|
|
The Big Picture
reports about fraud at AIG.
(emphasis mine) [my
comment]
AIG:
Before CDS, There Was Reinsurance
By Chris Whalen - April 2nd, 2009, 5:38AM
Updated!!
Below is the latest issue of The Institutional Risk Analyst. We
did a lot of work on this one. Look forward to your comments.
Also, check out the earlier writings of Lucy Komisar on offshore shenanigans
of AIG and the offshore transaction set:
http://www.ritholtz.com/blog/2009/04/aig-before-cds-there-was-reinsurance-part-2/
– Chris
“What do many corporate buyers of insurance have in common with
American International Group? Perhaps more than they would like to admit.
Like AIG, many companies in the past few years have bought finite insurance,
which transfers a prescribed amount of risk for a particular liability. What
regulators now want to know is, how many companies, like AIG, have used
finite insurance to artificially inflate their financial results?”
Infinite Risk?
CFO Magazine
June 1, 2005
“In the regulatory world, a ’side letter’ is perhaps the
most insidious and destructive weapon in the white-collar criminal’s
arsenal. With the flick of a pen, underhanded executives can cook the books
in enormous amounts and render a regulator helpless.”
Fraud Magazine
July/August 2006
PRMIA Event: Market
& Liquidity Risk Management for Financial Institutions
First, a housekeeping item. On Monday, May 4, 2009, in partnership with the
Federal Deposit Insurance Corporation (FDIC) & the Office of Thrift
Supervision (OTS), the Washington DC chapter of Professional Risk
Managers’ International Association (PRMIA) is presenting an important
day-long conference on managing liquidity and market risk for financial
institutions. Speakers include some of the leading risk practitioners,
investors, researchers, bank executives and regulators in the US financial
community. PRMIA free and sustaining members may
register on the PRMIA web site. Members of the
regulatory community may register via the FDIC University. IRA co-founder
Christopher Whalen will participate in the conference and serve as MC. See
the PRMIA web site for more information on the program and speakers.
And yes, our favorite bank regulator is making the opening remarks.
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.
Does Reinsurance +
Side Letters = CDS?
One of the most widespread means of risk shifting is reinsurance, the act
of paying an insurer to offset the risk on the books of a second insurer.
This may sound pretty routine and plain vanilla, but what most people
don’t know is that often times when insurers would write reinsurance
contracts with one another, they would enter into “side letters”
whereby the parties would agree that the reinsurance contract was essentially
a canard, a form of window dressing to make a company, bank or another
insurer look better on paper, but where the seller of protection had no
intention of ever paying out on the contract.
Let’s say that an insurer needs to enhance its capital surplus by $100
million in order to meet regulatory capital requirements. They can enter into
what appears to be a completely legitimate form of reinsurance contract, an
agreement that appears to transfer the liability to the reinsurer. By doing
so, the “ceding company” - an insurance company that transfers a
risk to a reinsurance company - gets to drop that $100 million in liability
and its regulatory surplus increases by $100 million.
The reinsurer assuming the risk does actually put up the $100 million in
liability, but with the knowledge that they will never have to actually pay
out on the contract. This is good for the reinsurer because they are paid
a fee for this transaction, but it is bad for the ceding company, the insurer
with the capital shortfall, because the transaction is actually a sham, a
fraud meant to deceive regulators, counterparties and investors into thinking
that the insurer has adequate capital. Typically the fee is 6% per year or
what is called a “loan fee” in the insurance industry.
When it operates in this fashion, the whole reinsurance industry could be
described as a “surplus rental” proposition, whereby an insurer
literally loans another insurer capital in the form of risk cover, but with a
secret understanding in the form of a side letter that the loan will be
reversed without any recourse to the seller of protection. You give me $6
million in cash today, and I will give you a promise that we both know I will
never honor.
Does this sound familiar? What our contacts in the insurance industry
describe is almost a precise description of the CDS market, albeit one that
evolved in the reinsurance industry literally decades ago and has been the
cause of numerous insurance insolvencies and losses to insured parties. Or
to put it another way, maybe the inspiration for the CDS market - at least
within AIG and other insurers — evolved from the reinsurance market
over the past two decades.
