Much of the media attention on Capitol Hill over the past two weeks has focused on the $165 million in bonuses paid to AIG employees, but many have begun to point the finger at what they say is the “real outrage,” so-called “counterparty payments” from AIG to other financial institutions. The counterparty question has gained substantial steam on the internet and in certain corners of the mainstream media. Geithner was asked directly about these payments during the hearing today in Congress.
So what exactly is a counterparty payment?
When one party (such as a bank or a corporation) enters a financial agreement with another party, there is always a certain amount of “counterparty risk,” that is to say that there is a chance the borrower won’t pay their debt or otherwise fulfill their side of the deal.
AIG was in the middle of a LOT of deals on Wall Street and around the world, involving all kinds of financial instruments. In particular they were insuring a lot of this counterparty risk. So when AIG suddenly ran out of money last year, they took the federal TARP bailout funds they received, and paid their counterparties. In AIG’s case, the counterparties included the world’s biggest banks. AIG ended up paying $12.9 billion to Goldman Sachs, and similar amounts to Bank of America, Merrill Lynch, Germany’s Deutsche Bank AG, and France’s Société Générale.
A (very) simplified example, using three parties, Alex, Bob, and Carl:
Alex wants to borrow $100 from Bob, but Bob is worried that Alex won’t pay him back. So Alex tells Bob to give him some collateral. Bob doesn’t have anything worth $100, but he does have a little money. His friend Carl offers to make him a deal: if Alex goes bankrupt, Carl will pay Bob the $100 he is owed. In exchange, Alex pays Carl a smaller amount, maybe $5.
A month later, Alex loses his job and can’t pay his debt. Alex tells Carl what happened, but Carl admits he doesn’t have the $100 he owes Bob. Carl asks the government for help, and with some new capital from the Treasury, Carl pays Alex (his counter party), Alex pays Bob (all of this with taxpayer dollars).
Now just multiply that scenario by a billion or two, and you’ve got some idea of what’s happening with AIG.
One Comment
Great simple analogy but it also misses the impact of these transactions on the reported GDP growth of the Bush era, which easily seen as an accounting illusion.
For example, the fact that Alex doesn’t have the $100 because he spent it on something. This kind of calculation allowed GDP to appear robust (after all, Alex just bought a $100 dinner or new car or something), but the debt supporting this was kept off the books.
This is a great summary of American capitalism: If you win, you (personally) get paid through salary and bonus from a corporation. If you lose, you (personally) lose nothing, with one of two possible corporate outcomes: either the company you made the bet for simply walks away (Lehman) or gets government money (AIG).
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