AIG's CDS Hoard: The Great Unraveling

The process of unwinding AIG's credit default swaps isn't rocket science, but it is messy and expensive. Here's why

By Ben Levisohn

Credit default swaps got American International Group (AIG) into its current mess. Unraveling them might get U.S. taxpayers out of it. But it won't be easy or cheap.

The white-hot furor over AIG's retention bonuses seems to have died down a bit. Last week the House of Representatives passed a watered-down version of the bill that was supposed to tax those payments out of existence. But AIG isn't leaving the bull's-eye anytime soon. The Government Accountability Office said on Mar. 31 that AIG should demand concessions from its trading partners and employees. On Apr. 2, deposed AIG Chief Executive Hank Greenberg paid a visit to Capitol Hill, blaming his successors for the company's failings and calling its government bailout a failure. And New York State Attorney General Andrew Cuomo is probing the $165 million bonus payments and the billions AIG transferred to such banks as Goldman Sachs (GS) and Société Générale (SOGN.PA).

Amid all this hubbub, AIG's employees plug away, trying to wind down the beleaguered company's remaining credit default swaps, which are basically insurance policies purchased against the default of various forms of debt.

So what's so hard about unwinding a CDS? And does it really take a financial rocket scientist, chained to a seat by a fat retention bonus? Or could it be done by some of the vast army of recently unemployed Wall Street workers?

Large, Complex Web of Derivatives

Part of the problem is that not only are the financial instruments themselves complicated, but they involve tangled relationships of companies and investors, each with their own interests. AIG owns $1.5 trillion in derivatives, including CDSs, interest rate swaps, and currency swaps, among others. And these trades overlap in a large web across all its companies. Since everyone knows that AIG needs to rip up its contracts, its partners are holding out for the best deal possible.

The nastiest, most complicated, and most controversial types of AIG's CDSs have largely been taken off the company's books. Those swaps were customized by the insurance company to protect financial institutions from default in illiquid pools of mortgage-backed securities, the now infamous collateralized debt obligations, or CDOs. When the value of the CDOs tanked and AIG's credit rating was cut, the insurance company was forced to pay billions of dollars in collateral to companies known as "counterparties"—money it didn't have.

To exit the contracts, AIG used Federal Reserve and Treasury Dept. cash to pay the counterparties 43¢ on the dollar for the securities (which now reside on the Fed balance sheet as Maiden Lane III). Then the company paid off $26 billion in insurance on the same CDOs to Goldman Sachs ($5.6 billion) and Société Générale ($6.9 billion), among others. This cost taxpayers $46 billion.

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