Chris Whalen:

For some time now, we have been trying to reconcile the apparent paradox of American International Group (NYSE:AIG) walking away from the highly profitable, double-digit RAROC business of underwriting property and casualty (P&C) risk and diving into the rancid cesspool of credit default swaps (”CDS”) contracts and other types of “high beta” risks, business lines that are highly correlated with the financial markets.

In our interview with Robert Arvanitis last year, “‘Bailout: It’s About Capital, Not Liquidity; Seeking Beta: Interview with Robert Arvanitis’, September 29, 2008,” we discussed the difference between high and low beta. We also learned from Arvanitis, who worked for AIG during much of the relevant period, that the decision by Hank Greenberg and the AIG board to enter the CDS market was, at best, chasing revenue. No rational examination of the business opportunity, assuming that Greenberg and his directors were acting based on a reasoned analysis, could have resulted in a favorable decision to pursue CDS and other “high beta” risks, at least from our perspective.

In an effort to resolve this conundrum, over the past several months The IRA has interviewed a number of forensic experts, insurance regulators and members of the law enforcement community focused on financial fraud. The picture we have assembled is frightening and suggests that, far from just AIG, much of the insurance industry has been drawn into the world of financial engineering and has thus become part of the problem. Below we present our preliminary findings and invite your comments.

One of the first things we learned about the insurance world is that the concept of “shifting risk” for a variety of business and regulatory reasons has been ongoing in the insurance world for decades. Finite insurance and other scams have been at least visible to the investment community for years and have been documented in the media, but what is less understood is that firms like AIG took the risk shifting shell game to a whole new level long before the firm’s entry into the CDS market.

In fact, our investigation suggests that by the time AIG had entered the CDS fray in a serious way more than five years ago, the firm was already doomed. No longer able to prop up its earnings using reinsurance because of growing scrutiny from state insurance regulators and federal law enforcement agencies, AIG’s foray into CDS was really the grand finale. AIG was a Ponzi scheme plain and simple, yet the Obama Administration still thinks of AIG as a real company* that simply took excessive risks. No, to us what the fraud Bernard Madoff is to individual investors, AIG is to the global financial community.

As with the phony reinsurance contracts that AIG and other insurers wrote for decades, when AIG wrote hundreds of billions of dollars in CDS contracts, neither AIG nor the counterparties believed that the CDS would ever be paid. Indeed, one source with personal knowledge of the matter suggests that there may be emails and actual side letters between AIG and its counterparties that could prove conclusively that AIG never intended to pay out on any of its CDS contracts.

The significance of this for the US bailout of AIG is profound. If our surmise is correct, the position of Feb Chairman Ben Bernanke and Treasury Secretary Tim Geithner that the AIG credit default contracts are “valid legal contracts” is ridiculous and reveals a level of ignorance by the Fed and Treasury about the true goings on inside AIG and the reinsurance industry that is truly staggering.

I guess I see all the "have we reached bottom" material floating about these days as fundamentally off point; indeed, premature triumphalism so characteristic of OFB-style instrumentalism. How can a system so corrupt and so broken be said to "recover"? We've never seen the loan tapes! We still don't know how big The Big Shitpile is! What does recovery look like in such circumstances?

NOTE * If you're more cynical, you think they identify a Ponzi scheme with being a "real company."