As best as we can tell, the questionable practice of using side letters to
mask the economic and business reality of reinsurance transactions started in
the mid-1980s and continued until the middle of the current decade. This
timeline just happens to track the creation and evolution of the OTC derivatives
markets. In particular, the move by AIG into the CDS market coincides with
the increased awareness of and attention to the use of side letters by
insurance regulators and members of the state and federal law enforcement
community.
Keep in mind that what we are talking about here are not questionable risk
management policies but acts of deliberate and criminal fraud, acts that
often result in jail time for those involved. As one senior forensic
accountant who has practiced in the insurance sector for three decades told
The IRA:
“In every major criminal fraud case in which I have worked, at the
center of the investigation were these side letters. It was always very
strange to me that on-site investigators and law enforcement officials consistently
found that these side letters were being used to mask the true financial
condition of an insurer, and yet none of the state regulators, the National
Association of Insurance Commissioners (NAIC), nor federal law enforcement
authorities ever publicly mentioned the practice. They certainly did not act
like the use of side letters was a commonplace thing, but it was widespread
in the industry.”
It is important to understand that a side letter is a secret agreement, a
document that is often hidden from internal and external auditors, regulators
and even senior management of insurers and reinsurers. We doubt, for
example, that Warren Buffet or Hank Greenberg knew the details of side
letters, but they should have. Just as a rogue CDS trader at a large bank
like Societe General (NYSE:SGE) might seek to hide losing trades, the
underwriters of insurers would use sham transactions and side letters to
enhance the revenue of the insurer, but without disclosing the true nature of
the transaction.
There are two basic problems with side letters. First, they are a criminal
act, a fraud that usually carries the full weight of an “A”
felony in many jurisdictions. Second, once the side letter is
discovered by a persistent auditor or regulator examining the buyer of protection,
the transaction becomes worthless. You paid $6 million to AIG to shift
risk via the reinsurance, but the side letter makes clear that the
transaction is a fraud and you lose any benefit that the apparent risk
shifting might have provided.
As the use of these secret side letters began to become more and more
prevalent in the insurance industry, and these secret side deals were
literally being stacked on top of one another at firms like AIG, the SEC
began to investigate. And they began to find instances of fraud and to
crack down on the practice. One of the first cases to come to the surface
involved AIG helping Brightpoint (NASDAQ:CELL) commit accounting fraud, a case that eventually led the SEC to
fine AIG $10 million in 2003.
Wayne M. Carlin, Regional Director of the SEC’s Northeast Regional
Office, said of the settlements: “In this case, AIG worked hand in hand
with CELL personnel to custom-design a purported insurance policy that
allowed CELL to overstate its earnings by a staggering 61 percent. This
transaction was simply a ’round-trip’ of cash from CELL to AIG
and back to CELL. By disguising the money as ‘insurance,’ AIG
enabled CELL to spread over several years a loss that should have been
recognized immediately.”
Another case involved PNC Financial (NYSE:PNC), which used various contracts
with AIG to hide certain assets from regulators, even though the transaction
amounted to the “rental” of capital and not a true risk transfer.
As the SEC noted in a 2004 statement:
“The Commission’s action arises out of the conduct of Defendant
AIG, primarily through its wholly owned subsidiary AIG Financial Products
Corp. (”AIG-FP”), (collectively referred to as “AIG”)
in developing, marketing, and entering into transactions that purported to
enable a public company to remove certain assets from its balance sheet.”
Click here to see the SEC statement regarding the AIG transactions with PNC.
The SEC statement reads in part: “In its Complaint, filed in the
United States District Court for the District of Columbia, the Commission
alleged that from at least March 2001 through January 2002, Defendant AIG,
primarily through AIG-FP [AIG-FP is the part of AIG that
wrote all the CDS contracts.], developed a product called a
Contributed Guaranteed Alternative Investment Trust Security
(”C-GAITS”), marketed that product to several public companies, and
ultimately entered into three C-GAITS transactions with one such company, The
PNC Financial Services Group, Inc. (”PNC”). For a fee, AIG
offered to establish a special purpose entity (”SPE”) to which
the counter-party would transfer troubled or other potentially volatile
assets. AIG
represented that, under generally accepted accounting principles
(”GAAP”), the SPE would not be consolidated on the
counter-party’s financial statements. The counter-party thus would be
able to avoid charges to its income statement resulting from declines in the
value of the assets transferred to the SPE. The transaction that AIG
developed and marketed, however, did not satisfy the requirements of GAAP for
nonconsolidation of SPEs.”
