Tuesday, September 29, 2009

AIGFP's Mistakes

I want to expand on something I said in the comments to my last post. In discussing AIGFP's excuse for not understanding the risk they held, I said that it was broadly a combination of three factors:

  1. AIGFP not understanding or particularly caring about the declining underwriting standards in the subprime market (a mortgage was a mortgage to them);
  2. AIGFP not fully understanding how the (somewhat new) collateral posting process on these trades worked; and
  3. Old-fashioned excessive optimism.
The first two factors require a bit more explanation. Why would a huge financial institution like AIG take on $100+ billion in risk without understanding, or particularly caring about, material terms of the deals? You have to understand the players in the ABS CDS market at the time, and how AIGFP viewed itself in the market. The natural protection sellers for CDS on ABS or CDOs were the monoline insurers (MBIA, Ambac, etc.), since "wrapping" deals is what they do. The market had been trying to develop standardized documentation for ABS CDS for a while, and the monolines had been notoriously difficult to work with. The market never did settle on a single template for ABS CDS, and that was primarly because of the monolines. Instead, the market settled on two forms: the so-called "dealer form" and the "end user form." Ironically, the monolines were adamantly opposed to this because — I kid you not — they said they didn't want to be exposed to market risk.

AIG billed itself as the protection seller that was easy to work with. AIG was willing to use the dealer form, which was more favorable to protection buyers. It was even willing to fully collateralize its ABS CDS trades with shockingly loose Credit Support Annexes (CSAs), on which more below. The monolines were sometimes heavily involved in the negotiations over the underlying deals that they would wrap, so they had at least some say on the quality of the loans that went into the deal (which isn't to say that they were prudent about loan quality, because they obviously weren't). Since AIG wanted to be seen as the hassle-free alternative, it was perfectly willing to simply write protection on deals that the Street brought them. This, from Michael Lewis's article, is actually pretty accurate:
When traders asked Frost [the head of AIGFP's CDS sales] why Wall Street was suddenly so eager to do business with A.I.G., says a trader, “he would explain that they liked us because we could act quickly.” (emphasis mine)
AIG's hands-off attitude meant that it had no line-of-sight to the mortgage market, or to the mortgages underlying their deals. So when the lending standards in the subprime market plummeted, AIG was the last to find out.

In the end, though, it was the terms of the Credit Support Annexes (CSAs) on the CDS trades that really killed them, because they left AIG massively exposed to market risk. CSAs govern the passing of collateral between counterparties to a swap transaction. Standard CSAs provide the parties with the right to demand collateral whenever the party's "Exposure" — defined as the cost of replacing the trade in the market — exceeds a certain threshold. The CSAs on AIG's trades required them to post collateral based on the market value of the underlying cash bonds (i.e., the subprime RMBS), and included moderate thresholds in the 5-10% range, if they included a threshold at all. This meant that as the ABS and CDO markets collapsed and liquidity dried up, AIG had to post more and more collateral — even if, as was sometimes the case, the underlying ABS had yet to suffer any principal or interest shortfalls.

Honestly, it's a mystery why AIG agreed to fully collateralize these trades with CSAs, because it was a phenomenally stupid idea, and it literally brought down the entire company. Again, it left AIG completely exposed to the market risk of the underlying ABS and CDOs, and as everyone knows now, the ABS and CDO markets completey collapsed. What's more, by agreeing to CSAs that provided for collateral posting based on the market price of the underlying securities, rather than the market price of the CDS, they probably deprived themselves of the ability to use the much-more-liquid ABX index as a reference price. Instead, they almost certainly had to use the utterly collapsing prices in the cash ABS and CDO markets. (No word yet on whether they understood the difference between exposure to market risk and the amount of market risk, but all signs point to no.)

AIG also apparently didn't fully appreciate how the process for determining the "market value" of the cash ABS/CDOs — which determines how much collateral they have to post — would work if liquidity completely dried up. When liquidity actually did dry up in 2007, AIG discovered that, per the CSAs, the dealers had the final say on what the market value was. So when, say, Deutsche Bank told AIG that it had to post an additional $25mm of collateral because, according to Deutsche Bank's correlation trading desk, the market value of the underlying CDO had falled from $300mm to $275mm, AIG had no recourse. In the end, it had to post the collateral. (I understand that AIG disputed this reading of the CSA language, which isn't uncommon when a firm is facing large collateral calls, but you can only play that game for so long.)

