How CDS kills AIG

We start with a simple loan: a lender passes money to a borrower, receiving an IOU in return.

(In the real world, the IOU is a corporate bond, or possibly a collection of debts called a Collateralized Debt Obligation.)

Len is taking some risk, because Barb may not be able to repay the loan. Len shells out some money for a guarantee from his buddy Sid:


Sid says to Len, “If Barb doesn’t pay your money back, I’ll step up and pay you the money Barb owes.” Sid is like a co-signer, except he isn’t Barb’s uncle. Sid is doing this as a for-profit business. He hopes to collect the CDS fee without ever having to make good on the loan.

To some folks, it sounds like gambling on Barb’s finances. I’ve heard people say that shouldn’t be allowed. (They probably don’t like craps, either.)

Here’s the benefit: Len can be more liberal in his lending because of Sid’s guarantee. Len does not have to study Barb’s finances in detail. If Barb is borrowing from many different guys, it might be more efficient for only the one person, Sid, to check her credit quality.

The obvious risk of the CDS is that the original bond issuer (Barb in the simple explanation) cannot repay her debt. In AIG’s case, they did extensive computer modeling of this risk. They felt pretty good about the risk.

However, there were two additional risks not considered in the computer models. First, the CDS contract had provisions that could require the guarantor (like Sid in yesterday’s example, or like AIG in real life) to put up collateral. That collateral would ensure that the guarantee would be solid. AIG received several calls for collateral from its counter-parties. That placed a significant burden on its balance sheet.

The second risk was marking the contract to market prices. For the guarantor, the CDS is a liability on the balance sheet. When other folks are trading credit default swaps, they establish a market price for this liability. AIG was forced to recognize larger liabilities on its CDS portfolio, even before it had sustained an actual loss.

Imagine this scenario: you’ve done a great job assessing risk, but the rest of the market is nervous. They start pricing CDS’s as if they are very risky. You are right, they are wrong. What happens? We would like to live in a world in which the folks who are right profit, and the folks who are wrong lose money. But in this scenario, the guarantor gets in trouble even if its right about the credit risk, simply because it has to recognize losses on the market value of its portfolio, even though it has not had to actually pay off on any claims.

If the guarantor has a lot of staying power, it simply accepts a hit to its balance sheet while waiting to be proved right. As the CDS’s expire over time, it can recover the reserves it booked when it marked the liabilities to market, showing huge profits. That is, if it has staying power.

However, it that guarantor is highly leveraged, the financial losses it has to report (before it has any genuine losses) cause its own credit rating to suffer. It has to post more collateral with its counter-parties. Its borrowing costs go up. Nobody wants to do business with it anymore, because its finances are shaky. Eventually, the company goes bust. Or gets bought by the U.S. Treasury, which may be even worse. And all of this bad stuff can happen even if the guarantor is ultimately right about the risks of the borrowers it was guaranteeing.

Listen to any of the radio personal finance shows, such as Clark Howard or Dave Ramsey. They’ll tell you not to co-sign credit card applications or car loans or mortgages, not even for your own family members. If you’re a corporation with a very strong balance sheet, you can co-sign a few notes and make a little easy money. But if you start doing this on a large scale, a large enough scale that it really helps your company, then you are piling up risk that ultimately could sink your company.

There’s an old saw in investments: The market can stay irrational longer than you can stay liquid.

AIG began selling credit-default swaps around 1998. Mr. Gorton’s work “helped convince Cassano that these things were only gold, that if anybody paid you to take on these risks, it was free money” because AIG would never have to make payments to cover actual defaults, according to the former senior executive at the unit. However, Mr. Gorton’s work didn’t address the potential write-downs or collateral payments to trading partners.

AIG became one of the largest sellers of credit-default-swap protection, according to a Moody’s Investors Service report last week. For years, the business was extremely lucrative. In a 2006 SEC filing, AIG said none of the swap deals now causing it pain had ever experienced high enough defaults to consider the likelihood of making a payout more than “remote, even in severe recessionary market scenarios.”

AIG charged its trading partners a fraction of a penny a year for every dollar of credit protection. The company realized, of course, that it might have to post collateral if the market values of the underlying securities declined. But AIG executives believed that such price moves were unlikely to occur, according to people familiar with AIG’s operation.

Well, that sums up the problem in a nutshell: it wasn’t so much that there is anything wrong with CDS in of themselves per se, it’s that some of the people selling them were operating under the misguided notion that they were getting “free money” and would never have to raise any capital to cover the risks they were taking on. In effect they were disobeying a fundamental rule of the Insurance business, you know that rule about setting premiums at a high enough level to cover potential payouts in addition to having enough capital on hand to cover additional risks?

I guess no one ever told the folks at AIG that there was no such thing as a “free lunch”. The irony here is that if some “local businessman” came to a friend or family member of Mr. Gorton with a similar sounding get rich scheme, he probably would’ve advised them that they were being scammed.
At least I would hope so.

Reading through the article I was reminded of a quote from the TV Show “News Radio” spoken by Jimmy James the multi-billionaire owner of the radio station:

“Beth you sold something of no value that you didn’t own, there is nothing left about business for me to teach you”

After all, what else would you call AIG’s CDS business?

The fact that the regulators allowed this to happen, on top of executives turning a blind eye (as long as their bonuses were rolling in) and none of their investors and/or creditors scrutinized the books enough to raise a red flag about this issue is downright criminal.

But let’s stop kicking the dead horse with the aid of 20/20 hindsight and think about the future:

It’s becoming more and more clear that many aspects of our economy, banking system, etc, operate in much the same fashion as a Ponzi scheme. If the new administration, financial executives, etc, truly want to save us they need to start attacking the Ponzi aspects of our financial systems as if they were a cancer, and replace them with a financial system that is firmly grounded in reality.

I’m sure the above statement may sound like a mere abstraction to some, but if you think about it some of the solutions are obvious:

Regulate CDS just like any other insurance product, in order to prevent a situation where a company is selling risk protection products as if they’ll never have to cover any losses.

Make it unlawful for banks to use CDS as regulatory arbitrage to meet capitalization requirements; in fact just set higher standards for what can qualify as a Tier-1 asset so that banks aren’t using derivatives as capital.

The idea is simple you review the banking and insurance industries and work to eliminate situations where we have de facto Ponzi schemes, and/or financial systems that are a house of cards. Now I’m sure the financial industry will squawk very loudly about this, but considering that they’re coming to the Government for handouts to stay in business it should be easy to shut them up.