American International Group Inc. (NYSE: AIG) looks to be in the soup again.  Reports of two top executives in Paris quitting the firm may leave AIG with a big black hole that could end up triggering defaults in vast numbers of trading contracts.  This is far from certain, but the amount be thrown out there is  $234 billion in derivatives transactions.   It’s just like Yogi’s Berra’s deja vu all over again.

The WSJ was the one that got the ball rolling on this.  It  noted that this is “an unlikely but expensive situation in which billions in AIG trading contracts could default.”   The paper also said that US and EU regulators are speaking about how these departures could trigger defaults.

We have done some digging around on this for our own take and there are some considerations in this matter.  This does not mean that there is going to suddenly be a real $234 billion due upon demand.  At least, that is our understanding.  But European banks did use the Banque AIG unit to hedge risks and exposure.  While this would likely include corporate debt or mortgage risks, it could ultimately involve many types of securities which are ultimately backed by collateral.

AIG apparently has to replace these executives with individuals approved by French regulators.  There is just one problem here.  Who wants to go work at AIG, whether in the U.S. or abroad?  AIG can call around with great promises of $10 million per year, and most of the individuals who get the call would likely hang up or say “thanks, but no thanks.”

French regulators might actually appoint their own designee(s) if these vacancies (and possibly others) are not filled.  This would even possibly go beyond a change of control clause in many contracts.  A contract is a contract, but there are not necessarily automatic binding terms if a change in control occurs in the counterparties.

The good news is that the executives in France have agreed to stay on for a transition period. But employees who are on the way out the door generally tend to slow down their work, tend to take longer lunches, tend to leave earlier, and on and on.  That is generally true even in the executive suites.

AIG’s CEO Edward Liddy has said that employees need to kept on board while the company winds down and sells off pieces to limit the exposure.  That part of the business (financial products) is still believed to have well in excess of $1 trillion in trades or contracts that are still outstanding.  No matter what the market is, that amount of transactions cannot be unwound in short order.

In the worst case scenario (actually the second to worst case) this could force AIGFP counterparties in the E.U. to raise more capital to offset these obligations.  Again, that is just the “second to worst case” scenario.  The worst case is that this could create another run on the banks that leaves more and more financial companies in a situation where they become mathematically insolvent all over again.

What the actual exposure really is probably won’t be known for some time.  We have asked around to contacts of our own and the answers range from worse to better to completely unknown.

Either way, one thing is certain.  AIG cannot afford to have to go back to any government branch with its hat in hand.  Not right now.  The bonus issue is not resolved.  The Congressional powers in charge are still using “AIG” in every other sentence.  Bernanke and Geithner are probably not in a position today to deflect any additional capital needs this soon, even though they have warned that AIG (and others) may need additional capital infusions in the future.

The good news is that AIG stock is down only 2.5% at $1.18 at 11:00 AM EST.  The near-term odds of a sudden call on capital seem rather low.  But any more “new developments” will only create more of an overhang against AIG and all of its counterparties.  It is still the position that the U.S. has not absorbed AIG entirely because it does not want to take on all of the liabilities that would be triggered.  It doesn’t want to add this vast sum to the balance sheet, and it can’t afford the fallout if all of the remaining financial contracts just failed.  Imagine if millions of retirement beneficiaries, insurance policy holders, and the numerous counterparties were suddenly defunct.  The media reports wouldn’t be showing members of the government calling for outrage.  The media would be broadcasting something akin to the French Revolution.

JON C. OGG
March 26, 2009

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