In both cases, AIG was engaged in transactions that were meant not to
reduce risk, but to hide the true nature of the risk in these companies from
investors, regulators and the consumers who rely on these institutions for
services. Keep in mind that while the SEC did act to address these issues, the
parties involved received light punishments when you consider that these are
all felonies that arguably would call for criminal prosecution for fraud,
securities fraud, conspiracy and racketeering, among other things. Indeed,
this is one of those rare cases where we believe AIG itself, as a corporate
person, should be subject to criminal prosecution and liquidation.
Birds of a Feather:
AIG & GenRe
Click here to
see a June 6, 2005 press release from the SEC detailing criminal charges
against John Houldsworth, a former senior executive of General Re Corporation
(”GenRe”), a subsidiary of Berkshire Hathaway (NYSE:BRKA), for
his role in aiding and abetting American International Group, Inc. in
committing securities fraud.
The SEC noted: “In its complaint filed today in federal court in
Manhattan, the Commission alleged that Houldsworth and others helped AIG
structure two sham reinsurance transactions that had as their only purpose to
allow AIG to add a total of $500 million in phony loss reserves to its
balance sheet in the fourth quarter of 2000 and the first quarter of 2001.
The transactions were initiated by AIG to quell criticism by analysts
concerning a reduction in the company’s loss reserves in the third
quarter of 2000.”
But the involvement of the BRKA unit GenRe in the AIG mess was not the first
time that GenRe had been involved in the questionable use of reinsurance
contracts and side letters.
Click
here to see an example of a side letter that was made
public in a civil litigation in Australia a decade ago. The faxed letter,
which bears the ID number from the Australian Court, is from an insurance
broker in London to Mr. Ajit Jain, a businessman who currently heads several
reinsurance businesses for BRKA, regarding a reinsurance contract for FAI
Insurance, an affiliate of HIH Insurance.
Notice that the letter states plainly the intent of the transaction is to
bolster the apparent capital of FAI. Notice too that several times in
the letter, the statement is made that “no claim will be made before
the commutation date,” which may be interpreted as being a warranty by
the insured that no claims shall be made under the reinsurance policy. By
no coincidence, HIH and FAI collapsed in a $5.3 billion dollar fiasco that
ranks as Australia’s biggest ever corporate failure.
Click here to
read a March 9, 2009 article from The
Age, one of Australia’s leading business publications,
regarding the collapse of HIH and FAI.
In 2003, an insurer named Reciprocal of America (”ROA”) was
seized by regulators and law enforcement officials. An investigation ensued
for 3 years. According to civil lawsuits filed in the matter, GenRe provided
finite insurance to ROA in order to make the troubled insurer look more
solvent than it was in reality. Several regulators and law enforcement
officials involved in that case tell The IRA that the ROA failure forced
insurers like AIG and Gen Re to start looking for new ways to “cook the
books” because the long-time practice of side letters was starting to
come under real scrutiny.
“These reinsurance deals made ROA look better than it really
was,” one investigator with direct knowledge of the ROA matter tells
The IRA. “They went into the ROA home office in VA with the state
insurance regulators and law enforcement, and directed the employees away
from the computers and records. During that three-year investigation, GenRe
learned that local regulators and forensic examiners had put everything
together and that we now understood the way the game was played. I
believe the players in the industry realized that that they had to change the
way in which they cooked the books. A sleight- of-hand trick that had worked
for 25 years under the radar of regulators and investors was now
revealed.”
Several senior officials of ROA eventually were prosecuted, convicted of
criminal fraud and imprisoned, but DOJ officials under the Bush
Administration reportedly blocked prosecution of the actual managers and
underwriters of ROA who were involved in these sham transactions, this even
though state officials and federal prosecutors in VA were anxious to proceed
with additional prosecutions.
