Remember when the good old days when we could pretend short-sellers had brought down Wall Street in coordinated bear-runs on stocks and credit default swaps? That reassuring story was just given its coda by this morning’s blockbuster story in the Wall Street Journal about the ridiculous lack of counter-party risk control at AIG. Because the odds are it wasn’t just AIG that had its head up its posterior on this stuff.
Usually we think of “counter-party risk” as the risk of a counter-party on a trade no making good on their obligations. That’s pretty much the classical definition. But as AIG’s fate shows us, there is also the risk that your counter-parties will think maybe you can’t make good on your obligations. Let’s call that reflective counter-party risk—the risk to your firm that your counter-parties will view you as riskier.
Just putting it that way, you can see why it was tempting to ignore it. Wall Street executives are nothing if not a confident bunch. They might view other firms as risky but the people who ran Bear Stearns, Lehman Brothers, AIG and Merrill Lynch apparently believed their main risk was exposure to the failures of others rather than exposure to perceptions that they might fail.
“We were all drinking their own Kool-Aid,” a source who worked at one of the failed firms told us. It’s a particularly apt metaphor since the original Kool-Aid drinkers were cult members who committed suicide by drinking a punch brewed up by their maniacal leader. (A more modern version might be “we were all wearing Nikes” to reference the Heaven’s Gate cult’s familiar footwear.)
We’re told by long experienced financial professionals that it is very likely that Bear, Lehman and Merrill also failed to model for the type of risk that crushed AIG. Indeed, we know that both Lehman and Merrill were crippled by demands for additional collateral by JP Morgan Chase.
So did everyone fail to analyse the possibility that they would have to post collateral in the event of the decline in value of bonds and other debt linked assets that had yet to default? That’s the likely post-mortem that will follow as forensic accountants, regulators, class action lawyers and journalists continue to investigate this story, we’re told by our sources.
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