[Corp. Watch] Time to shut down the Wall Street casino -- and the illegal betting it creates

[Corporation Watch]

The Real AIG Scandal: How the Game Is Rigged at Wall Street's Casino

  By Lucy Komisar

(AlterNet, March 26) -- There's nothing like a grandstanding member of  
Congress to deflect attention from the real issues at hand by throwing  
a few juicy bones to the masses.

	Most legislators at a House Finance subcommittee hearing last week  
deftly avoided the real story of AIG's collapse. Instead, they homed  
in on the public relations disaster of hundreds of top AIG officials  
and staff getting $165 million (later revealed to be over $218  
million) in bonuses.

	The key issue ignored by the Congressional representatives was the  
potential catastrophe represented by as much as $2.7 trillion in AIG  
derivative contracts, and how AIG and the U.S. government are dealing  
with them.

	(To put that number in context, we've so far provided the company  
only about $170 billion; this is more than 15 times more than that.)

	An exception at the hearing was Rep. Joe Donnelly (D-Ind.), who  
declared that "naked credit default swaps" were little more than  
"gambling ... dreamed up" by Wall Street to create additional profits,  
and he suggested that instead of being bailed out, "when the casino  
goes bust, the guys who are gambling close shop."

	He noted that if ordinary citizens acted the same way as the titans  
of Wall Street had, they'd be in jail. But Donnelly never got to  
explain what he meant by "naked credit default swaps."

	We did learn early at the hearing that the Federal Reserve is in  
charge of overseeing AIG. The Fed is strongly influenced by some of  
the same big banks and brokerages that are getting AIG payouts and  
taxpayer funding.

	These firms opposed regulating credit default swaps, other  
derivatives and naked short selling (which are explained below). That  
should have set the stage for the rest of the questions, not to  
mention an investigation into where, exactly, all that money that AIG  
received went.

More Money for AIG

	We discovered in passing at the hearing that AIG has $1.6 trillion of  
derivatives left to "unwind" -- the mess remaining of the AIG  
derivatives debacle. Nobody asked the basic details of how the other  
$1.1 trillion were "unwound", or how the rest will be dealt with.

	And nobody got an answer to the question of how much more in taxpayer  
money it will take to finish the job, and who will benefit from this  
unwinding process.

	Or, given that the U.S. government is now in the derivatives business  
-- through its financial support not only of AIG, but also of  
Citigroup ($300 billion in guarantees) and other financial companies  
-- how much taxpayer money may be required to pay off those firms'  
derivatives bets.

Derivatives

	Derivatives are financial instruments derived from something else,  
hence the name. (In the lingo of Wall Street, nouns are turned into  
verbs and verbs beget nouns.)

	If a bank or brokerage firm "securitizes" debt -- for example,  
turning a bundle of mortgages into financial products -- the resulting  
securities are derived from those mortgages, thus they are mortgage  
"derivatives."

	They can be sliced and diced and sold and -- at the insistence of  
Wall Street powers and their representatives in Washington -- the  
derivative transactions are unregulated.

	Central to AIG's demise were derivative credit default swaps (CDSs),  
basically insurance on financial deals. Some people bought insurance  
against their houses burning down, but others -- without a house at  
risk -- made bets on somebody else's house burning down.

	The first type of contract should be seen as legitimate. But should  
U.S. taxpayers, who own nearly 80 percent of AIG, pay off a wager that  
somebody else's house would burn down in this financial casino Wall  
Street built out of the ashes of cut-and-burn deregulation?

	More importantly: Should they pay off the wager if there are  
indications that the game may have been rigged in the first place?

Hedging the Bets

	Derivatives contracts on stocks can be "hedged" with a short sale --  
selling a stock that you've borrowed. You borrow the stock at a  
certain price, sell it to someone else, and then hope the price of the  
stock goes down.

	At which point, you buy the same security for less and give it back  
to the lender, thereby gaining a profit from the difference the price  
you sold it for (after you borrowed it) and the price you bought it  
back for when you returned it to the lender.

