AIG saga shows how dangerous credit default swaps can be By Henny Sender Published: March 7 2009 02:00

In retrospect, a glance at AIG’s second quarter 2008 financial statement makes for an interesting read. Buried in that report is a cautionary tale showing just how dangerous credit derivatives can be when combined with insufficient risk management and regulatory oversight - or both sides of these transactions. Unfortunately, few people read the report when it would have been relevant.

The report fully discloses the $446bn in credit insurance AIG sold. The swaps were written out of AIG Financial Products, a non-bank hidden at the heart of the insurance giant. But because AIG wasn’t regulated as a bank, it wasn’t saddled with any requirements to hold capital against these massive potential liabilities.

A large part of those credit default swaps, about $307bn worth, was bought by European banks in endearingly named "regulatory capital forbearance" trades. By buying such insurance, these banks didn’t have to hold capital against their long-term holdings of securities. Another large chunk went to Wall Street firms to hedge their holdings of complicated securities backed by subprime mortgages.

By the end of the year, just this part of this massive book of credit default swaps would cause almost $30bn in losses and trigger what is likely to prove one of the most costly bail-outs ever. Meanwhile, the $307bn "forbearance" book produced a mere $156m in revenue for the first half of last year. These exposures probably represent one of the most skewed risk-reward equations of all time.

AIG did such a booming business selling credit protection because it offered to post generous collateral if the value of the insured securities dropped or if its own credit rating fell. (Other providers, such as the monoline insurers, balked at such terms.) That collateral was meant to give AIG’s clients assurance that they were safely hedged. In fact, that sense of safety was always an illusion. Clients hadn’t reduced their risk, they had increased it.

That’s because the hedges depended on the health of a single institution, AIG, that could never fully compensate counterparties for a big drop in the value of these securities. It might offer to post collateral but if the market plunged, would AIG even be there to post collateral?

"Derivatives were meant to disperse risk," says Dino Kos, a former Fed official who is now at research boutique Portales Partners. "But at AIG, derivatives were used to concentrate risk."

As the value of the securities insured by AIG plunged, AIG faced a bottomless pit of plunging values and collateral calls that was draining the firm of its cash. By the time AIG was downgraded in mid-September and the Fed had to step in, AIG needed to post $32bn in collateral in the following 15 days - on top of $20bn it had already posted just over the summer. In other words, by demanding the ability to protect themselves through collateral calls and the right to terminate transactions, these counterparties unwittingly triggered AIG’s near-death experience.

As the market continued to plunge, AIG and the Fed approached 20 counterparties with an offer to buy these CDOs at a price determined by an independent valuer and then cancel the credit protection on these CDOs. Because these counterparties ultimately received 100 cents on the dollar, the process was reasonably harmonious. That meant both sides were able to avoid another pitfall of the credit default swap market, valuation disputes.

As of year end, Maiden Lane, a vehicle established by the Fed and AIG, bought about $62bn in face value of these CDOs for nearly $30bn while AIG terminated the credit default swaps, spending $32.5bn recognising $21bn in losses in the process. (In bailing out AIG, the Fed was also handing out tens of billions of dollars more to Wall Street.)

Many players in the financial market stay away from credit derivatives because of the issues the AIG saga raises, including pricing uncertainties, valuation disputes and counterparty risk. "People took risk, which the market never fully reflected in prices and then looked the other way," says Mark Mckissick, with Denver Investment Advisors. "The whole CDS market was part of the bubble."

henny.sender@ft.com