Fruadulent Transactions Made Real?
I just finished reading Chris Whalen’s piece on AIG and the implications leaves me speechless.
Here is the gist. Before credit default swaps came into vogue, insurance companies would create reinsurance contracts with each other. Reinsurance is simply one insurance company transferring some of its risks to another insurance company.
Insurance companies, like banks, have strict capital requirements. Reinsurance contracts allowed an insurance company that was undercapitalized to quickly bring itself into compliance by transferring some of its risk. All of this would be fine, except for one stark fact. There were often hidden side agreements that stated these reinsurance contracts were sham transactions (i.e., no transfer of risk was really ocurring). The sole purpose of the contract was to fool regulators.
Credit default swaps started to be used by banks to solve shortfalls in their capital requirements in the same way that reinsurance was used by insurers to solve their capitalization problems. Information is starting to come to light that the traders entering into these contracts (many of whom had experience in the reinsurance shell game) also had side agreements making the CDS contracts sham transactions. The side agreements were often in the form of emails. As a result they didn’t need to price in the true risk of these contracts.
So now we have the US taxpayer making good on billions of dollars of contracts which were potentially fraudulent to begin with. If true, this simply leaves me stunned at the audacity of it all.