I know the mistakes that AIG made on the collateral posting probably seem like highly technical mistakes, but believe me, they're not — they're serious, fundamental mistakes that no moderately sophisticated investment shop should ever make.

17 comments:

Anonymous said...

I find your posts interesting: Everybody knew that AIG was taking on huge risks and AIG was making fundamental mistakes on collateral posting contracts. But to me this raises the fundamental question: Why would any dealer bank agree to do business with a counterparty who was all but guaranteed to fail?

anne said...

So let me ask you this, EOC, let's just say lending standards hadn't gone out the window - let's say that even if the housing market declined in value, people had been given loans they could manage - instead of the junk loans they could never afford.

Would the collapse have happened?

I'm just a girl on Main Street trying to figure out how Wall Street, et al. tanked so terribly. And after nearly a year of researching this topic, I still do not understand how so many bad loans were handed out across the country, nor do I understand how so many highly compensated and well-educated businessmen took on huge risks with so little understanding of the risks. (Or to borrow a phrase from you, made fundamental mistakes so striking that they took down the economy.)

(I have the same question about Arthur Andersen - what compelled them to abandon accounting principles in ways that destroyed their business so thoroughly?)

Anonymous said...

A few weeks ago I started asking people this question:

Why only one AIG?

Anne, because they believed in George Bush. He asked them to do it. Also, hasn't Arthur Anderson been significantly exonerated?

anne said...

To Anonymous who posted at 8:07pm - Andersen's obstruction of justice conviction was overturned - is that what you mean?

I was speaking more about the accounting practices that had gotten the firm in trouble - see this from a 6/1/05 NY Times article:

"After all, well before Enron's fraud was disclosed, Andersen had entered a settlement with securities regulators as a result of its role in fraud at Waste Management. And barely months after Andersen was convicted, another audit client, WorldCom, filed for bankruptcy protection. The reason was an $11 billion accounting fraud."

Anonymous said...

@ Anne

Hi Anne,

I will take a crack at this.

"I'm just a girl on Main Street trying to figure out how Wall Street, et al. tanked so terribly."

One of the key things here is the issue of "leverage." I think EOC does a very good job of explaining the details, details which at time can be very arcane. But these fancy details would not matter so much if so much money had not been at stake.

Let's assume you and I both have a net worth of $1 million. Let's also assume that I have IBM in my portfolio. You and I can enter into some sort of an agreement where you will insulate me against losses in IBM's share price. I will pay you a fee for this protection. This agreement can have many of the sophisticated details that a real Wall St. type deal between two institutions would have.

But if we are only talking about 100 shares of IBM - which is just under $119/sh right now, you are on the hook for a max of about $1,200. The "worse case scenario" can hit - and it would be no big deal. Now your net worth is $999,000.

On the other hand, you and I can bet $30 million on who will win the Coney Island Hot Dog Eating Contest. This will be very simple and far from complex. But the consequences of losing are huge given the leverage.

"I still do not understand how so many bad loans were handed out across the country,"

Back in the times of Andy Griffith and Mayberry RFD - banks loaned money and held the loans. If the borrower defaulted, the bank felt the bite. Now banks and - importantly - mortgage bankers, can simply get paid for "originating" a loan. The loan gets passed on to Wall Street types who bundle it with other stuff. By not having to hold the loan, you don't have to care about the success of payback.

"nor do I understand how so many highly compensated and well-educated businessmen took on huge risks with so little understanding of the risks."

This link may help with that.

It is an op-ed by William D. Cohan. He has a book out re: Bear Stearns, which I have not read. But I found the op-ed interesting.


http://www.nytimes.com/2009/03/12/opinion/12cohan.html?ref=opinion

We can escape from the details for only so long. At the risk of over simplification, most of the "toxic assets" that these banks held were "allergic" to mortgage defaults. Whether we are talking skin rash allergic reaction or potential pulmonary shock allergic reaction depends on how much they were holding and etc. With more and more of these bad loans finding their way into "the mix" - the likelihood of mortgage defaults increased.

And, as you now know, most of these institutions were holding enough of this stuff to have to go to the emergency room. In the emergency room, they could not do their day job - which is to lend money to Main St.

This leads to the current debate re: oversight, by the Fed or another body as monitoring the aggregate leverage of the financial sector. Picking a number to make the point - take everything that these firms did wrong and divide it by 50 (or even by 10) - and you have a problem that is significantly less severe.

Hope this was helpful.

RBB

Best bank rates said...