AIG: From
Reinsurance to CDS
While some reinsurers are large, well-capitalized entities that generally
avoid these pitfalls, AIG was already a troubled company when it began to
write more and more of these risk-shifting transactions more than a decade
ago. It is easy to promise the moon when people think that they can deliver,
but because AIG and their clients saw how easy it was to fool regulators and
investors, the practice grew and most regulators did absolutely nothing to
curtail the practice.
It was easy for AIG to become addicted to the use of side letters. The
firm, which had already encountered serious financial problems in 2000-2001,
reportedly saw the side letters as a way to mint free money and thereby help
the insurer to look stronger than it really was. AIG not only helped banks
and other companies distort and obfuscate their financial condition, but AIG
was supplementing its income by writing more and more of these reinsurance
deals and mitigating their perceived exposure via side letters.
A key figure in AIG’s reinsurance schemes, according to several
observers, was Joseph Cassano, head of AIG-FP. Whereas the traditional
use of side letters was in reinsurance transactions between insurers, in the
case of both CELL and PNC neither was an insurer! And in both cases, AIG used
sham deals to make two non-insurers, including a regulated bank holding
company, look better by manipulating their financial statements. Falsifying
the financial statements of a bank or bank holding company is an felony.
AIG-FP was simply doing for non-insurers what was common practice inside
the secretive precincts of the insurance world. The SEC did investigate
and they did finally obtain a deferred prosecution agreement with AIG, which
was buried in the settlement with then-New York AG Elliott Spitzer.
The key thing to understand is that if you look at many of these
reinsurance contracts between ROA and Gen Re, they look perfect. They
appear to transfer risk and seem to be completely in order. But, if you
don’t get to see the secret agreement, the side letter that basically
says that the reinsurance contract is a form of window dressing, then you
cannot understand the full implications of the transaction, the reinsurance
agreement. Not, several experts speculate, can you understand why AIG
decided to migrate away from reinsurance and side letters and into CDS as a
mechanism for falsifying the balance sheets and earnings of non-insurers.
Several observers believe that at some point in the 2002-2004 period,
Cassano and his colleagues at AIG began to realize that state insurance
regulators and the FBI where on to the reinsurance/side letter scam. A
number of experts had been speaking and writing about the issue within the
accounting and fraud communities, and this attention apparently made AIG move
most of its shell game into the world of CDS. By no coincidence, at around
this time side letters began to disappear in the insurance industry, suggesting
to many observers that the industry finally realized that the jig was up.
It appears to us that, seeing the heightened attention from regulators and
federal law enforcement agencies such as the FBI on side letters, AIG began
to move its shell game to the CDS markets, where it could continue to falsify
the balance sheets and income statements of non-insurers all over the world,
including banks and other financial institutions.
AIG’s Cassano even managed to hide the activity in a bank subsidiary of
AIG based in London and under the nominal supervision of the Office of Thrift
Supervision in the US, this it is suggested to hide this ongoing activity
from US insurance regulators. Even though AIG had been investigated and
sanctioned by the SEC, Cassano and his colleagues at AIG apparently were
recalcitrant and continued to build the CDS pyramid inside AIG, a financial
pyramid that is now collapsing. The rest, as they say is history.
Now you know why the Fed and EU officials are so terrified about an AIG
liquidation, because it will result in heavy losses to or even the insolvency
of banks and other corporations around the globe. Notice that while
German Chancellor Angela Merkel has been posturing and throwing barbs at
President Obama, French President Nicolas Sarkozy has been conciliatory
toward the US.
But for the bailout of AIG, you see, President Sarkozy would have been forced
to bailout SGE for a second time in two years. So long as the Fed and
Treasury can subsidize AIG’s mounting operating losses, the EU will be
spared a financial bloodbath. But this situation is unlikely to remain stable
for long with members of the Congress demanding an investigation of the past
bailout, a process that can only result in bankruptcy for AIG.
Are the CDS
Contracts of AIG Really Valid?
The key point is that neither the public, the Fed nor the Treasury seem to
understand is that the CDS contracts written by AIG with these various
non-insurers around the world were shams - with no correlation between
“fees” paid and the risk assumed. These were not valid contracts
as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy
guru Larry Summers claim, but rather acts of criminal fraud meant to
manipulate the capital positions and earnings of financial companies around
the world.
