There is a lot of outrage and questioning why 'tough love' is not being exercised with the banks and financial institutions similar to the auto industry. I think this article from the WSJ helps explain why. It is about another part of AIG, Banque AIG, basically another form of its financial products division for European banks and the current fire that the resignation of two managers is causing in Europe.
Representatives of the Federal Reserve, AIG's lead U.S. overseer, are talking with French regulators and AIG officials to deal with the consequences of a complicated legal scenario in which the departures of the managers in Banque AIG, a subsidiary of AIG's Financial Products unit, could trigger defaults in $234 billion of derivative transactions, according to people familiar with the situation and a document AIG provided to the U.S. Treasury.
The bonus flap was cover for this more important issue. The mangers of these derivative contracts wrote triggering clauses into the language of the contracts that could bring the whole house of cards crashing down.
The executives at Paris-based Banque AIG, Mauro Gabriele and James Shephard, have resigned in recent days but have agreed to stay on for a transition, according to people familiar with the matter. In the wake of their resignations, AIG must replace them to the satisfaction of French banking regulators.
If they don't, French regulators may appoint their own designee to manage the bank -- an outcome that could trigger defaults under the bank's derivative contracts. The private contracts say that a regulator's appointment of a manager constitutes a change in control, according to a person familiar with the matter; the provision is often included in derivative contracts where parties want to preserve a way out if something about their counterparties changes.
So basically AIG has written derivatives that will default if the current management creating and shepherding these contracts is somehow changed or removed.
So how much exposure do European banks have with these cocked and loaded contracts.
Representatives of the Federal Reserve, AIG's lead U.S. overseer, are talking with French regulators and AIG officials to deal with the consequences of a complicated legal scenario in which the departures of the managers in Banque AIG, a subsidiary of AIG's Financial Products unit, could trigger defaults in $234 billion of derivative transactions, according to people familiar with the situation and a document AIG provided to the U.S. Treasury.
And so what would defaults do to the European banking system? Basically if there are massive derivative defaults then the banks would have to get real capital to replace the 'capital' that the derivatives have provided. Like their counterparts in the US, European banks have been using CDSes to allow them to get around their reserve requirements so that they could provide more credit.
And this is tied to the bonus flap. From the Agonist
The lawyers said breaching the contracts would expose AIG to serious consequences. First, under Connecticut law the parent company could be sued by the employees for willful abrogation of a legal contract. The suits would be easy to win and the penalty is double the amount under dispute. Second, all of AIG’s derivatives contracts around the world have standard cross-default clauses, which say that if AIG fails to make a payment in excess of $25 million, all swaps, options and similar derivatives contracts could be placed in default. Failing to make this bonus payment of $165 million could lead to massive claims of default against AIG on all of its derivatives contracts.
So we dodged a bullet with AIG making the payout and then getting their executives to return the bonuses. But what this means is AIG structured it's derivative contracts to protect the bonus payments and to protect the system as it is, ie the 'contractual obligations' that Summers and Geithner talked about prior to the bonus blow-up. Our economic leadership knows and understands the gun pointed at our government's head. The question becomes, why aren't they talking about it? Why aren't they directing the outrage and anger toward these contracts? And why aren't they talking about other triggering clauses that may be in these contracts that will force the govt (or govts) to continue to prop up and bailout this predatory system?
And this isn't going into all the derivative bets that are gambling on the failure of AIG and GM. So maybe it isn't just a gun but many many guns pointed at the head of the US government.
There will not be any serious change in the financial industry until these derivatives are voided. These contracts are the taproot of the crisis, drawing all the resources from the soil of our common future. And without serious change in the financial industry, we will see many more companies and individuals be forced to suffer bankruptcy and unemployment to ensure the returns promised by these hedging bets. The derivatives market is notionally a quadrillion dollars. This is insane.