The Wall Street Journal explains (subscription required) how hedge funds are the ultimate beneficiaries of a substantial part of AIG bailout money. Hedge fund clients of Deutsche Bank wanted to bet against residential mortgage-backed securities (RMBS). So the Bank sold them protection credit default swaps.

Deutsche Bank wanted to hedge its exposure to its own CDSs, so it set up portfolios of notes, secured by residential mortgages, in off-shore jurisdictions. They called these entities Starts, and designed them to track the value of RMBS. Then it bought protection from the Starts. But that was not enough. So the Starts bought protection credit default swaps aggregating $1bn from AIG. The premiums for this insurance were in the range of $10mn per year. The outcome?

Last fall, after AIG’s credit rating was cut, the insurer paid roughly $800 million to START, according to two people familiar with the matter. Much of the money is being held in escrow and will be used to pay off Deutsche’s swap contracts if mortgage defaults in the portfolio rise above a certain level. Some of that money could go through Deutsche to its hedge-fund clients.

Goldman Sachs (them again) did the same thing, using CDOs named Abacus.

AIG paid $5.4 billion to Deutsche Bank, and $8.1 billion to Goldman Sachs, on their CDSs. This is both money from Maiden Lane II, and direct transfers of cash collateral to these institutions.

Let’s see what the implications of this might be. First, one of the questions FDL gave to the House committee to ask AIG’s CEO Ed Liddy was whether any of the CDSs supported by the AIG bailout went to pay off naked credit default swaps. (Thanks, Hugh). If this story is right, the answer is almost certainly yes. Credit default swaps are used as a substitute for shorting debt instruments, because, in thinly traded markets, it is not often possible to borrow the instrument and sell it, and then buy it back when you want to cash out. That almost certainly means the hedge funds held naked CDSs.

Second, Goldman Sachs creates various investment funds for its clients, and its employees are expected to invest. Employee money makes up as much as 1/3 of the total funds invested. If investment funds of Goldman Sachs bet against housing, that means the employees of Goldman are big winners. But maybe not. The primary point of the NYT article is that Goldman Sachs employees have lost a lot of money in the most recent funds–so much so that Goldman has to lend money to them to meet their capital calls. Why, you ask?

…[S]ome Goldman employees who financed their gilded lifestyles by borrowing in good times are suddenly short on cash needed to meet commitments to their personal investments in the funds. “It’s a problem with the culture of spending,” said Gustavo Dolfino, the president of Whiterock Group, a Wall Street recruitment firm. “No matter how much you have, you spend like you have a lot more.”

Ah, that dratted culture of spending.

Third, I mused in a recent post whether AIG counterparties were planning to cash in on the next bank bailout, under which Treasury will lend money to hedge funds and other private groups to buy up toxic waste on sumptuously favorable terms.

Now we have an answer to that question. Not only do the rich get bailed out, they use those profits to fund a no-lose proposition buying banks out of their problems at non-market prices.

Fourth. Why are the Treasury people such wusses?

masaccio

masaccio

I read a lot of books.

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