Even by knowing a huge risk, why they took it. You have explained the matter really well, but this action of AIG is still not easy to understand.

anne said...

To RBB,

Thank you. However, I remain puzzled. And here's why. You say:

"But the consequences of losing are huge given the leverage."

So when the consequences are huge, given the leverage, I still do not understand how an insurance company would race toward that risk. It's really such a very poor business decision, that it's almost incomprehensible.

I also don't think we need to go back a half century to Mayberry to find the time when banks were on the hook for the loans they approved. Wasn't the shift about 5 or 6 yrs ago?

It's all making this liberal girl want to become a libertarian, if business people feel that government guarantees and regulations give them free rein to make horrible business decisions that make no sense at all (but garner nice profit, until the economy tanks as a result.)

Thanks very much for the link to the Cohan op-ed piece. Very illuminating.

Anonymous said...

Thanks for the feedback Anne.

re: "I still do not understand how an insurance company would race toward that risk ..."

First, they had "grown" past the point of seeing themselves as a plain vanilla insurance company. Probably saw themselves as more of a super slick hedge fund, IMO.

What I have read is that one main the theory supporting much of this activity was based on U.S. real estate data doing back a "long time" (I can't remember if it was 50 or 100 yrs. - probably post Great Depression). No significant real estate price declines or spikes in foreclosures during this period that had the magnitude to crater these securities.

I have also read that this was not the main driver. Anyone familiar w/alternative views - chime in.

Anyway, I know that after the dot com crash, I heard from many people who had the misfortune of buying 2,000 shares of "nuttyfirm.com" at $300/sh and watched it only go $0/sh. say "I could have bought a home in Chevy Chase, Md for CASH - and then rented out and been better off. I mean, real estate never goes down ..."

I'm sure, prior to last year, you have heard people you know say the same thing about real estate.

Seems like the institutions ultimately got the quants to "reinforce" this notion.

A long way to say "they thought they couldn't lose." Far superior to betting on Joey Chestnut eating hot dogs at Coney Island. Not at all defending this. Just seems to be the frame of mind.

Again, the irony is that what was fueling the creation of these securities (the "origination fee" loans with dubious credit standards) was also "poisoning the well" - creating an environment far more negative and very inconsistent with the time period the data initially covered.

Re: "if business people feel that government guarantees and regulations give them free rein to make horrible business decisions ..."

Some would argue that it was the "lack" of regs and oversight that allowed this to happen.

For better clarity on this, you will probably have to rely upon Mr. EOC.

For example, Bernanke said the way things were organized last year - no one could really step in and properly address AIG. From what I've heard and read - he makes a decent case. I'm sure there are those who don't believe him. So maybe Mr. EOC can help with stuff like that.

At the risk of being "abstract" (or simply kind of weird)- I was watching the PBS special on the Nation Parks in the U.S. the other night. The episode that dealt with the arguments that Teddy Roosevelt, John Muir and others had to fight in order to create and preserve the National Parks kind of reminded me, conceptually, of the "more regs" / "less regs" / "different regs" /argument re: the financial markets going forward.

Linking the financial mkts with the National Parks ... Maybe I need to get out more ... :-)

Anonymous said...

I still can't find an answer. There does not appear to be another failure quite like AIG. If CDS are evil and all that other Rollin' Stone nonsense, shouldn't there be other AIGs?

Anonymous said...

@ Anonymous 10:45 am

I have read (actually more liked skimmed) articles and/or blog posts saying that AIG was like 80% of the CDS market. I think that Mr. EOC is also implying that Ms. Tett should have picked up on the role AIG played in the CDS mkt if she had read the Fitch report objectively as opposed to cherry picking to underscore a point she seemed pre-determined to make.

If AIG was in fact either side of 80% of the mkt., then no one else could be 80% of the mkt. Hence, there could only be one AIG.

RBB

Anonymous said...

This is an excellent post, the author is one of the rare few who actually understand what they are talking about when it comes to CDS, CDOs and structured fin. There are far too many clueless commentators who wrap themselves is a mantle of arrogance to preach to us about reforming the financial system just because they have a Phd in Economics.

Anonymous said...

"I have read (actually more liked skimmed) articles and/or blog posts saying that AIG was like 80% of the CDS market. ..."

I find that somewhat hard to believe.

It appears one reason there are not other AIGs is the collateral issue. GS was sawing off pounds of flesh willy nilly. Another is their failure to hedge their bet. The bet the farm on black, and they had no plan if it landed on red. The other CDS makers apparently handled their CDS better.

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