Why AIG Was in the CDS Business

by: Felix Salmon November 14, 2008 | about stocks: AIG    
Felix Salmon

Felix Salmon

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Gari has a question about AIG, in the comments:

Why did a well-capitalised insurance company with plenty of long-dated liabilities decide that it was a better use of shareholders' and policyholders' cash to write protection against debt instruments rather than owning them? I think part of the reason was the anomaly in the pricing of CDS compared to bond yields that the CPDO tried to exploit. I don't know whether I'm just raging against accounting arbitrage here, but doesn't any examination of systemic risk and CDS need to focus on this question?

You don't need to know about CPDOs or about the spread between CDS and bond yields in order to answer this question. It's much, much simpler than that. The fact is that AIG didn't use "shareholders' and policyholders' cash to write protection against debt instruments". If it wanted to buy bonds, then it would have needed to come up with some cash to do so. But writing protection, by contrast, was a way of receiving money, not spending it.

When AIG wrote protection on CDOs and the like, it got insurance premiums in return, and considered those premiums to essentially be free money, since (according to AIG's own models, and those of the ratings agencies) the chances of those CDOs defaulting were essentially zero.

Now, of course, it's clear that those insurance contracts constitute an enormous contingent liability for AIG -- one so big that without government help the company would have gone bust. But at the time, no one at AIG was worried about that, so busy were they raking in the dollars insuring CDOs which they were positive would never suffer any losses.

AIG's biggest mistake was in failing to realize that this business couldn't scale in the way that most insurance does scale. Most insurance does scale: if you insure a house against fire, for instance, it's easy to lose much more money than was paid in insurance premiums. But if you insure houses across the country against fire, you'd need a nationwide conflagration in order to lose lots of money.

The CDO market doesn't work like that, however. The reason AIG's models said the CDOs couldn't suffer any losses was that house prices don't fall in all areas of the country simultaneously. Since AIG was only insuring the last-loss CDO tranches, investors with lower-rated tranches took the risk that prices in Florida, or Arizona, or California might fall. AIG would only lose money if prices fell in all those states at once -- which is, of course, exactly what happened.

But AIG never stopped to think that the event which would precipitate a payout on one CDO was exactly the same event which would precipitate a payout on all the other CDOs as well. AIG could easily afford any given CDS contract. What it couldn't afford was lots of CDS contracts -- because with CDS, unlike with most insurance, there was no safety in numbers, only more danger.

The investors in CPDOs, at least, put their money up front, and looked to make their relatively modest profits slowly, over time. They lost their money, but at least they had their money before they lost it. At AIG, the financial products group booked its profits immediately, without spending any money at all. When their losses arrived, the firm had to scramble to find the cash, since it had never allocated much in the way of capital to the group.

Insurers are always happy to take your money. But spending money on insurance is always fraught. You've spent your money up front, and now you hope that if the thing you're insuring against comes to pass, the insurance company will do the right thing and pay out. Your big fear is that they won't, either because they think they've found a reason to reject the claim, or because they've gone bust.

That's why insurers need to be very highly regulated. If they weren't, anybody could set themselves up as an insurer, take in lots of premiums, and then simply disappear. But that's also why AIG was writing protection on bonds rather than buying bonds outright. Under the insurance model, you can rake in your premiums and provision very little capital against them, so long as you wow your regulator with enough whiz-bang models saying that you'll never need to pay out on those policies. If you buy a bond, by contrast, the seller wants cash up front. And where's the fun in that?

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This article has 13 comments:

  •  
    Nov 15 08:11 AM
    nice explanation of a faulty business model, clueless regulators gave it a pass.
    > jack
    Reply | Link to Comment
  •  
    Nov 15 08:44 AM
    I don't think losses ever arrived. They had to post tons of collateral when their credit ratings were cut after their stock was blitzed. They didn't have the cash. Shouldn't have put themselves in that position, but it still IS highly unlikely that they'll have to payout on their super senior CDO CDS contracts.
    Reply | Link to Comment
  •  
    Nov 15 09:45 AM
    Thanks for insight. With the benefit of hindsight, what should AIG have done with premiums: 1) diversification forbade any further exposure in real estate and 2) equities were clearly overvalued at that time?
    Reply | Link to Comment
  •  
    Nov 15 11:36 AM
    It seems like Paulson & Co and Goldman were two of the earlier firms to recognize and act on the problems in the market by becoming major CDS buyers either in 06 or early 07. Anyone know when AIG recognized their problem and how they attempted to mitigate their loss.
    Reply | Link to Comment
  •  
    Nov 15 11:37 AM
    What we will never understand is why AIG management would enter a line of business (CDS)that had the potential of taking the firm down, or simply did not know what the risk was.

