What Should Hank Greenberg Do with AIG options?

The attached article appeared in The Wall Street Journal over the weekend. Basically, Mr. Greenberg feels that American International Group (AIG) got the short end of the stick last fall. He feels that Goldman Sachs (GS) changed the rules of the game by getting over-the-counter (OTC) contracts marked to market instead of paying off at maturity. When the housing bubble burst, GS could demand cash immediately as margin from AIG.

No offense, Mr. Greenberg, but AIG hardly seems to be in the class of widows and orphans. This is a multi-billion dollar company with a phalanx of attorneys. Should we feel bad for them because they did not know, understand, or react to the terms of the contracts they were entering?

He thinks the government should voluntarily reduce both the interest it is charging AIG and its 79.9% stake in the company. Let’s make no mistakes here. AIG was insolvent last fall. The existing equity holders at the time should have been completely wiped out. What they have now is a gift. It is amazing how little responsibility Mr. Greenberg wants to accept for the firm’s role in the mess we just went through. Mind you, most of this occurred after he had left, so it is not like he was personally responsible for the trades. He just happens to still own a ton of stock.

Anyway, what should Mr. Greenberg do if he wants to trade around his views? If he really thinks the government will give back a chunk of its stake in AIG, he should look to buy options. Volatility has collapsed in this name, so calls investors can buy now have better break evens than they did six months ago. Currently, the Jan 2011 (because the government always takes a long time to do anything) 50-strike calls are priced at $2.09 at Friday’s close. Considering how levered the company is, and depending on how giving the government is, the stock could make large moves. The risk to buying options is 100% of the premium paid.

The other thing investors could consider is buying put spreads in GS, with the maximum loss limited to the net debit paid.  Greenberg seems to be implying that GS was not playing nice in the OTC sandbox. He wants “investigative reporters” to look into it. If GS is going to be made the scapegoat, its stock might be at risk. A trader could buy put spreads on this stock, or trade risk conversions by buying downside puts and selling upside calls. This is a risky strategy, but Hank is accusing the firm of some serious stuff.

The benefit of the risk conversion strategy is that a trader does not have to pay a lot of premium. Based on Friday’s close, traders could buy the Jan 150 puts and simultaneously sell the 200 calls for only a $0.30 premium. The risk is that if you have this position on, you are effectively short naked calls and have unlimited risk. Considering most of the government seems to be GS alumni, betting that the government is going to go after them is a stretch. If GS stock were to rally above 200, the person with the risk conversion on could be subject to very large losses.