Hedge funds to America: Thanks for all that AIG money!

Billions of taxpayer dollars that the U.S. government gave to AIG (AIG) to prop up the insurer could end up in the pockets of hedge funds that bet on a falling U.S. housing market, according to a story in the Wall Street Journal. No one knows how much will end up in the pockets of hedge funds or which hedge funds will benefit right now, but what is known is that $52 billion of taxpayer money has been spent to cover AIG's housing-related bets.

Until AIG exited the market in 2006, "AIG was by far the single largest ultimate taker of risk in the [subprime mortgage] CDO space," a senior investment banker whose firm bought credit protection from AIG told the Journal. Essentially, the documents that the Journal has unearthed show that Wall Street banks were middlemen in trades with hedge funds. AIG insured those trades and was left holding the bag on billions of dollars of assets tied to souring mortgages.

AIG has already put money in escrow for Deutsche Bank (DB), whose hedge-fund clients made bets against the housing market. These funds will be paid off if mortgage defaults rise above a certain level. So while the U.S. is trying to prop up the housing market by limiting foreclosures, it's also paying out money to investors who bet housing prices would tumble and mortgage holders would default.

"AIG's financial-products division went heavily into the business of speculation, and its gambling debts are what taxpayers are paying off right now." Martin Weiss, an investment consultant, told the Journal.

Here's how the scheme worked: Hedge funds bet on mortgage defaults rising by buying financial instruments called credit default swaps from investment banks, such as Goldman Sachs (GS) and Deutsche Bank. This is a form of insurance that pays out in the event of a debt default. It is unknown which hedge funds made these bets with specific banks, but it is known that these wagers were profitable for the hedge funds. The actual dollar profits and whose paying whom still needs to be exposed.

The banks then wanted to protect themselves so they set up a complex set of financial instruments that were insured by AIG and other insurers. AIG was the biggest player in this gamble. The banks formed offshore companies known as collateralized debt obligations or CDOs. By doing this the banks neutralized hedge fund exposures, by buying swaps on the securities their clients were betting against. For example, in one deal cited by the Journal, AIG made less than $10 million annually on $1 billion worth of insurance. Now the U.S. taxpayer is paying for AIG's bad bets.

According to the Journal, from mid-September through the end of last year, AIG and the U.S. taxpayer paid $5.4 billion to Deutsche and $8.1 billion to Goldman Sachs when assets dropped in value. Some of this money could end up in the hands of hedge funds.

Should we as taxpayers have an obligation to pay for bad bets made by an insurer? Unfortunately, since the U.S. now owns such a large stake in the company, we do. Our only hope for keeping our tax dollars our of the hedge funds' hands is if mortgage defaults stop. Maybe it's time for Congress to take another look at how it's taxing hedge fund profits.

Lita Epstein has written more than 25 books, including Trading for Dummies and Reading Financial Reports for Dummies.

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