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The first article in this series explained how stock trading works, and by extension, how pretty much all financial trades work. Details differ considerably, of course, and the reality is far more complex, but the basics are similar and hopefully you've gotten the general gist of things.
The purpose was to set up an explanation why all the indignation and anger about the AIG bonuses is misplaced. People should be angry, but at politicians, not at AIG. That's what this article demonstrates.
Now we'll see how the trading principles we described worked in the real world of AIG's Financial Products division, the group who lost them so much money that we taxpayers had to lend them billions of our hard-earned dollars.
The previous article set the scenario for you to trade stocks on margin. Using leverage multiplies your profits by as much as 10 times what they would be if you didn't use leverage, but also multiplies your losses by just as much when things go down.
We also explored the various ways things could turn out to cost you money instead of making you money; hopefully you can now picture yourself as a trader. If you don't understand margin buying, loan covenants, collateral, margin calls, leverage, lines of credit, and counterparties, please read that article or this one won't make much sense.
Suppose you make money trading some financial instrument or other. Success makes you greedier. You decide to get a job working for, say, AIG so you can play big with other people's money.
AIG puts you at a trading desk where you buy and sell stocks, bonds, or whatever you're good at. They start you with a low limit on the amount of their money you can risk and they limit your leverage to, say, 3:1 like the beginner you are.
You have a good year. After deducting commissions, phone bills, interest, taxes, desk rent, electricity, and whatever other charges are listed in your contract, you make them a million bucks your first year. Why not pay you a bonus? Nobody has told us the percentages, but 1% of a million is 10 grand. Some AIG bonuses were as low as $1,000.
You succeeded, they raise your limit so you can bet more of their money and they increase your maximum leverage ratio. You succeed again, they double up, and you soon become one of the "masters of the universe."
Your percentage goes up, too, instead of 1% they pay you 10% of your net trading profits. If you make them $100 million, which isn't at all far-fetched given the billions involved, you're in line for a $10 million bonus. 10% commissions are common in other lines of work. Waitresses are entitled to 15% performance bonuses on top of their pay; we call them "tips."
Note that your employment contract is between you and AIG, it doesn't matter what other traders do. If you make money, the contract says they gotta pay you based on whatever money you made even if everybody else lost.
What's wrong with that? If you're a good waitress and the other waitresses are lousy, wouldn't you expect to be tipped well even if they all get stiffed?
It's possible to lose money even when stocks are generally going up. We've written of a trader who lost more than $7 billion for his employer all by himself. To keep that from happening, AIG has people who watch for dangerous situations and try to block unsafe trades.
That's called "risk management;" it's an inexact science. What happens when a risk manager won't let a trader do something? The trader keeps track of how it turned out and beats up on the risk manager if the trade would have been in the money; he forgets about it when the risk manager keeps him out of a loser, of course. If a trader with a good track record gets irritated at the risk management department, he moves someplace else where his genius is properly appreciated and rewarded.
Nobody likes risk managers. By now, it should be pretty easy to understand why risk management is always going to have a hard time holding risks down to reasonable levels: most of the time, it's in nobody's interests for them to do so, and on those few occasions when caution would help, things still look so good that nobody wants to hear about doom or gloom - until it's too late.
We've explained how the whole game runs on faith as in "full faith and credit of the US Government." If your broker has faith you can pay, he won't issue a margin call even if the loan covenant says he can, he'll wait a while and hope values go back up and take care of you both. In a rising market, that's what usually happens.
A broker who makes too many margin calls drives his customers elsewhere no matter what the contract says. Remember the old saying that a bank won't lend you money unless you can prove you don't need it? Brokers are like that. Your broker issues a margin call when he loses his faith that you can pay. If he's wrong and you're able to pay, you survive, but if not..... wipeout!
So it was with AIG. They had AAA credit, they were making billions, everybody was writing how smart their traders were. Other banks gladly acted as counterparties.
They had enough faith in AIG to accept leverage as high as 50 to one. You put up $2 per share; you get a loan of $98 per share. Your $100 buys you 50 shares, when they double, you make $5,000 on your $100 investment, or 50:1. Not bad.
Of such profits are million-dollar bonuses made and rightly so. The band played on until someone lost faith in AIG's ability to pay. Without faith, AIG unraveled.
Who popped the bubble? Who wrecked the market's faith in AIG? The answer is stunningly simple: One man, Attorney General, then Gov. Eliot Spitzer (D-NY).
He got hugely favorable publicity by bringing questionable charges against Wall Street firms. His tactic was to announce criminal charges, extort fines from banks and brokers, preen for the press, and move on.
