Commentaries

Time to get tough with AIG

It’s time for someone in the Obama administration to read the riot act to Robert Benmosche, American International Group’s new $7 million chief executive.

Since getting the job, Benmosche has spent more time at his lavish Croatian villa on the Adriatic coast than at the troubled insurer’s corporate offices in New York.

And in the short term, Benmosche’s vacation strategy appears to be paying dividends.

This week, AIG’s shares surged 44 percent, to nearly $50, after Benmosche said that he intended to move slower than his predecessor in selling off AIG’s still viable divisions.

Maybe Benmosche should consider relocating AIG’s headquarters to Dubrovnik.

But the big run-up in AIG shares is merely a sideshow for momentum players, speculators and Hank Greenberg, the former AIG chieftain who controls about 11 percent of the company’s outstanding shares.

The reality is that AIG exists today only because of the $180 billion lifeline the insurer has received from the federal government. Even Benmosche acknowledges that, telling The Wall Street Journal: “If the U.S. government doesn’t continue to support AIG, we will fail.”

Cat bondage

Catastrophe bond lovers and other insurance-linked securities enthusiasts should take a look at a report on insurance securitisation published today by the International Association of Insurance Supervisors (IAIS).

There is an interesting section in the report looking at the various cat bonds that have gone pear-shaped since the dawn of the market in the 1990s.

The first bond in which investors suffered losses was Georgetown Re, sold by Goldman in 1996.  The report explores four other deals that have come under stress since then due to losses from natural disasters or other insured risks.

All in all, the track record is pretty good for most of the 300-odd deals sold. Unfortunately, the dogs start to mount up after the financial crisis broke in 2007.

Most of the more recent deals that ran into trouble did so not because of the insured risks, but as a result of the way the deals were put together, and bankers’ occasional fondness for using them as dumping grounds for dodgy assets.

First there are the four cat bonds in which Lehman acted as a derivative counterparty and which were collateralised in some cases by asset-backed debt. Investors were left out of pocket when Lehman failed and the bonds’ had to rely on the toxic debt to pay interest and principal.

Then there is Ballantyne Re, sold by Bermudan insurer Scottish Re. This deal was supposed to provide the insurer with regulatory capital, but the collateral it held as cover for that insurance turned out to be subprime and other mortgage assets. That left Scottish Re short of insurance cover and hurt investors. A similar situation developed with Orkney Re II.

Citadel’s big Lehman loss

It’s long been suspected that Ken Griffin’s Citadel Investment Group took a big blow when Lehman Brothers went bust nearly a year ago. But Griffin and his management team have been reluctant to put a number on the damage to the Chicago-based fund.

That is, until now.

In a brief, one-page filing, Citadel claims it is owed some $470 million on a derivatives contract. The $12 billion hedge fund conglomerate offers no details about the derivatives deal in the proof of claim, submitted as part of the Lehman bankruptcy filing.

To date, Citadel’s claim is the third largest submitted by a creditor in the bankruptcy.

As the one-year anniversary of Lehman’s collapse approaches, expect more hedge funds and banks to fess-up about their Lehman losses.

Wall Street’s $4 trillion kitty

The Obama administration’s plan for reining in derivatives leaves unchecked one of Wall Street’s dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it’s a form of free money for derivatives dealers to use as they please — even to repost it as collateral to finance their parent company’s own borrowings.

And we’re talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That’s an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it’s not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

There’s nothing wrong with a dealer taking legitimate steps to insure an orderly unwind of a busted trade.

But Wall Street firms should not have free license to reuse this collateral any way they see fit. The Obama administration should revise its proposal to require derivatives dealers to hold all cash collateral in segregated escrow accounts that can’t be reused or touched by the dealer.

The same rule should also apply with any collateral that is posted with a regulated exchange on which a derivative contract gets traded.

Pain in Spain hits cat bonds

Defaults by catastrophe bonds, securities used by insurers to shift the risk of severe losses from natural disasters, have been few and far between.

When deals have run into trouble, it has often been due less hurricanes or earthquakes than some flaw in the way they were structured, such as the four bonds that imploded last year because of their links to Lehman Brothers and dodgy asset-backed debt.

Today Standard & Poor’s downgraded another deal in trouble, Swiss Re’s 252 million euro Crystal Credit transaction. Once again, the problem here is man-made.

This deal is different from most other cat bonds in that it doesn’t reference losses from natural disasters, but is instead tied to the performance of Swiss Re’s credit reinsurance business. Losses on the reinsurance contracts have started to climb as the economy soured. In particular, S&P says, the credit reinsurance business got hit by a “steep increase” in Spanish reinsurance claims.

It’s not the first time these bonds have been downgraded, although things seem to be getting worse. S&P says it’s “most likely” the class C bonds won’t make their principal payments in full at maturity. These were once rated B, and have now fallen to CC. The senior bonds, which were once investment grade, are now B+.

Contrarian Capital…not so much

With a name like Contrarian Capital one would think this Greenwich, Conn. hedge fund would have been savvy enough to sniff-out the impending trouble at Lehman Brothers. But apparently, the managers of Contrarian weren’t contrarian enough.

A week ago, Contrarian filed a rather large $100 million notice of claim in the Lehman bankruptcy, an indication that it was a bit too bullish on the failed investment house. But what makes the claim really interesting is that it stems from losses on Lehman-issued structured notes–something often sold to retail investors.

I’ve been writing a lot about structured notes being a terribly flawed investment product. The main problem with structured notes is that they generate big fees for investment banks and often are falsely pitched as conservative investments. Many are described as being “principal protected.” But as the Lehman experience has shown, that guarantee means nothing if the issuer goes bust.

Additionally, the main feature of a structured note–an embedded derivative that tries to capture the price increase in an underlying basket of stocks, commodities or a particular index–is something that often can be replicated by a investor without the aid of an investment bank. And the embedded derivative is notoriously complex and simply adds more counterparty risk into the financial system. 

Yet structured notes, up until the financial crisis, were a big business for banks in Europe and Asia. The main buyers: retirees and average investors.

And here’s what really interesting about the notes purchased by Contrarian–they were issued by a little-known Lehman subsidiary in Amsterdam that sold some $35 billion in these now worthless securities. Back when I was a reporter for BusinessWeek, I wrote a long article about this Lehman subsidiary with my former colleague David Henry. In the story, we described how dubious products like structured notes had imperiled the concept of global banking and posed a big problem for regulators trying to tackle the derivatives mess.

It’s been nine months since Lehman collapsed and the bankruptcy case is quickly fading from the headlines. But it shouldn’t. In many ways, the Lehman case is just getting going as the battle over the fallout from the messy unwind of Lehman’s hefty derivatives book is just getting started.