In “AIG Is A Fracking BLACK HOLE,” we noted that AIG CEO Edward Liddy has admitted that the company may need even more than the $123 billion US taxpayers have already promised to provide collateral for its credit default insurance bets. We wondered lightheartedly whether AIG’s losses were potentially infinite.
Well, are they?
Has anyone out there had a good look at AIG’s gambling book?
Our understanding of credit default swaps is rudimentary, but here’s what we’re wondering about:
AIG was free to write as many insurance contracts as it wanted on the same company’s debt, right? It wasn’t subject to, say, regulations or anything.
So let’s say the company in question goes bankrupt or defaults on its debt. If AIG has written 1,000 contracts insuring the same $1,000 bond against default, it will be out $1 million, right? No biggie.
But what if 10 companies go bankrupt, each with $10 billion of debt, and AIG has written 1,000 contracts on each company’s debt? That would be $10 trillion of losses, right? That’s getting close to the size of the US economy.
We hope (pray) that AIG’s “risk control” people considered not this eventuality (because we know AIG couldn’t care less about the “system”) but the eventuality that its own shareholders would have to cover some big losses…and therefore put some limits on how much exposure it could take to any one company. But did they limit the exposure AIG was taking to the entire economy? What likelihood did AIG’s “risk models” place on the possibility that, say, 25 major financial companies would go bust?
Can any AIG or CDS aficionados out there enlighten us? (While you’re at it, please explain why Hank Paulson doesn’t just rip all those insurance contracts up).
See Also: AIG Is a Fracking BLACK HOLE