New York law makes it possible to bring criminal charges without proving criminal intent. In this prosecutor's paradise, announcing charges brought enormous pressure on firms to settle even if the charges were bogus.
Everybody knew how the accounting firm Arthur Andersen was put out of business by false criminal charges after the Enron scandal. The US Supreme Court ultimately rejected the charges, but Arthur Andersen was destroyed even though they were innocent because everybody lost faith in them. The same thing happened to AIG, only more slowly.
If a financial business is criminally charged and management goes to trial instead of settling, the value of their assets goes down. Their counterparties think they might get convicted and lose faith that they can cover margin calls. Remember, nobody actually issues margin calls unless they lose faith that you can pay.
Criminal trials have a bad effect on faith and lead to lower asset values. Lower asset values violate loan covenants and the trades all unwind. Given the choice of going to trial and seeing their bonuses vanish versus paying a fine with stockholders' money, what do you think management generally did?
Spitzer racked up many fines which sounded like a lot of money but were in fact chicken feed given the staggering numbers involved. He was on a roll.
Then Spitzer went after AIG. Instead of caving, longtime CEO Hank Greenberg, who knew AIG had done nothing illegal, fought back and made Spitzer look bad.
This wouldn't do -- Spitzer wouldn't get elected governor if people realized he'd brought so many false charges. He told the AIG board members he'd charge them, personally, unless they got rid of Greenberg, like the mafia threatening to break your leg if you don't go along with them. The Wall Street Journal explains:
State, foreign and various U.S. federal regulators were all looking over AIG's shoulder and approving the bad housing bets. Americans always pay their mortgages, right? Mr. Polakoff [acting director of the Office of Thrift Supervision] said his agency "should have taken an entirely different approach" in regulating the contracts written by AIG's Financial Products unit.
That's for sure, especially after March of 2005. The housing trouble began -- as most of AIG's troubles did -- when the company's board buckled under pressure from then New York Attorney General Eliot Spitzer [D-NY] when it fired longtime CEO Hank Greenberg. Almost immediately, Fitch took away the company's triple-A credit rating, which allowed it to borrow at cheaper rates. AIG subsequently announced an earnings restatement. The restatement addressed alleged accounting sins that Mr. Spitzer trumpeted initially but later dropped from his civil complaint.
Other elements of the restatement were later reversed by AIG itself. But the damage had been done. The restatement triggered more credit ratings downgrades. Mr. Greenberg's successors seemed to understand that the game had changed, warning in a 2005 SEC filing that a lower credit rating meant the firm would likely have to post more collateral to trading counterparties. [emphasis added]
Once Spitzer forced out the financial genius who built AIG, the rating agencies dropped AIG's credit rating. This was perfectly logical, the genius was no longer at the helm.
That increased AIG's interest costs; suddenly, AIG wasn't as profitable as before. Their interest costs were huge because they'd used loans to support extremely high leverage. Being downrated also increased the amount of collateral they had to put up to fulfill their loan covenants with many, many counterparties. Putting up more collateral reduced their reserves which downrated them again, and so on.
What's worse, Spitzer made so much noise that everybody knew why Greenberg was no longer there. Having the government talk about criminal charges and force the boss out constituted an unmistakeable "material change in circumstances" which triggered covenants; some loans had to be paid off in full right away.
AIG stock cratered; billions of dollars worth of shareholder value vanished. Do you think Mr. Spitzer's self-promoting bogus charges helped anyone who owned AIG stock or who worked there?
No matter, the publicity helped elect him governor, mission accomplished! We know how that turned out, but his downfall didn't undo his damage to AIG.
The AIG warning of 2005 was correct; AIG had to put up more and more collateral as they were downrated. The billions we taxpayers lent them went to pay off counterparty obligations that were triggered by wrongful government action in the first place. Given that most of their problems grew from malicious prosecution, there is a certain justice in government putting up the cash to bail them out.
Now that we understand how AIG got in this fix and how gigantic bonuses can be earned, we can understand what's going in the anti-AIG mob scene. The Wall Street Journal pointed out:
Current AIG CEO Ed Liddy was picked by the government in 2008 and didn't create the mess, and he shouldn't be blamed for honoring the firm's lawful bonus contracts. [emphasis added]
Mr. Liddy testified to Congress that the people who received bonuses because their trades made money in 2008 are precisely the ones he wants to keep.
What's more, you as a major investor in AIG via your tax dollars should agree with him; it's in your interest for these people to stay and for them to earn far bigger bonuses next year.
