By Lucy Komisar
AlterNet, March 26, 2009

Congress has deftly avoided the real story of AIG’s collapse, which makes a few million in bonuses seem like peanuts.

There’s nothing like a grandstanding member of Congress to deflect attention from the real issues at hand by throwing a few juicy bones to the masses. Most legislators at a House Finance subcommittee hearing last week deftly avoided the real story of AIG’s collapse. Instead, they homed in on the public relations disaster of hundreds of top AIG officials and staff getting $165 million (later revealed as over $218 million) in bonuses.

The key issue ignored by the congressmen and women was the potential catastrophe represented by as much as $2.7 trillion in AIG derivative contracts and how AIG and the U.S. government are dealing with them. To put that number in context, we’ve so far provided the company only about $170 billion.

An exception at the hearing was Rep. Joe Donnelly, D-Ind., who declared that naked credit default swaps were little more than gambling … dreamed up by Wall Street to create additional profits, and he suggested that instead of being bailed out, when the casino goes bust, the guys who are gambling close shop. He noted that if ordinary Indiana citizens acted the same way as the titans of Wall Street had, they’d be in jail. But Donnelly never got to explain what he meant by naked credit default swaps. We did learn early at the hearing that the Federal Reserve is in charge of overseeing AIG. The Fed is strongly influenced by some of the same big banks and brokerages that are getting AIG payouts and taxpayer funding.

These same firms have opposed regulating credit default swaps, other derivatives and naked short selling (which are explained below). That should have set the stage for the rest of the questions, not to mention an investigation into where, exactly, all that money that AIG  received went.

More Money for AIG

We discovered in passing at the hearing that AIG has $1.6 trillion of derivatives left to unwind — the mess remaining of the AIG derivatives debacle. Nobody asked the basic details of how the other $1.1 trillion was unwound or how the rest will be dealt with. And nobody got an answer to the question of how much more in taxpayer money it will take to finish the job, and who will benefit from this unwinding process. Or, since the U.S. government is now in the derivatives business through its financial support of not only AIG but also Citigroup ($300 billion in guarantees), and other financial companies, how much taxpayer money may be required to pay off those other firms’ derivatives bets.

Derivatives

Derivatives are financial instruments derived from something else, hence the name. In the lingo of Wall Street, nouns are turned into verbs and verbs beget nouns. If a bank or brokerage firm securitizes debt — for example, turning a bundle of mortgages into financial products — the resulting securities are derived from those mortgages, thus they are mortgage derivatives. They can be sliced and diced and sold and at the insistence of Wall Street powers and their representatives, the derivative transactions are unregulated. Central to AIG’s demise were derivative credit default swaps (CDS), basically insurance on financial deals. Some people bought insurance against their houses burning down. Others made bets on somebody else’s house burning down. That’s an insurance policy for someone without a house at risk.

The first type of contract should be seen as legitimate. But should U.S. taxpayers, who own nearly 80 percent of AIG, pay off a wager that somebody else’s house would burn down in this financial casino Wall Street built out of the ashes of cut-and-burn deregulation?

More importantly: Should they pay off the wager if there are indications that the game may have been rigged in the first place?

Hedging the Bets

Derivatives contracts on stocks can be hedged with a short sale. Short selling is selling a stock that you borrow. The short-seller hopes the price will go down in order to buy the security cheaper and transfer it back to the lender, gaining a profit from the difference in prices from the time the shares were borrowed and the time the shares were returned to the lender.

Naked short selling is selling shares that were never borrowed — it’s selling thin air, or in essence, selling counterfeit securities. Done on a large scale, this pushes down share prices across the board as the artificial supply of shares — ballooned by those phantom shares — outweighs demand.

The Securities and Exchange Commission’s real effort in stopping naked short selling has been on a par with its interest in investigating Bernie Madoff. A newly released report from the Office of Inspector General revealed that the SEC received 5,000 complaints regarding naked short selling of stocks in 2007 and 2008, which led to zero enforcement actions by the SEC.

A Market Ripe for Fraud and Manipulation

Here‘s how naked short selling relates to manipulation of CDSs. The face value of CDS contracts at one time was $60 trillion. Even Christopher Cox, who took no meaningful action on the matter as SEC chairman, got worried and acknowledged in testimony, Holding a credit default swap is effectively, or nearly effectively, taking a short position in the underlying … and because CDS buyers don‘t have to own the bond or the debt instrument upon which the contract is based, they can effectively naked short the debt of companies without any restriction, potentially causing market disruption and destabilizing the companies themselves. This market is ripe for fraud and manipulation.

This is a problem we have been dealing with, with our international regulatory counterparts around the world with straight equities (stock), and it‘s a big problem in a market that has no transparency and people don‘t know where the risk lies.

The most profit from these types of contracts is obtained if the security that is the asset for the contract declines to a price of zero. Derivative trades are often sham transactions between cooperating dealers designed solely for the purpose of creating shares to sell into the public market. Securities prices can be manipulated downward through naked short selling. Even though derivatives are unregulated transactions, the stock manipulation occurring from the sham transactions that create the naked short shares is regulated and is illegal under U.S. securities laws.

If the derivatives contracts were hedged with a short sale by the casino operators, they have already received profit from the sale of the securities they did not own.

Where Does the Money go?

Derivatives trades are generally accounted for by the big broker dealers (now getting taxpayer money) as off balance sheet transactions. They are hidden from regulators and investors, via special purpose entities (SPEs), which can be offshore and presumably are for the profit of elite special partners or clients of these same firms.

More Transparency Needed

So, we need to know about the claims AIG and others on Wall Street are paying out from taxpayer funds. Who made these derivative trades? Did they own the underlying assets or not? Did the parties that received money from the taxpayers write sham contracts to create shares to sell and then naked short sell securities they didn’t own into the U.S. markets? Is AIG paying on losses for which no claims have yet been made?

Shouldn’t Congress, the Fed — which is overseeing AIG — and law enforcement agencies be investigating these SPEs and the money they  received? Shouldn’t they investigate whether it was obtained illegally? What if there are trillions of dollars in the special purpose entities that have been hidden for the benefit of a powerful few? Should the U.S. taxpayer come to the aid of the largest U.S. banks and brokerages that created these fancy off-balance-sheet financial instruments without full disclosure to at least one government agency of the monies in SPE accounts? How can Congress make intelligent regulation without understanding the scope of the problem and the trading techniques they are trying to regulate, which took down AIG and are destroying the economy — especially the sham transactions designed for the purpose of creating shares of publicly traded companies?

Since Congress is so focused on Wall Street salaries and bonuses that compensate obscenely paid Wall Street executives, shouldn’t it be asking if these titans of business have reaped financial rewards through the use of SPEs? Beyond that, were offshore SPEs used to avoid taxes or hide improper gains?

Why should we pay anything for the casino gambling debt? If there were illegal profits made on derivatives transactions that created sham shares sold into the marketplace, we should claw back that money, which could amount to a lot more than the bonuses paid to AIG officials.

  AIG, Credit Default Swaps, Crime & Corruption, derivatives, Fraud, Naked Short Selling, SEC, World