"The way these underlying securities take loss, they're not binary events," says Nacey, who is now managing principal of WestSpring Advisors, a credit-focused firm. "In corporate credit, there's a default and that's an event. With these securities, it happens over time, by not paying interest or not paying principal or a combination of both."
As credit quality continues to degrade, AIG is responsible for additional payments over the life of the contract, unless it is extinguished. However, the loan pools have been packaged and sliced up into securities with different levels of risk, sometimes more than once, creating confusion at times over who even owns the underlying assets. Furthermore, if AIG approaches a counterparty to exit a trade early, it can be difficult to come up with a price tag that satisfies both sides.
"It's not like the underlying securities are trading day to day," says Nacey. "It's not as simple as, 'Let's see where this is trading in the market,' because it's not trading in the market."
As a result, AIG can be locked in tough negotiations with holders of toxic debt for months or years, staring down two choices that appear equally bleak: The insurer can make payments on money-losing assets, hoping they retain or recover some value; or, it can purchase the assets, try to sell them into a still-icy market, and take a related loss.Outcomes can be wildly different -- depending on market conditions, the horizon of a contract, and a counterparty's willingness to negotiate. In one case last year, AIG took a charge of nearly $200 million related to guarantees on office-space leases it entered back in 2002. In two other residential-mortgage trades, AIG posted an unrealized gain of $137 million because it believes it will receive premiums even after the underlying assets mature. In yet another case, AIG purchased $1.5 billion worth of debt that is heavily weighted in subprime real estate in Spain. AIG believes it will lose less by selling or holding onto the assets than continuing to make contractual payments. Complicating the situation further, some transactions are tied to more than one level of a debt structure, and AIG can't extinguish one bet while another is still in place. To hedge against losses on less-healthy, "mezzanine-level" debt, AIG has at times purchased CDS from third-party issuers to offset losses on its own CDS.
Select the service that is right for you!COMPARE ALL SERVICES
Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.
- Real Money + Doug Kass + 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV