Why it's all worse than even the gloomiest think

Amazing article on how the insurance industry works and why were are all doomed. A bit of a challenge if you aren't used to reading about CDOs and CDEs, etc., but a rewarding piece if you dig your teeth into it. Read it, then read it again. Then cry.

The article: "AIG: Before Credit Default Swaps, There Was Reinsurance"
Link:
us1.institutionalriskanalytics.com...

the Silent Thunder Executive Summary: The insurance industry since WWII has basically been a gigantic pyramid scheme where the risk is shuffled off in an ever-more-confusing shell game of entities and entites-of-entities. AIG and other insurers have relied for many years on a blatantly illegal practice known as writing "side letters." This cannot continue, but because it involves so many banks and big companies around the globe, if AIG or another big insurer goes under, the entire global financial system could collapse in a single blast.


A few tasty tidbits...

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.

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.

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...

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.

Isn't money itself a kind of shell game? In a classic shell game the possiblilty that you can honestly win is a complete illusion. Due to slight-of-hand the pea isn't really under any of the cups until the propietor picks up one of the cups that you didn't pick and shows you another pea on the felt while telling you, "sorry, the pea's over here"!. Money is nothing more than a "promissory note", it's a piece of paper that claims that it is backed by something of real "value", like gold. But what is the source of gold's value other than our willing participation in a game that claims that this soft, malleable and sparkely lump of metal somehow contains within its mass an intrinsic worth? As metals go it is completely worthless for fashioning tools since it is too soft to make a good hammer. It is valued because the human species thinks that it is pretty and chooses to adorn itself with easily fashioned baubbles that are made of the stuff. So it is only human vanity that gives this otherwise useless metal any value at all. In a survival situation gold would be useless and valueless. The sad truth is that real people have been forced to experience catastrophic loss and deprivation all in the name of continuuing to pretend that money has any real worth at all. Money is the equivalent of those corrupt gods in the Hercules movies that demand systematic blood sacrifices. Real human beings have to suffer so that it can exist.

Originally posted by godless
Isn't money itself a kind of shell game? In a classic shell game the possiblilty that you can honestly win is a complete illusion. Due to slight-of-hand the pea isn't really under any of the cups until the propietor picks up one of the cups that you didn't pick and shows you another pea on the felt...

Yes, this is valid but even these games have rules that can be broken. The example in the article contains massive, blatant, and in-yer-face illegal action, as well as stuff like ignoring GAAP guidelines and just deciding to create entities that are against the law. Very crass, they don't even bother to hide it.

To use your analogy, it would be like the shell-game man not even trying to hide the pea, just sticking it under any old cup, lazily belching, and leaning back in his chair while you pick the correct cup. "I found the pea," you say. "No you didn't" says the guy. "Yes I did, look, its right here. give me my money." The con replies, "Geddouda here while you still have two good legs, before I have my goons beat the tar out of you and take your wallet. Now scram." That is the kind of thing going on here.

[edit on 4/2/09 by silent thunder]