Friday, September 25, 2009

Risk held at AIGFP was not a surprise

Gillian Tett is going way out of her way to avoid admitting that she (or any financial journalist, really) could have and should have known that AIG Financial Products was holding a substantial portion of the risk in the credit derivatives market. In today's FT, she argues that the opacity of the CDS market prevented anyone from knowing about the huge risk concentration at AIGFP in advance. I won't deny that the CDS market is opaque and that more transparency is needed, but the risk concentration at AIGFP was neither a secret nor a surprise—and it certainly shouldn't have been a surprise to a financial journalist who is supposedly an expert on the credit derivatives market. The "hoocoodanode?" card won't play on this one. Tett cites a Fitch survey of the CDS market from 2007 to make her point about AIGFP:

[W]hat is ... striking is that a well-respected Fitch survey before the collapse of the credit bubble suggested that AIG was just the 20th largest credit default swap player in the sector, based on gross notional outstanding volumes. No wonder those billions of lossmaking contracts subsequently came as such a shock.
Tett is being very disingenuous here. First, not until a few paragraphs later does Tett admit that the 2007 Fitch survey was ranking counterparties by gross notional rather than net notional amounts. The Fitch survey wasn't wrong—AIG was only the 20th largest counterparty in the CDS market by gross notional amount. What's wrong is to suggest that a ranking of counterparties by gross notional amount is the same as a ranking of "the largest players in the CDS market." More importantly, though, what Tett conveniently fails to mention is that this very same Fitch survey clearly explained that AIGFP was the 800-pound gorilla in the credit derivatives market, and that by the end of 2006, AIGFP had sold a net total of $384 billion in CDS protection. From the 2007 Fitch survey (emphasis mine):
Global Insurance The global insurance/reinsurance sector, representing principally AIG Financial Products, remained a large seller of protection, registering an aggregate gross sold position of USD503bn. On a net basis, the sector stood at USD395bn sold, up slightly from the USD383bn tallied at year-end 2005. Structured finance synthetic CDOs and corporate synthetic CDOs accounted for 93% of the sold volume. In terms of quality, of the total gross amount sold, 93% was in the super-‘AAA’ segment, versus 91% reported in last year’s survey.
In addition, 68% of the tenor sold ranged from one year to four years (compared with 44% at year-end 2005) though that was driven by AIG’s dominant “footprint” in this market. Excluding AIG Financial Products’ sizeable position, the global insurance industry had a net position of only USD11bn (USD21bn gross sold), down from the USD15bn (USD29bn gross sold) compiled at year-end 2005. Some of the decline can be attributed to a smaller sample than in the previous year.
By product on a sold basis, single-name CDS consisted of 63% of the volume, while corporate synthetic CDOs and structured finance synthetic CDOs made up just 16% of the total. Similarly, the credit profile, excluding AIG, of the industry changed, with ‘BBB’ representing 40%, ‘A’ at 35%, and ‘AA’ at 10%, while speculative grade represented 8%, and ‘AAA’ 6% of the notional amount sold.
The Fitch survey—which is publicly available (with a free Fitch account)—was published in July 2007, and was very well known in the markets. If you're a financial journalist covering the credit derivatives market, there's no excuse for not knowing about AIGFP until September 2008.


anne said...

So if "the risk concentration at AIGFP was neither a secret nor a surprise" - and if Gillian Tett should have known all about it, what's AIG's excuse for not understanding the risk they held?

Economics of Contempt said...


AIGFP's excuse, or the real reason? ;)

Their excuse seems to be that it was all Joe Cassano's fault.

I doubt we'll ever truly know the real reason. My sense, from talking to people in a better position to know than me, is that it was a combination of AIGFP: (1) not understanding or particularly caring about the declining underwriting standards in the subprime market (a mortgage was a mortgage to them); (2) not fully understanding how the (somewhat new) collateral posting process on these trades worked; and (3) old-fashioned excessive optimism.

The mistake that the people who knew about the risk concentration at AIGFP (myself included) made was assuming that AIG was a modestly sophisticated financial institution, with a non-dysfunctional risk management system. It turns out they lacked both sophistication and a functional risk management system. Could we have known about this in advance? I've never looked into it, but my guess is that we could've at least known about the problems with their risk management. I highly doubt that any institution could've known about the collateral posting requirements on all AIGFP's trades with other counterparties though.

Best Bank Rates said...

Even by having lots of discussion on AIGFP, we will never get the real reason from it.

Anonymous said...

The Gene Park story makes sense to me.

Would love to see a comment on Alan Grayson's latest camera time at Barney Frank's hearing.

Philip Crawford said...

If the report was well known, which I don't doubt, why did AIG equity price hold up so well throughout 2007? I remember lots of discussions in the comments section of CR guessing who the CDS bag holder was going to be and I don't recall a consensus on AIG. (The consensus was always the tax payer. heh)

I guess that is what you're saying in your comment. We knew they had exposure, but assumed they were properly managing it. Even with that said, it still seems the stock price should have been hit from this exposure before the start of 2008.

Anonymous said...

AIG's stock price remained high because its investment strategy was actually rational from the perspective of shareholders. By simultaneously selling credit default swaps linked to subprime mortgages and buying lots of mortgage-backed securities for its own investment portfolio, AIG transferred expected wealth from its creditors (and taxpayers) to its shareholders. See

Anonymous said...

I think you miss Tett's point that the really worrisome questions are: Who is selling CDS now that AIG is out of the picture and do the Central Banks have the data they need to monitor the situation?

Anonymous said...

If the risk held at AIGFP was indeed not a surprise to anyone trading in the CDS market, then can we assume that AIG's counterparties deliberately caused a systemic collapse of the CDS market?

Anonymous said...

@ Philip Crawford
@Anonymous 10:53 am

Re: AIG's Price - It actually did not "hold up well." I know this because I was shorting it.

I don't know when in July 07 this report came out - but the early July price for AIG was about $70/sh. The late July price was about $64/sh. It did bounce around either side of $65/sh. until late October and then it went on to sniff the lower 50s before settling around $58/sh. for the year.

Using the end July price, it was dropping at about a 20%/yr. pace. Using the early July price, it was dropping at about a 30%/yr. pace.

Pretty tame compared to what was to come, but far from holding up well. Before the reverse split, the float for AIG was about 2.5 bln shares - so it takes awhile to move a stock like that. Also, the report was "out" - but possibly not widely read or discussed. I don't think Maria Bartiromo or Larry Kudlow spent a lot of time talking about this - assuming they were even aware of its existence.

The price action at that time was, IMO, consistent with institutional liquidation. More big money going out the door than coming in ...


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