We’ll admit that we’ve been sceptical about the argument that AIG’s financial products teams need to be retained because they are the only people capable of understanding the credit default swaps safely hedged as they are well down. Are these things really so complex that AIG couldn’t hire some of the unemployed masses from Bear Stearns or Lehman Brothers to manage the unwind?
Yesterday, however, AIG’s Ed Liddy very forceably argued that it wasn’t just the CDS portfolio but the whole array of complex derivatives, including currency and interest rate waps, that needed to be managed by the folks in the financial products division. So does this mean we should all acquiece to the retention bonuses?
Not at all. In his Financial Times column today, John Gapper describes the possibility that Liddy is correct as “appaling.” It would mean that by developing this complex portfolio, the traders at AIG had built themselves a downside job protection hedge. In good times, they are paid mighty sums for marketing these products. In bad times, they are still paid (slighty less) mighty sums to unwind the positions.
Consider the implications. We are by now familiar with the trader’s option – that an employee of an investment bank has an incentive to take big risks to make money. If his trading strategy works he gets a bonus but if it fails, the bank (and ultimately the taxpayer) pays.
In recent years, a lot of traders, including those at AIG, exploited this by coming up with derivatives that were very profitable in the short term but had expensive long-term risks embedded in them. That allowed the traders to enjoy several years of large bonuses before the bill for their recklessness fell due.
Now, the ever-ingenious AIG traders have come up with a derivative of the trader’s option. Call it the trader’s option squared.
They had an incentive not only to sell financial contracts that paid out a lot of money immediately in return for assuming a long-term liability, but also to make these contracts very complicated and opaque.
This allowed them to charge big fees (which brought big bonuses) and it also made them irreplaceable at the institution that employed them. If you are the only one who can understand your own handiwork, it puts you in an enviable bargaining position.