

If they’re wrong, the consequences could be disastrous for all of us.

I hope they’re right.  Fortunately, I think they’re right.

Time to choose

Just as Bernanke and Paulson were making their bet, so was the executive leadership (pre-Liddy, one should note) at AIG.

Shit must have been hitting the fan at AIG about this time last year, they were realizing all those “uncorrelated” contracts they’d written were now converging.  The CDS traders saw the writing on the wall, or should have. 

Can you translate that?

Right about that time, I was working on another large transaction – one that (probably fortunately) never came to fruition – involving assumption of risk and the need for a strong balance-sheet guarantor.  I heard lots of speculation as to which monolines and other insurers were insolvent and hence worthless as a guarantor.  AIG’s name was among those I heard being thrown about.

The firm had just posted its first quarterly loss, the credit markets were cracking up.  They were not going to be making very much money that year at AIG based on performance of their positions.  But they could very easily have left for Paulson & Co or any of the banks.  Demand for people with understanding of credit markets was spiking not dropping off! 

“It might be – bad – to burn them?”

AIG, realizing that the whole team had lots of better opportunities out there were they not well compensated, locked the team down with a guaranteed bonus.   The fact that this was the team drove AIG into ground was beside the point, everyone who knew the book was poised to walk out the door. 

Lastly. This is a point people who never worked on Wall Street seem to miss.  When you hate your job, no bonus is worse than no job. 

We have to remember how far things have changed in a year.  A year ago:

Hillary Clinton was the Democratic front-runner.

Bear Stearns was solvent and independent.

Lehman Brothers had not failed.

Wachovia and WaMu were independent banks.

Fannie Mae and Freddie Mac were independent companies, apparently strong.

TARP did not exist.

Too much change is making me woozy

Can you imagine going to sophisticated traders at a major financial institution and saying, We know AIG’s probably going down the tubes, meaning you won’t have a chance at bonuses.  But please hang around for a year, working your butts off to defuse these complex financial instruments, and get paid nothing but a salary, because it’s the right thing to do?

All these people saying the AIG guys are “lucky to have their jobs” have no idea.  The only reason those people stuck around AIG during the most tumultuous credit event in the last 70 years, was because of the bonuses.  They don’t need the freakin job (well, maybe some of them do). 

We just use it to keep score

These guys would have been on their merry way a year ago, or in September.  They could have started their own funds (depending on timing), joined other firms, spent time with their family.  The only reason they stuck around was because of the bonus, they weren’t being paid for performance, they were being paid not to quit.

Want a couple of million not to toss in your badge?

10.  We really need them on the job

Now, when these people are being pilloried, is precisely when we really need them on the job.  From the hearing:

“These are not the people that ran the company into the ground,” Liddy says.

Again from the AIGFP explanation:

The team that remains at AIGFP has made significant progress in bringing down the risks and winding down the portfolio. Since October of 2008, they have reduced the number of trades by over 25% and AIG believes they have reduced most risks commensurately. They have focused initially on reducing complex and difficult to manage positions, so several risk measurements have been disproportionately reduced.

25% of AIG’s bombs have been disarmed, and none have exploded.

We want you guys to clean this up for a buck, you hear?

From another perspective, late last year AIG divided the risks at AIGFP into 22 separate risk businesses or “books”. Progress has been made on assessing and managing the risk in all books, and five books are almost completely wound down.

How long do we need these folks to toil?  From the hearing:

Liddy looks to Omaha for his answer: Warren Buffett had a similar business, a third of the size of AIGFP, that took him four years to wind down. “I think you’ll see tremendous progress winding it down” late this year and particularly by the end of first quarter 2010, Liddy says.  Some of these contracts go out 50 years, requiring a delicate balance negotiating those contracts. As it gets smaller it represents much less risk, he says, in making the obvious point to Congress.

Think of these contracts like radioactive material – used properly, they provide financial energy for years; used improperly, they can still melt down.

