Where's the AIG 'Smoking Gun' Memo on Default Swaps?(Mortgage Scene)

Byline: Paul Muolo

A decade ago the Federal Reserve came to the rescue of Long-Term Capital Management, a gargantuan private hedge fund founded and managed by former Salomon Brothers trader John Meriwether. Even though LTCM wasn't a depository (or even a securities firm) Uncle Sam stepped in to calm the markets.

Over the past few months as talking heads from the left and right blathered on about the "bonus scandal" at American International Group, I couldn't help but think of LTCM. The reason is this: the Fed came to the aid of that hedge fund - which had bet the wrong way on Russian debt - because commercial banks had lent the company $125 billion. A decade ago $125 billion was a lot of money. And just think of the economic damage our banks would've suffered had the Fed not intervened to structure an "orderly" unwinding of LTCM's positions.

If you think the government stepped in with $185 billion in assistance (and counting) to "save" AIG because it was concerned about all those 60-and-over retirees and their annuity and life insurance policies, I have some Enron bonds I'd like to sell you. The Fed and Treasury stepped up to the plate because it was concerned about - you got it - our commercial banks. Specifically, banks that were "counterparties" on credit default swaps that AIG had written on subprime ABS and CDO investments.

Just to recap: a credit default swap is an insurance contract where one party (in this case AIG) agrees to pay another party, in this case its bank customers who were on the other side of the swap and who stood to reap a payout in the event their subprime CDOs went south. Well guess what? Their subprime CDOs went south which meant AIG had to open the vault.