	"Naked" short selling is selling shares you never borrowed in the  
first place: It's selling counterfeit securities -- or, in essence,  
selling thin air. On a large scale, it pushes down share prices, as  
the supply of shares -- ballooned by those phantom shares -- outweighs  
demand.

	The real efforts of the Securities and Exchange Commission (SEC) to  
stopping naked short selling have been on a par with its interest in  
investigating Bernie Madoff.

	A newly released report from the Office of Inspector General revealed  
that the SEC received 5,000 complaints about naked short selling of  
stocks in 2007 and 2008, all of which led to exactly zero enforcement  
actions by the SEC.

A Market Ripe for Fraud and Manipulation

	Here’s how naked short selling relates to manipulation of CDSs, which  
at one time had a face value of $60 trillion. Christopher Cox, who  
took no meaningful action on the matter while he was head of the SEC,  
described the problem in testimony to Congress:


> "Holding a credit default swap is effectively, or nearly  

> effectively, taking a short position in the underlying [assets] ...  

> and because CDS buyers don’t have to own the bond or the debt  

> instrument upon which the contract is based, they can effectively  

> naked short the debt of companies without any restriction,  

> potentially causing market disruption and destabilizing the  

> companies themselves. This market is ripe for fraud and  

> manipulation. This is a problem we have been dealing with, with our  

> international regulatory counterparts around the world with straight  

> equities [ordinary stock], and it’s a big problem in a market that  

> has no transparency and people don’t know where the risk lies."


	The highest profit from these types of contracts comes when the  
security that is the asset for the contract declines to a price of  
zero. Derivative trades are often sham transactions between  
cooperating dealers designed solely to create shares to sell into the  
public market.

	Securities prices can be driven downward through naked short selling.  
Even though derivatives are unregulated transactions, the stock  
manipulation that occurs from the sham transactions that create the  
naked short shares is regulated, and is illegal under U.S. securities  
laws.

	If the derivatives contracts were hedged with a short sale by the  
sellers, they have already received profit from the sale of the  
securities they did not own.

More Transparency Needed: Where Does the Money go?

	Derivatives trades are generally accounted for by the big broker  
dealers (the ones now getting taxpayer money) as "off balance sheet"  
transactions.

	They are hidden from regulators and investors via so-called "special  
purpose entities" (SPEs), which can be offshore and presumably are for  
the profit of elite special partners or clients of these same firms.

	So, we need to know a lot more about the derivative contracts that  
AIG and others on Wall Street are paying out from taxpayer funds. Who  
made these derivative trades? Did they own the underlying assets or not?

	 Did the parties who received money from the taxpayers write sham  
contracts to create shares to sell and then naked short sell  
securities they didn't own into the U.S. markets? Is AIG paying on  
"losses" for which no claims have yet been made?

	Shouldn't Congress, the Fed (which is overseeing AIG), and law  
enforcement agencies be investigating the SPEs and the money they  
received? Shouldn't they investigate whether it was obtained illegally?

	Should the U.S. taxpayer come to the aid of the largest U.S. banks  
and brokerages that created these fancy off-balance-sheet financial  
instruments without full disclosure to at least one government agency  
of the money in SPE accounts?

	How can Congress make intelligent regulations without understanding  
the scope of the problem, and the trading techniques they are trying  
to regulate -- especially the sham transactions designed for the  
purpose of creating shares of publicly traded companies?

	Since Congress is so focused on Wall Street salaries and bonuses that  
compensate obscenely paid Wall Street executives, shouldn't it be  
asking if these titans of business have reaped financial rewards  
through the use of SPEs?

	Beyond that, were offshore SPEs used to avoid taxes or hide improper  
gains? And finally, why should the taxpayers pay anything for what is  
essentially casino gambling debts?

	To the contrary: If illegal profits were made on derivatives  
transactions that created sham shares sold into the marketplace, we  
should claw back that money, which could amount to a lot more than the  
bonuses paid to AIG officials.

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Lucy Komisar is an investigative journalist who focuses on offshore  
and financial corruption