Monday, March 16, 2009

Sanctity of Contracts

Over the last few years, AIG sold insurance against defaults on mortgage back securities.  They sold huge amounts of this insurance, at low prices.  Those insurance contracts call for AIG to post bonds which show the ability for AIG to pay, should it's credit rating drop.

Now, because it is supposedly in the U.S. taxpayer's interest that the folks who bought this insurance not suffer any loss, our bailout money is being used to post those bonds.  Furthermore, the people at AIG who misestimated the likelihood of defaults on mortgages, and thus mispriced the insurance, are being paid huge bonuses, again with my money.

AIG's position is that both the bonds and the bonuses are required to be paid by contracts that AIG signed.  Those contracts cannot be abrogated.

Complete crap.  Those contracts can't be abrogated by AIG.  There is no such contractual obligation on the U.S. government.  AIG is failing.  If we let it fail, part of the bankruptcy proceedings will be that some entity, possibly the government, will purchase some portion of the assets.  They make take on some of the liabilities if they so choose, as well.  So, during the bankruptcy proceeding, the government can negotiate with the folks who have claims on AIG's assets to determine what percentage, if any, of those liabilities the government chooses to fulfill.

Since every serious person involved understands this already, the government can renegotiate those credit default swaps even without AIG going bankrupt.  This is called a workout, and it happens between creditors and debtors all the time.  If the debtors don't like the proposed workout, they can force the company into bankruptcy.

As part of this workout, we can reduce the bonuses to the folks that sold the credit default swaps to zero.  If this causes them to be unable to afford their current homes, that is karmic justice.  My guess is that if outraged AIG salespeople attempt to recover a portion of their bonuses by forcing AIG into bankruptcy, they'll be either shot down by a reasonable judge, or just lynched.

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