Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.
Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.
So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.
"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.
Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.
Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.
Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year ? long before the actual profit on the contract was made.
With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.
It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.
Facebook
Twitter