My brain hurts

Does the world of credit default swaps (CDOs), derivatives, counter parties and such, make your brain hurt (as Jethro Bodine was found of saying)? Try this analogy:

Imagine that A.I.G. wrote insurance policies (CDOs), for a specific period of time, for fleets of cars owned by Goldman Sachs, Merrill Lynch and a bunch foreign banks (the counter parties). A.I.G.’s credit rating was cut last September, which required it to put up additional capital in reserve against potential claims. They didn’t have the money, so in order to prevent the cascading collapse of counter parties, the government gave A.I.G. a series of capital infusions which have now reached $170 billion -- money supplied by the taxpayers.

Either A.I.G. didn’t tell the government, or the government didn’t tell us, how that money was going to be used, but this week we found out that A.I.G. used almost $50 billion of the money to buy the fleet of cars from Goldman, Merrill and the foreign banks, paying them the full value of the cars even though there has been no accident claims against them so far. Here are a couple of things A.I.G. and the government could have done instead:

1. They could have waited until one of the cars was in an accident, and paid that claim only; after all, it’s unlikely that all the cars are going to have accidents. If an accident did occur, they could have negotiated with the clamant, offering, say 75 cents on the dollar, since this was taxpayer money. What could Goldman do about it?

2. They could have offered the banks fifty cents on the dollar for the cars. Then at the end of the insurance time period they could have sold the cars at market value and had the possibility of making a profit. (But, since they paid full value, that possibility no longer exists.)
So A.I.G. was simply a clearing house for the funds which were passed on to other large financial firms that may, or may not, have had a pressing need for the funds.

This analogy is flirting with the border of Oversimplificationland, but is essentially the reality of what has gone on. The five largest sums went to:

Société Générale $11.0 B
Goldman Sachs 8.1 B
Deutsche Bank 5.4 B
Merrill Lynch 4.9 B
UBS 3.3 B

This, you will notice, is quite a lot more money than the $165 million in bonuses that everyone has their knickers in a twist over now. And while I don’t think those bonuses should be paid, the bonus flap is a pimple on Lawrence Summer’s behind compared to this. If one guy on Wall Street ever earned his money, I think we can say the Henry Paulson earned every penny Goldman ever paid him for arranging this deal for his long-time employer. And he’ll never have to buy a meal again when traveling through France, Germany or Switzerland.