“Concretations of risk, plagued with deadly correlations”
The FT’s Gillian Tett makes a simple but important point: AIG’s role in the credit default swap market meant that a lot of risk that the bank regulators thought had been dispersed into many strong hands ended up in a single weak hand.
Tett:
What is equally striking, however, is the all-encompassing list of names which purchased insurance on mortgage instruments from AIG, via credit derivatives. After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.
But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else. Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.
Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.
If the US creates a “systemic risk” regulator, it should be on the lookout for similar concentrations of risk.
One other point. The fact that several of AIG’s largest counterparties are European financial firms is by now well known. What is I think less well known is that the expansion of the dollar balance sheets of “European” financial firms — the BIS reports that the dollar-denominated balance sheets of major European financial institutions (UK, Swiss and Eurozone) increased from a little over $2 trillion in 2000 to something like $8 trillion (see the first graph in this report) — played a large role in the US credit boom.
As the BIS (Baba, McCauley and Ramaswamy) reports, many European banks were growing their dollar balance sheets so quickly that many started to rely heavily on US money market funds for financing. And if an institution is borrowing from US money market funds to buy securitized US mortgage credit, in a lot of ways it is a US bank, or at least a shadow US bank.
Consequently I think it is possible to think of AIG as the insurer-of-last resort to the United States’ own shadow financial system. That shadow financial system just operated offshore. There was a reason why investors in the UK were buying so many US asset backed securities during the peak years of the credit boom."
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From A Credit Trader:
http://www.acredittrader.com/?p=65
” * A bank buys CDS protection from an insurance company (wrong-way because credit spreads tend to be correlated suggesting that when the trade is positive mtm to the bank, the insurance co’s credit spread is wider)
Did you catch that last one? This is what happened with AIG.
In fact, I would argue that the credit quality of AIG was not just somewhat correlated to the credit quality of the insured CDOs but was in fact 100% correlated, especially in the case that matters i.e. impairment of super-senior tranches. By the time this happens AIG will have gone bankrupt posting collateral and even if it survived up to this point the very high correlation between the super-senior tranches it wrote protection on means AIG would have to pony up an unbelievable amount of cash.
So, where does that leave us? Making the back-of-the-envelope assumptions above of 100% correlation in credit quality between AIG and its insured CDO as well as zero recovery, the value of protection that investment banks bought was zero. Remember that the correct value of the trade is the risk-free valuation less the credit exposure. In our case, the credit exposure would be equal to the risk-free value of the trade.
Why did Banks buy Protection from AIG?
Did the banks realize the value of its protection held against AIG was zero? Of course they did - they aren’t as dumb as the media suggests. The reason they continued to pay the full market CDS offer (rather than a much lower level due to AIG’s massive wrong-wayness) to AIG was because they considered it a cost that allowed them to continue originating CDOs. If they could not offload super-senior risk to someone, their originating desks would be effectively shut down.
So, while the trading desks continued to buy super-senior protection from AIG, the risk management desks, realizing that the protection was effectively worthless, bought protection on AIG itself from the street and clients in large size. In fact, I would imagine the size they needed to buy was too large and they likely ended up buying puts on the AIG stock or just shorting outright. Let’s hope the Fed unwinds of AIG’s trades took into account the huge gains these banks took on the AIG hedges.
Onwards and Upwards: the CDS Clearinghouse
In the better late than never column, market participants are establishing a CDS Clearinghouse whose members will face the clearinghouse on all trades, rather than each other as is the case now. This will help in assigning trades, posting collateral, unwinding trades etc. This will hopefully do away with zero-collateral posting by AAA counterparties, which means that selling protection in massive size will be less of a “free money” trade than before.”
And Tett:
“And therein lies an important moral. Notwithstanding the disaster at AIG, the basic idea of using derivatives contracts to share risk is not stupid; on the contrary, risk dispersion remains a sensible idea, if used in a prudent, modest manner.
But diversification can only occur if potential correlations are monitored – and that oversight can only take place if the business of risk transfer is made as visible as possible. That means that regulators and investors should demand dramatically more disclosure about credit derivatives deals and about their counterparties, too. The type of transparency seen at AIG this week, in other words, is not just badly overdue; it now needs to be replicated on a much bigger scale.”
I agree with Tett. CDSs and CDOs can be very useful in certain marginal investments. What occurred here was the result of human decisions. I consider them fraud or negligence, while others disagree.