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The AIG morality play, coming to a town near you

The collective knickers certainly are in a twist. People who had never heard of the insurance giant AIG 15 minutes ago are suddenly in a swivet over the bonuses being paid to some of its executives. According to a Drudge Report headline "AIG outrage has employees living in fear." Meanwhile, Obama is calling for sweeping new regulation of executive pay at banks, hedge funds, and "other companies." What an opportunity! An economic situation that features not only public fear but also public anger. Believe me, we're going to be treated to a lot of moralizing lectures about the evils of "greed" from our elected representatives not to mention journalists from establishments like of The New York Times. The whole skit reminds me of that classic performance by Representative Maxine Waters endeavoring to grill executives from Citibank, Bank of America, et al. She was so outraged at the idea that they were paying themselves fees from the money Congress had expropriated from the taxpayers that she did not mind making a fool of herself by demonstrating beyond cavil a complete ignorance about the banking business. The best scene is four or five minutes in to the clip when the CEO of Bank of America says: "I have no idea what you are talking about." Really, it was a choice moment.

But back to AIG. Last fall, the company got a huge government bailout worth some $170 billion. The company recently awarded derivative traders in one of its subsidiaries $165 million n bonuses. Was that a bad thing? More to the point, was it an avoidable thing? This is the question the redoubtable Edward Jay Epstein asks, and his basic answer is no, it wasn't avoidable.

As Epstein explains, for more than a decade some 400 traders in a London-based subsidiary of AIG have managed $1.6 trillion in derivative contracts for the company. It's an interesting story:

In 1998, this tiny group got into the newly-created credit default swap business when JP Morgan Chase came to it with a proposition to transform debt on its books into security packages that could be sold off its books. To make these bank debt packages salable to other institution, they needed credible insurance against default to get Triple-A rating. So the AIG financial product group, seeing no risk of default, sold it in the form of credit default swaps. Soon afterwards, with the support of Treasury Secretary Lawrence Summers (now President’s Obama’s economic advisor), the Commodity Futures Modernization Act was passed, which excluded credit default swaps from being considered a "security" under the jurisdiction of the SEC or any other government agency. This act allowed these swaps to be deployed on a massive scale to convert all kinds of debt, including even subprime mortgages and car loans, into triple A securities and turned AIG’s arm, now headed by Joseph J. Cassano, an aggressive Brooklyn-born alumni of Drexel’s back office operations, into a multi-billion dollar profit center for the insurance behemoth. Even though the unit’s 400 or so traders constituted less than one-third of one percent of AIG’s loyal employees, it produced close to twenty percent of its total operating profits. While Cassano kept the list of his counter parties in the credit default swaps a closely held secret, he bragged at a conference in 2007 that they included a global swath of “investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.” By 2006, his group was raking in nearly $4 billion in profits, and, as is the tradition in the derivative game, he and his traders got a rich cut of the loot, which on average amounted to roughly $1.1 million a trader.

So far, so good, right? No complaints then. These guys were coining money and a lot of people got rich, spent their money, and made a lot of people happy.