Notwithstanding the disaster at AIG, the basic idea of using derivatives contracts to share risk is not stupid

TO BE NOTED: From the FT:

"Good idea that turned bad

By Gillian Tett

Published: March 16 2009 19:14 | Last updated: March 16 2009 19:14

A couple of years ago, one of the more brilliant minds at Merrill Lynch made a striking confession. “The problem with credit markets is that we still don’t understand correlation,” he told British academics. “That is unfortunate because correlation is central to the credit world.”

It is a problem haunting AIG with a vengeance – not to mention its bruised counterparties, such as Merrill Lynch. As the list of AIG’s counterparties emerged on Sunday, politicians have – unsurprisingly – expressed outrage at the size of its liabilities.

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.

AIG, for its part, blames this outcome on an unforeseen outburst of “systemic risk” (or, as its website says: “It is the quintessential ‘knee bone is connected to the thigh bone . . . ’ where every element that once appeared independent is connected with every other element.”)

The real problem, though, is that AIG – like other institutions – has been extraordinarily complacent about trying to analyse correlations of risk. Before the summer of 2007, almost no one inside AIG worried about the fact that subprime mortgage contracts all tended to look very similar.

Nor did they notice that these subprime loans were being bundled into similar types of collateralised debt obligation structures, with similar trigger points – and then insured by AIG with similar deals.

After all, when the credit markets were benign, such similarities barely appeared to matter: AIG just collected the fees. But what has become clear in the past 18 months is that those endemic similarities created the propensity for a deadly “tipping point” to occur: once one contract turned sour, numerous other deals turned sour, too. Hence those eye-poppingly large losses.

But what is most shocking of all, is that no one inside AIG – or in the ratings or regulatory world – appears to have spotted those risks before. That was partly due to a paucity of holistic thought. Another practical problem, though, was an information gap. Before this week, companies such as AIG insisted that the details of their credit derivatives deals were “confidential”. As a result, it was almost impossible for outsiders to spot those correlated exposures – until it was too late.

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.

Copyright The Financial Times Limited 2009"