“A person is smart. People are dumb, panicky dangerous animals and you know it.”

Maybe we could use this on AIGFP's customers to make them forget about their contracts?

It may seem silly to quote a movie (Men In Black) with such a sobering, outraging topic, but it most definitely applies.  The level of hatred being directed at AIG, at the government, and at the administration for the payment of bonuses by AIG to members of its Financial Products division (AIGFP) is staggering.  The only thing that is more staggering is the utter lack of desire of these people (politicians included) to find out any facts about the issue, and to determine whether actually paying the bonuses would be the best thing for taxpayer interests.

Yes, people are being dumb.  Very dumb.  They are being irrational and emotional, and there is no place in business for either type of behavior.  When we have US Senators claiming that executives should be committing suicide (even rhetorically) I would say we have crossed the line.  If we take a careful, rational look at the situation, we can quickly see exactly why the bonuses should be paid.

And before you get horribly angry at me or think I’m insane, regarding the moral issues here I’m largely playing devil’s advocate.  I’m all for the government taking those bonuses back in any legal way possible.

Why the big stink all of a sudden?

The number on everyone’s lips the past few days is 165.  Everyone is claiming that AIG is paying out $165 million in bonuses.  That’s not true.  Take a good look at this document - it’s only five pages but it very clearly illustrates why we’re stuck paying these things.  The real amount paid out for bonuses for 2008 is roughly $220 million, $55 million of which was paid out in December 2008.  There was a tiny blip on the media radar late last year regarding the payment of bonuses, but it all blew over and everyone quickly forgot about it.  If it wasn’t a big deal then, and it had to be done, why is it a big deal now?  There must have been some logical reason for their payment in December - has that same reason magically disappeared?  No.

AIGFP employees have indeed seen cuts in compensation. Many of us would rather use those scissors on them in other ways, though.

In fact, employees at AIGFP have taken a pay cut due to the company’s ‘performance’, and in some cases it is a significant cut.  The document gives as an example an AIGFP Senior Manager, whose compensation for 2008 worked out to about 43% of what they were paid in 2007.  AIGFP’s bonus structure included a very large ‘at risk’ portion - basically part of the bonus compensation was based on profits (or loss) of the division.  Considering the ‘losses’, none of that portion is being paid out.

While I agree with most everyone else that many of these people probably don’t deserve bonuses, it’s not like they’re being rewarded for screwing up the financial system - they are still taking a financial hit.  And don’t forget those bonuses are being paid out to about 400 people.  In fact, the smallest bonus amount is only $1000.  The highest bonus being paid is $6.5 million, and seven employees received over $3 million.  You can bet a good portion of those 400 people were doing their jobs, and maybe even doing their jobs extremely well.  The ‘bonus’ is part of their annual salary.  Shouldn’t they be compensated for the legitimate, good faith work they did?  We all felt sorry for the employees at Enron who lost their jobs and savings when it went under - why this sudden hatred of people who were lucky enough to not get screwed by their management?

It's not quite Dynomite, but AIGFP's position is potentially very explosive.

The Derivatives Contracts, or the C4

Ok, I think you can make the argument either way if you approach it from a ‘moral’ angle.  You could argue that each of those 400 were complicit in the collapse of AIGFP, that it would be impossible to work there and not know the dangers of holding $2.7 trillion in derivatives contracts, etc.  I will also admit that I’m playing devil’s advocate on the moral thing.  But contracts really are at the heart of all of this, so lets take a brief look at what contracts AIGFP holds (both between their employees and their customers), and what their responsibilities are.

First, the derivatives contracts.  What IS a derivatives contract?  There are various definitions, and they can get extremely complex, but let’s take a simple example.  Keep in mind I’m an engineer, not a financial expert.  This understanding is based on research I’ve done on my own, and I may well be missing some finer points.

Maybe today I buy some shares of GM Stock, thinking it could be a good investment.  I pay $2.00 per share.  There’s a chance, though, that GM could go out of business, rendering those shares worthless.  I would like to hedge my bet on GM, so I buy some insurance.

That’s where AIGFP comes in.  Maybe they have more confidence in GM.  Maybe they have done a lot of research, have looked at trends, and they’re certain that by this time next year, GM stock will be sitting at $14.00 per share.  They’re so confident, they’re willing to make a deal with me.  They will guarantee to pay me $10.00 per share for my GM stock one year from now - no matter if the stock is still at $2, or $50, or if GM even goes out of business entirely.  That’s a good deal for me - I get a ‘guaranteed’ return of $8 per share, and AIGFP profits from the contract itself.  The only way it could possibly fail is if somehow every investment worldwide suddenly went off a cliff……..