Think about it. 2008 was a lousy year for AIG and for just about everybody. Making money when stocks are going up is straightforward, but making money in the Obama bear market is far harder.
The AIG Financial Products division lost billions as a whole, but not every trader lost money. Some traders made lots of money, exactly what AIG needs just now. Having made money, they're entitled to their bonuses as the contracts say.
The money they earned is essential to AIG's survival and it's essential to you. The taxpayer money AIG got was loaned, not given - it's supposed to be returned with interest.
How on earth can anyone, even politicians, expect AIG to pay back those loans without the help of the really good traders who make them the most money? We know what happens when dumb bureaucrats force banks to issue home mortgages to people who can't pay back the loans, we should do the same with businesses?
That bears repeating - AIG got billions in taxpayer money, as a loan, not as a gift. They're supposed to pay it back out of future profits, and for that to ever happen, there have to be future profits generated by highly skilled employees who choose to generate them for AIG instead of moving on and working their magic elsewhere.
Unfortunately, the guys who created the housing bubble by getting government into the business of selling mortgages to people who couldn't pay them back are Democrats like President Carter, President Clinton, Rep. Barney Frank, and Sen. Chris Dodd. The government official who popped the bubble, Eliot Spitzer, is a Democrat. The bosses who collected millions in unearned bogus bonuses at Fannie and Freddie were Democrats.
If the media explained what really happened, they'd have to admit that Democrats helped cause the crash. They'd have to stop blaming the whole thing on President Bush, who is actually the one person least at fault - he tried to put tighter regulations on Fannie and Freddie, and was blocked by... no points for guessing... yes, that's right, the Democrats who were in the majority in Congress at the time.
No, the Democrats and their media allies will never admit that our financial crisis is mostly their fault; they'd rather lie about what happened and steal the lawfully earned bonuses by a special after-the-fact tax as Congress has passed legislation to do. This is not protecting the taxpayer investment in AIG; what competent trader would stay at AIG or at any other bailed-out firm knowing that their earnings could and probably would be stolen at any time by politicians?
Would you? No, they'll leave, work elsewhere, and we taxpayers will end up holding the whole bag.
What's worse, our politicians and talking heads have whooped up so much unjustified anger at AIG executives personally that their lives have been threatened. They're hiring private security guards to keep from getting killed. Having your money stolen by politicians making silly statements is one thing, having your life stolen through populist fury fanned by uninformed talking heads is quite another matter.
If the Obama administration is to have any hope of pulling us out of our financial mess, they need every investor they can persuade to buy assets, clean them up, and get the system working again. The idea is for government to guarantee, say, 50%-80% of the losses to encourage investors to buy questionable assets and clean up banks' balance sheets. Giving opportunities for profit would encourage investors to rehabilitate suspect assets as fast as possible.
But with all this populist hoo-hah, after all these death threats, what investor in his or her right mind would cooperate with any government program? You get in bed with government, Congress can re-write the rules at any time to steal your profits and maybe even put your life at risk.
When you encounter an ordinary armed robber, you get a choice: your money or your life. With government and the media involved, it's your money and your life. Given that stark truth, it's a wonder that there's any traders left in New York; almost all of them could still afford to flee in their Learjets to friendlier climes.
A few of the best have already left for jobs in other countries, but there's still some residual trust in the American way and in American justice. With every new assault on earned wealth by Obama, Democrats, and the media, unfortunately, that trust dissolves a little more; it won't last forever.
When the rich leave, their money and their talents leave with them. Five hundred years ago, Spain made the fatal mistake of expelling its Jews who happened to be the wealthiest, most successful bankers and traders. Spain was the superpower at the time.
Not so long thereafter, they were a two-bit Third World country at the mercy of whoever felt like invading them; countries that welcomed the Jews were doing rather nicely. Anti-Semitism enforces its own penalty, and so does class warfare such as we see today.
So there are two big lies about AIG. The first lie is that AIG's fall was their own fault. They climbed a cliff of very high leverage, but as we've shown, government pushed them off the cliff and kicked them on the way down with highly-publicized bogus charges which wrecked their "faith and credit."
The other Big Lie is that the AIG bonuses hurt the taxpayers. In actual fact, bigger and better earned bonuses are the taxpayers' only hope of getting our money back. An even bigger lie is the lie that government can fix the crisis or fix anything at all, but that's for another article.
Spread the word! No more bailouts, no more special taxes, and no more "regulation" by politicians who have only their own greed and lust for power at heart.