We hired the discount fixers

And from the hearing:

Liddy explains again that “these are not performance-based bonuses, these are retention bonuses.” It’s for people to stay and fix the company. And the worst unit of FP, credit default swaps, is no longer. The people getting the money are in another unit, with the $1.6 trillion in bets on derivatives.

To reduce these figures to household case, we have $160,000 in bets outstanding, and Congress is in a lather because AIG elected to pay $40 to the guys who can reduce our risk of loss.  Would you pay a quarter to save $1,000?

“It’s a risk assessment. If we keep those people, we have a higher probability of running this book down [meaning, amortizing the risk safely – Ed.] and not having it cost the American taxpayers more. … It was secondarily a legal consideration and primarily a risk consideration.”

11.  These AIG executives are being made scapegoats

To sum up:

You stick around and help or you’ll be in the doghouse

The bonuses – which, let’s be clear, are gargantuan sums of money by anybody’s standards – are nevertheless contractually obligated and were implemented consciously as retention incentives, back when then world looked totally different.

The people being paid now are innocent of the shenanigans that busted AIG.

The amounts we taxpayers still have at risk dwarf the bonuses being paid.

We are really, really going to need these people for years and years.

For this emailed death threats, lambasted by ignoramuses, and told they should give back all of their bonuses. 

Law professors agreed with the Fed’s assessment but said AIG employees could still agree to reduce their own bonuses.

Sure, and I could agree to work for a dollar as year – as Liddy did when he came out of retirement to endure this undeserved abuse.

Liddy says he asked the leadership group at AIGFP to return 100% of the bonuses and would like to see how they respond. “My fear is that the damage is done,” Liddy says. “We will get the bulk of that money back. They will return it, but they will return it with their resignations.”

Wouldn’t you?

As a matter of public policy, that is the multi-part test of the reasonableness of their compensation:

1. Will these folks resign? 

2. If they do resign, can we replace them with people of equal caliber at lower cost? 

AIG concluded that the executives would resign, and were not readily replaceable.  I fear we’re about to find out. 

Mr. Liddy also had to put up with this:

“This is like the captain and the crew of the ship reserving the lifeboats saying to hell with the passengers,” Representative Stephen F. Lynch, Democrat of Massachusetts, said.

To Mr. Liddy, who repeatedly sought to make clear that he was not responsible for creating the mess at A.I.G., Mr. Lynch’s observation was one criticism too far. “I take offense, sir,” Mr. Liddy responded, reminding lawmakers that he was not in charge when the bonuses were arranged but believed he was legally bound to pay them.

“Well, offense was intended,” Mr. Lynch retorted. “So you take it rightfully, sir.”

I’m embarrassed by my Congress, and if Mr. Lynch won’t apologize to Ed Liddy, then I will on his behalf.

The aptly named Congressman Lynch

POSTSCRIPT.  Well, that didn’t take long:

From Reuters, this morning (24 Mar):

NEW YORK (Reuters) – A handful of senior executives working within American International Group Inc’s controversial financial products unit have resigned, said a company spokeswoman late on Monday.

Under pressure from Capitol Hill, AIG Chief Executive Edward Liddy last week asked many recipients to return at least half the value of the awards. Many have also been asked to take sharp cuts in compensation for 2009.

The spokeswoman declined to specify the exact number of resignations, noting they were expected to be “manageable,” and said there were indications that more will follow.

Brilliant.  Just brilliant. 

Or not …

Workers at AIG Financial Products’ Wilton, Connecticut-headquarters have had to deal with ridicule and scorn, dodging picketers outside the workplace, while bus tours past some executive homes. Some have even received death threats, CEO Liddy said last week.

Meanwhile, the bombs keep ticking …

Keep doing this for free while we vilify you, okay?

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“Glad we killed all the guys who wired this together … oh, wait!”

