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:
- AIGFP not understanding or particularly caring about the declining underwriting standards in the subprime market (a mortgage was a mortgage to them);
- AIGFP not fully understanding how the (somewhat new) collateral posting process on these trades worked; and
- Old-fashioned excessive optimism.
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.