This all comes down to risk.  I *think* the investment will yield a decent return, but what if it becomes a loss?  There’s always a risk of loss with an investment.  The derivative contract becomes a way for me to mitigate that risk.  If the investment *does* mature to my liking, I just cash in the investment.  If it doesn’t, I exercise the contract and AIGFP eats the loss.

So yeah, AIGFP is on the hook for trillions of dollars now, as just about every risky investment has completely tanked.  No, they’ve done worse than tank - noone even knows what they’re worth, and they won’t guess, so noone will buy them at any price.  So AIGFP can’t even sell some of the assets gained as a result of the contracts to help stop the bleeding.  Worse, the counterparties to these contracts are all over the world.  If AIGFP goes down and fails to honor those contracts, it starts a chain reaction that could bring the whole financial system crashing down.  That’s why we’ve spent $170 billion on them so far, and that’s why we’ll continue to dump money into them.  The US Government is effectively bailing out the failed investments of banks and companies around the world through AIGFP’s derivatives contracts.

Modern day mob mentality could get us into real trouble here.

The Bonuses, or the Detonator

Ok, we’re all upset.  We’d like nothing more than to see a few of those people from AIG swinging from the gallows - financially if not literally.  The mere mention of the word bonus when talking about AIG has people seeing red, and it even has Obama banging on his podium - a rare sight indeed.  The problem is, AIG really has no choice in the matter.

First, the legal ramifications.  The contracts that comprise the ‘retention plan’ are governed by Connecticut state law.  Under the law, if AIG does not pay out the bonuses, the employees can sue.  If they sue and win, AIG would be liable for up to twice the bonus amount plus legal fees.  These contracts were entered in to before AIG took any bailout money.  What if the employees win?  Now $165 million in bonuses becomes $330 million, plus what would end up being probably millions in legal fees.  I’ll agree that there certainly should be some investigation regarding fraud, which could nullify the contracts. A legal decision against the employees, or worse action from the Federal government to nullify them ‘just because it’s morally reprehensible’ is a very bad road to start down, though.  You want socialism?  Government power to nullify any contract on a whim, especially out of ‘fairness’ is a HUGE step in that direction.

That’s not even the real problem, though.  Right now AIG is a ticking time bomb.  The incredibly complex web that AIGFP has woven must be carefully unraveled.  The best people to do that are the same people that wove it in the first place.  Not only that, but those people have so much information about AIGFP’s holdings that if they left, they could actually use it against the company to start trading against its positions, making money for themselves and doing even more harm to the company as a result.  It’s unfortunate, but we probably actually need a lot of these people to sort everything out.

But even THAT isn’t the real problem!  The REAL problem comes back to contracts:

AIGFP’s derivatives portfolio stands at about $1.6 trillion and remains a significant risk. Failure to pay the required retention payments [bonuses] therefore could have very significant business ramifications.

For example, AIGFP is a party to derivative and structured transactions, guaranteed by AIG, that allow counterparties to terminate in the event of a “cross default” by AIGFP or AIG. A cross default in many of these transactions is defined as a failure by AIGFP to make one or more payments in an amount that exceeds a threshold of $25 million.

In the event a counterparty elects to terminate a transaction early, such transaction will be terminated at its replacement value, less any previously posted collateral. Due to current market conditions, it is not possible to reliably estimate the replacement cost of these transactions.

However, the size of the portfolio with these types of provisions is in the several hundreds of billions of dollars and a cross-default in this portfolio could trigger other cross-defaults over the entire portfolio of AIGFP.

The above is from the document I linked, and the emphasis is mine.  This is why these silly, comparably tiny ‘bonus’ payments are the potential detonator for this very unstable situation.  In plain english, the above passage means that if AIGFP fails to make a payment that exceeds $25 million, AIGFP may have to pay out on their contracts.  The bonuses could constitute such a failure to pay, at which time AIGFP would be liable to pay up.

It would be as if your car loan had a stipulation that if you failed to pay your electric bill, you would be required to immediately pay off the entire balance of the loan, or at least the current cost of the car.  Oh, and you have no idea what the car is worth, because nobody is buying a 74 El Camino with a disco ball and an 8-track, so you couldn’t even try to sell the car to meet the obligation.

In short, AIGFP is screwed.  By extension, the US Government and the taxpayers are screwed.  If we refuse to pay the bonuses now, we risk not only paying out more than double after protracted legal battles, but we risk AIGFP’s customers calling in their liabilities too - all at once.  So, what will it be - $165 million, or $1.65 trillion?

So yes, investigate them.  Send them away for a LONG time.  Tax the bonuses into oblivion.  Find a legal way to free AIG from the obligation to pay them.  But don’t withhold the bonuses on emotion and cause an even bigger problem as a result.