CBS News somehow obtained a fascinating AIG internal memo from November 2007 detailing the status of the collateral calls on AIG's CDS portfolio. The memo was evidently written by AIG Financial Products VP Andrew Forster, and it provides tremendous data on AIG's CDS portfolio—it's easily the most and best data in the public domain. CBS also obtained an email from then-AIGFP chief Joseph Cassano to another AIG exec describing Forster's memo, but the only new piece of information in the email is that Cassano struggles with punctuation. The memo breaks down AIG's entire CDO CDS portfolio by counterparty, includes all the deal names, and most interestingly, shows how each dealer was pricing each deal. As the protection seller, AIG generally had to post collateral based on the value of the reference CDO bonds. As the price of the reference CDOs fell, AIG generally had to post additional collateral to compensate for the price decline. That's all well and good if you can accurately price the CDOs, but the CDO market was more or less completely illiquid by November 2007, so there were no reliable market prices available. Pricing methods were therefore highly subjective (and unreliable), and dealer quotes were all over the map. The memo stresses this point:
The market is so illiquid that there are no willing takers of risk currently so valuations are simply best guesses and there is no two way market in any sense of the term. ... There is no one dealer with more knowledge than the others or with a better deal flow of trades and all admit to "guesstimating" prices.To simplify greatly, the lower a dealer was pricing the reference CDOs, the more collateral it could demand from AIG. (And just in case you're confused by the terminology in the memo, a "CSA" is a Credit Support Annex, which is an annex to the ISDA Master Agreement, and governs collateral calls in CDS transactions.) So how were the various dealers pricing the reference CDO bonds in November 2007? Not surprisingly, Goldman seems to have been pricing the reference CDOs in its trades more aggressively than the other dealers. [Add: I should also note that another way to put it is that Goldman was pricing the reference CDOs more "realistically" than the other dealers.] For example, the memo notes on page 7 that Goldman was pricing a deal called Independence V at 67.5 for purposes of collateral calls, whereas Merrill was pricing Independence V at 90. More broadly, Goldman's average price for its reference CDOs was 74; Merrill's average price was 83. The memo also notes that SocGen and Calyon both relied heavily on Goldman for pricing, which would explain why this Bloomberg article from Monday essentially accused Goldman and SocGen of killing AIG. What's also interesting (though not at all surprising I suppose) is how willing AIG was to play fast and loose with collateral thresholds. Thresholds are the amount by which the reference CDO has to decline in value before the protection seller is required to start posting collateral to compensate for price declines. A 10% threshold to the CSA means that the protection seller wouldn't be required to start posting collateral until the value of the reference CDO fell below 90%. Given that AIG sold around $400bn of CDS protection (on net), you'd think that AIG would have insisted on high thresholds so that it wouldn't be exposed to mark-to-market risk on hundreds of billions worth of structured products at once. But no. According to the internal memo, several of AIG's CDS contracts (with multiple dealers) included no threshold to the CSA at all. The majority of its CDS contracts with Goldman, which was its biggest counterparty, had thresholds of only 4%. I guess I shouldn't be surprised anymore when I learn that AIGFP did something that stupid/reckless. But I still am.