    Insurance theory requires reserves against insured risk (as actuaries access the risk.) In this instance it was apparently believed that AIG was too big to fail, or management was ignorant of the risks, or less than honest.
    Reply | Link to Comment
  •  
    Nov 15 11:53 AM
    so who get's the bailout money then? In other words, who was responsible for getting paid once the "unthinkable"... happened? Obviously Goldman Sachs. Who else, though? Senators? Congressman? State and local govnerments?
    Reply | Link to Comment
  •  
    Nov 15 12:19 PM
    @whidbey
    "What we will never understand is why AIG management would enter a line of business (CDS)that had the potential of taking the firm down,""

    They did it BECAUSE OF STOCK OPTIONS AND BONUSES.

    POST A PROFIT TODAY AND RAKE IN THE MONEY,

    POST A LOSS NEXT YEAR & THE STOCKHOLDERS GET SCREWED.
    Reply | Link to Comment
  •  
    Nov 15 01:46 PM
    Hank Greenberg is certainly unrepentant and apparently thinks he has enough remaining assets to buy selected pieces of AIG. Recall he was dumped as CEO because of reinsurance sham transactions. Reinsurance is not regulated. AIG and others involved in derivative risk management used a variety of euphamistic (spell check doesn't like but I think it's correct) and opaque terms to disguise the essential nature of their transactions, in a manner quite reminiscent of the Enron energy bandits. These financial transactions were fairly far removed from conventional liability insurance, even if on an international scale...
    Reply | Link to Comment
  •  
    Nov 15 03:55 PM
    Though it has been touched on obliquely elsewhere, there has been a "multiplier effect" in the impact of CDS that were essentially "insurance." That is, that much of the exposure came about by selling to parties who had "no insurable interest;" particularly when the "premiums" were low.

    Sellers of latter day forms of CDS (where actually there was no true "swap" of "my risk for your risk," resulting in a comparative risk exchange) were "betting" with a third party against the "death" of a specific party with no requirement that the insured had any relation that might result in a loss from that "death."

    When epidemics began, the costs of "deaths" went far beyond the losses payable to those who incurred actual losses.
    Reply | Link to Comment
  •  
    Nov 15 03:57 PM
    AIG knew exactly what they were doing. This is part of the biggest conspiracy in the history of finance. AIG's top management gave in to the lure of a fantastic profit at the cost of the company's assets, and the possible end of AIG. Every man has his price, and AIG's top management found theirs, in this gigantic robbery.
    Reply | Link to Comment
  •  
    Nov 15 10:56 PM
    I would like to add that this exchange, like most I have read, seems to imply there is a big difference between buying a bond or writing protection on it via a CDS - there is not. Fundamentally, If I am a reasonably high rated counterparty and borrow money to buy the bond, the difference in spread will be very close to the rate I would receive by writing protection on the bond. If I own the bond and it defaults I am left with the recovery in bankruptcy. If I write protection and the bond defaults I have to buy the bond from the protection buyer at par and I am left with the recovery in bankruptcy. The big place one might see spread differences with this strategy is for those buying protection on a bond since the alternative is to short the bond which is often very difficult so there is no approximate arbitrage trade to tie the two together. Now I have left out some details on the borrowing side for buying the bond, particularly if the purchaser is not of high quality or the tenor of the default swap is very different from the tenor of the bond but the basic argument is sound.

    The problem here, as mentioned by another poster, is that AIG did not plan for the collateral calls of marking to market on something widely viewed as AAA+ (the super senior tranches of these CDOs). Why they did not is simply politics. When a business unit at one of these organizations is making money no one has the power to question them. Not internal risk managers and certainly not regulators. They may sing and dance about their independent reporting lines for risk management to the CEO but the reality is no one will get anywhere saying "you need to reserve againt AAA+ tranches going down, rating agencies don't know what they are doing, etc." With all the overlapping branches of regulation the one to try and call the company on the carpet BEFORE the problem occurs is always immediately attacked as extreme by the other regulators. I am not making this up - I have seen it myself. The other simple fact is that no one has cracked the code on default correlation or even default - recovery correlation on corporate names, let alone individual mortgage borrowers.
    Reply | Link to Comment
  •  
    Nov 15 11:02 PM
    Felix -- A very good explanation and if true, the regulators should be marched out back and shot. Laissez-faire does not mean nap time. The damage done to free markets by the regulators and their idealogue patrons is deep and will hurt our country.
    Reply | Link to Comment
  •  
    Nov 16 11:49 AM
    aswo1,
    Agree 100%.
    Felix,
    Best read ever. You're excellent.
    Reply | Link to Comment
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