I’m sure there’s important stuff going on locally, but the AIG mess has me fascinated. Sorry. What happened so far this week:

Monday: Obama: we’ll explore all legal avenues to get that bonus money back.

Tuesday: All done! Nothing we can do! We’ll ask for more next time we give them billions of dollars!

AIG has acted with all the dignity you would expect from a company that just destroyed the market. NY AG Andrew Cuomo discovered that the “retention bonuses” were not only ineffective for guaranteeing performance, they weren’t even good at guaranteeing retention. Can Obama hire Scott Boras to be the Assistant Secretary of Not Getting Screwed?

Perhaps even more outrageous is the white paper AIG sent to Timothy Geithner (PDF). As Marcy Wheeler describes, AIG makes a complicated argument that if they don’t generously compensate AIG’s financial products division, members of the French subsidiary Banque AIG might walk, which would force French bank regulators to take control, which would be a “default event,” which would blow up a bunch of agreements. She calls it the Semtex in the retention contracts.

True? Hell if I know, I don’t know anything about French banking regulation. But I was more blown away by this:

There are also substantial risks related to the hedging of AIGFP’s various books. Although we view the large-market risk books at AIGFP as generally well hedged, the hedging is dynamic – that is, it must be monitored and adjusted continuously.  To the extent that AIGFP were to lose traders who currently oversee complicated though familiar positions and know how to hedge the book, gaps in hedging could result in significant losses.  This is driven to some extent by the size of the portfolios.  In the interest rate book, for example, a move in market interest rates of just one basis point – that is 0.01% or one-100th of one percent – could result in a change in value of $700 million dollars if the book were not hedged.  It has virtually no impact on the hedged book.  There are similar exposures in the foreign exchange, commodities and equity derivatives books.

AIGFP’s books also contain a significant number of complex – so-called bespoke – transactions that are difficult to understand and manage.  This is one reason replacing key traders and risk managers would not be practical on a large scale.  Personal knowledge of the trades and the unique systems at AIGFP will be critical to an effective unwind of AIGFP’s businesses and portfolios.

In this current environment, any perceived disruption in AIGFP’s ability to conduct business, such as one that would result from the departure of a number of key employees, could also cause parties to limit or cease trading with AIGFP.  Obviously, this would adversely affect its ability to continue to cost-effectively hedge its positions.

This is a very roundabout way of saying: it’s cheaper to pay insane amounts of money to the maniacs who just destroyed your economy than it is to clean it up yourself.

If it helps, think of it this way:

Imagine that you hired an expensive contractor to completely renovate your house. In the process of doing the work, the company damages the load-bearing walls, the gas lines, the electrical system, the staircases, and the roof, and runs out of money in the process.

Then the contractor tells you this. The natural response would of course be to fire them and hire a new contractor. But then the contractor tells you that the damage is so profound and what’s left of your house is so fragile that if you hire anyone else, they might actually destroy the whole thing because they don’t know where all the damage is, and any misstep–any crossed wire or removed nail–might cause the whole thing to burn to the ground. And the only people who can fix it, they claim, will walk if they don’t get paid handsomely.

And then they ask you to continue to pay them lots of money to unfuck your house.

Hilzoy calls this extortion, at least on a moral level. I can’t think of another word.

Marcy Wheeler is calling for Timothy Geithner to testify under oath. It’s more polite than just calling for his head. Can’t imagine that he’s going to last much longer. Then again, that’d be just another position to fill.