What an idiotic week we have just seen in American politics, involving a hearing that was half circus and half show trial, culminating with probably the dumbest piece of tax legislation conceivable, all to appease ordinary taxpayers howling for blood, and since they cannot get the blood of those who made the mess, they will take it from those who are trying to clean up the mess.

“Burn them!”

I’ve previously posted about the mass drunkenness on risk-taking that consumed much of the world over the preceding decade, the belief that ’some other guy’ was doing the due diligence, the willingness to believe in a risk-mitigation perpetual motion machine, and the unlicensed insurance of Credit Default Swaps (CDSs).  There’s plenty of guilt to go around, including us, the consumers, the people who were happy to see our stock holdings and 401(k)’s soar, and the pension fund managers who, starving for yield, took risks to which they were blind, or the possibility of international currency manipulation creating irresistible economic pressure.

Let’s take a look at the facts-be-damned quality of last week’s outrage:

A tidal wave of public outrage over bonus payments swamped American International Group yesterday. Hired guards stood watch outside the suburban Connecticut offices of AIG Financial Products, the division whose exotic derivatives brought the insurance giant to the brink of collapse last year. Inside, death threats and angry letters flooded e-mail inboxes. Irate callers lit up the phone lines. Senior managers submitted their resignations. Some employees didn’t show up at all.

“It’s a mob effect,” one senior executive said. “It’s putting people’s lives in danger.”

“Yeah!  We like putting people’s lives in danger!”

What’s really going on is this:

People are mad at Bernie Madoff.

I took you for $65 billion

They’re mad at Allen Stanford.

And I thought I was doing well at $8 billion

They’re mad at the pompous bank CEOs who waltzed into the sunset toting $20 million annual compensation, even while suppressing criticism and telling us how everything was fine. 

“Everything’s fine, isn’t it?”

They’re secretly mad at Congress and the Administration for pushing through a $787 billion or so stimulus bill whose passage has preceded further stock market drops.

Since the mob cannot string up any of these people, they have chosen to string up the responsible executive, Ed Liddy, who is left trying to deal with the mess.

I swear I’m doing this to serve my country

To show how wrongheaded was last week’s hysteria, I’ve pulled this post together citing three sources, as follows:

Washington Post (indigo text)

The Business Insider, John Carney (red text)

The Business Insider (green text)

1.  These aren’t the people who wrote the dangerous Credit Default Swaps (CDS’s)

“No one – is innocent.”

It would be one thing if those who played with financial nitroglyercine were also asking premium pay for their penance, but they’re not:

Moreover, Fed officials also hope to keep current employees with the company. The senior executives whose decisions caused the company’s collapse are long gone.

Those who didn’t cause the trouble are the ones being not paid:

The payments represent only the most contentious of a larger group of bonuses being paid throughout AIG. The company’s top seven officials, including chief executive Edward M. Liddy, agreed in November to forgo bonuses through this year.

As Mr. Liddy wrote in his letter to Secretary Geithner:

I do not participate in any AIG bonus or retention program, have never attended a single AIG sales event or conference and, before September, did not have any relationship with AIG. I was asked to serve by your predecessor in connection with the acquisition by the government of almost 80% of AIG’s outstanding shares. 

For, we might note, a dollar a year.

What Liddy’s being paid

My only goals are to have AIG repay, with interest, to the maximum extent possible, the assistance the American taxpayers have given it and to continue AIG’s main insurance companies as strong, thriving businesses and contributors to the economy.  My only stake is my reputation.

That’s certainly the man we want to penalize, isn’t it?

2.  Those being excoriated could leave tomorrow

Politicians and the public spent yesterday demanding that AIG rescind payouts that they said rewarded recklessness and greed at a company being bailed out with $170 billion in taxpayer funds.

‘Greed’ is a word I’ve sought to banish from my vocabulary as completely subjective and thus meaningless; whoever says it means, more money for someone else than I personally think is equitable.  

But company officials contend that the uproar is scaring away the very employees who understand AIG Financial Products’ complex trades and who are trying to dismantle the division before it further endangers the world’s economy.