Indeed, our sources as well as press reports suggest that the CDS
contracts written by AIG may have included side letters, often in the form of
emails rather than formal letters, that essentially violated the ISDA
agreements and show that the true, economic reality of these contracts was
fraud plain and simple. Unfortunately, by not moving to seize AIG
immediately last year when the scandal broke, the Fed and Treasury may have
given the AIG managers time to destroy much of the evidence of criminal
wrongdoing.
Only when we understand how AIG came to be involved in CDS and the fact
that this seemingly illegal activity was simply an extension of the
reinsurance/side letter shell game scam that AIG, Gen Re and others conducted
for many years before will we understand what needs to be done with AIG,
namely liquidation. Seen in this context, the payments made to AIG by
the Fed and Treasury, which were then passed-through to dealers such as
Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be
reversed once the US Trustee for the Federal Bankruptcy Court for the
Southern District of New York is in control of AIG’s operations.
(Editor’s note: Officials of BRKA and GenRe did not respond to
telephonic and email requests by The
IRA seeking comment on this article. An official of AIG did
respond but was not willing to comment on-the-record for this report. We
shall be happy to publish any written comments that BRKA, AIG or GenRe have
on this article.)
My reaction: What
do you know: the entire US financial system WAS a Ponzi scheme.
1) By the time AIG had entered the CDS market five years ago, the firm was
already doomed.
2) When AIG wrote hundreds of billions of dollars in CDS contracts, neither
AIG nor the counterparties believed that the CDS would ever be paid.
3) What most people don't know is that often times when insurers would write
reinsurance contracts with one another, they would enter into "side
letters" whereby the parties would agree that the reinsurance contract
was essentially a canard, a form of window dressing to make a company, bank
or another insurer look better on paper.
4) A side letter is a secret agreement, a document that is often hidden from
internal and external auditors, regulators and even senior management of
insurers and reinsurers.
5) There are two problems with side letters:
A) They are a criminal act
B) Once the side letter is discovered, the transaction becomes worthless.
6) Reinsurance contracts with these “side letters” are bad for the
insurer with the capital shortfall because the transaction is actually a
sham.
7) The fraudulent practice of using side letters to mask the economic and
business reality started in the mid-1980s and continued until the middle of
the current decade.
8) The use side letters constitutes an act of deliberate and criminal fraud
9) As explained by one senior forensic accountant who has practiced in the
insurance sector for three decades, "In every major criminal fraud case
in which I have worked, at the center of the investigation were these side
letters.”
10) The inspiration for the CDS market probably evolved from the reinsurance
market over the past two decades.
11) As the use of these secret side letters began to become more and more
prevalent in the insurance industry, the SEC began to investigate.
12) AIG not only helped banks and other companies distort and obfuscate their
financial condition, but AIG was supplementing its income by writing more and
more of these reinsurance deals and mitigating their perceived exposure via
side letters.
12) The move by AIG into the CDS market coincides with the increased
awareness of and attention to the use of side letters by insurance regulators
and members of the state and federal law enforcement community.
13) Several sources as well as press reports suggest that the CDS contracts
written by AIG may have included side letters
14) Seeing the heightened attention from regulators and federal law
enforcement agencies on side letters, AIG began to move its shell game to the
CDS markets, where it could continue to falsify the balance sheets and income
statements of non-insurers all over the world
15) Now you know why the Fed and EU officials are so terrified about an
AIG liquidation, because it will result in heavy losses to or even the
insolvency of banks and other corporations around the globe.
16) The position of Feb Chairman Ben Bernanke and Treasury Secretary Tim
Geithner that the AIG credit default contracts are "valid legal
contracts" is ridiculous
17) the payments made to AIG by the Fed and Treasury, which were then
passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed
as an illegal taking that must be reversed
Conclusion: The entire US financial system is a giant fraud, which the
fed is trying to prop up by printing money and destroying the dollar…
Eric de Carbonnel
Market Skeptics
Support Market Skeptics with a donation :
please click
here
Also
by Eric de Carbonnel
| |
