The twists and turns of the AIG story keep on, well, twisting and turning. This morning the Wall Street Journal is reporting that some of the billions of dollars that the U.S. government paid to bail out the failed insurance giant will benefit hedge funds that were short the housing market.
Documents reviewed by the WSJ reveal that some of the banks listed as the beneficiaries of the AIG bailout were themselves middlemen for hedge funds. So AIG is a conduit to conduits to hedge funds. It seems that the investment banks sold credit default swaps on mortgage backed securities, and then hedge their risks by buying CDS from AIG. The swaps payoff if mortgage defaults rise above a certain level.
“In essence, while the U.S. government is busy trying to prop up the housing market — by trying to limit foreclosures, among other things — it is simultaneously putting up cash that could be used to pay off investors who bet housing prices would tumble and many mortgage holders would default,” the WSJ notes dryly.
We don’t think there’s anything wrong with people making money from declining housing prices. In fact, the short-mortgages trade probably helped reveal the stress in the housing market earlier, preventing more wealth from being wasted on bad real estate linked investments.
But the payments to hedge funds do raise questions about the bailout of AIG and the banks that bought back-to-back credit default swaps from AIG. Should the government be assuming the counterparty risk taken on by these hedge funds? Would letting hedge funds fail, or perhaps even just suffer diminished returns, pose a systemic risk to the global economy?