“Have fun disarmin’ the instruments!”

“Think they’ll do it?”

“Not a chance.”

3.  If they people go, the CDS’s could explode worse

This is the most insane part.  We the taxpayer are sitting on a huge risk, and we’re threatening the lives of the people who can defuse these bombs?  Washington Post:

Most of those left behind are trying to unwind complicated derivative contracts. Completing that process correctly is essential to preserving as much value as possible for taxpayers, officials at both the government and AIG have argued. If it is mishandled, it could expose taxpayers to billions of dollars in additional losses.

You want an example?  Here’s just one, plucked largely at random from the AIGFP retention plan justification:

Departures also have regulatory ramifications. As an example, the resignation of the senior managers of AIGFP’s Banque AIG subsidiary would allow the Commission Bancaire, the French banking regulator, to appoint its own designee to step in and manage Banque AIG.

So we’d have French bureaucrats deciding how to settle contracts where the US government is a counterparty.  That’s a gargantuan international conflict of interest, you know.

Don’t you feel Sarkozy about now?

Don’t you feel all warm and cozy now?

For better or worse, we’re linked now

It gets better:

Such an appointment would constitute an event of default under Banque AIG’s derivative and structured transactions, including the regulatory capital CDS book ($234 billion notional amount as of December 31, 2008), and potentially cost tens of billions of dollars in unwind costs.

Default accelerates all sorts of other penalties, many likely to be adjudicated in foreign jurisdictions by judges friendly toward AIG’s claimant counterparty.

“We want blood!”

Although it is difficult to assess the likelihood of such regulatory action, at a minimum the disruption associated with significant departures related to a failure to honor contractual obligations would require intensive interactions with regulators and other constituents (rating agencies, counterparties, etc.) to assure them of the ongoing viability of AIGFP as well its commitment to honoring counterparty contracts and claims.

Smart people I know close to Wall Street have said that we made a huge mistake letting Lehman Brothers go under, because the disruptive costs were much greater than backstopping Lehman would have been … and we’re long since past the safety point on moral hazard.

4. The bombs are still live …

It would be one thing to tar and feather after the risks were all behind us, but they’re not.

“Tell us how to fix it it!”

From Mr. Liddy’s Wednesday Op Ed:

Although we have wound down more than $1 trillion in the portfolio of the AIG Financial Products unit that is at the root of the company’s troubles, there remains substantial risk in that portfolio. The financial downside for taxpayers is potentially very large, and that’s why we’re winding down this business.

It takes time to wind this down

There’s no need to repeat my previous astonished posts regarding the massive amount of unlicensed insurance that was written on CDS’s.  The point is that, like the post-Soviet nuclear weapons, they don’t just disappear or atrophy.  They have to be dismantled, in real time:

“It’s going to blow up,” said a senior Financial Products manager, who spoke on condition of anonymity because he was not authorized to speak for the company. “I have a horrible, horrible, horrible feeling that this is going to end badly.”

5. … so we need the world’s best bomb-defusers

From Mr. Liddy’s Wednesday Op Ed:

To prevent undue risk exposure in the meantime, AIG has made a set of retention payments to employees based on a compensation system that prior management put in place. As has been reported, payments were made to employees in the Financial Products unit. Make no mistake, had I been chief executive at the time, I would never have approved the retention contracts that were put in place more than a year ago. It was distasteful to have to make these payments. But we concluded that the risks to the company, and therefore the financial system and the economy, were unacceptably high.

You’ve made a bad bet for $1,000, and you really, really want to prevent it from exploding in your face.  So you decide that, since the original charlatans who talked you into it are long gone, you’ll offer a bounty of sixteen cents.

… would you pay this?

To save this …

That’s the arithmetic involved. 

When I started this post, I expected it to be only a single part.  But the spectacle was so surreal, and yet so dangerous, I have to continue it tomorrow.

“Sentence first!  Then trial!”

[Continued tomorrow in Part 2.]

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