UPDATE 26 Mar 2009: Paul Kedrosky has a good post up on how collateral in CDS contracts work. See Collateral 101: How It Works at AIG and Elsewhere
Back on March 6th, I noted that the nationalized insurance company AIG had settled Credit Default Swaps contracts with a number of counterparties at the top of the market. In effect, AIG was offering a hidden subsidy to its counterparties by settling the contracts and exchanging collateral for money at inflated prices.
As an example, imagine AIG made a deal with Goldman Sachs to make Goldman whole if Company X defaulted on its bond payments. In this arrangement, Goldman might hold bonds of Company X (and then again, it might not) against which it wanted downside protection via this contract with AIG. Now, after Lehman Brothers defaulted, in all likelihood the price of downside protection for Company X skyrocketed along with the Credit Default Swaps of all other companies. That means any contractual settlement during the time frame of market dislocation was made at unrealistically high levels which no insurer would reasonably accept… that is, except AIG. Goldman would be receiving money that it would not normally receive were it not for the fact that AIG was controlled by the Federal Reserve.
This is the crux of the issue. AIG was effectively nationalized. Thereafter it settled contractual arrangements which it was under no obligation to settle at prices which reflected an enormous premium due to dislocated markets. Therefore, the company gave free money to its counterparties — all large international financial institutions. By the way, many of these institutions are not even American companies.
Who ended up footing the bill? American taxpayers.
On the back of recent outsized bonus revelations at AIG, those in the know about this are indignant. As a result, AIG has released a list of counterparties which Federal Reserve Vice Chairman Donald Kohn had originally refused to give. Below is the document detailing these activities.