Up until now the tales of AIG’s near collapse have largely focused on the derivatives trades, largely credit default swaps, built by the company’s small Financial Products division. This morning the Wall Street Journal directs our attention to the larger AIG Investment unit, which placed huge bullish bets on credit products in the quest to achieve $1 billion in annual profits.
The story is long and a bit complex. Here’s what we think was going on with AIG’s unit. It’s easy to see how the kind of strategy AIG followed could produce almost endless losses.
AIG Was A Huge Securities Lender. The main purpose of securities lending is facilitating short sales. Basically, a securities lender buys a security and lends it out to a short seller or someone who wants to hedge a long position in the market. In exchange for lending out the security, AIG got a fee and some collateral. AIG would then turn around and use that collateral and fee to buy more of the securities, particularly mortgage backed securities. This means that AIG was institutionally long the market in mortgage backed securities.
Why Were They So Big? Securities lending is a low margin business. It started out as a service for settlement failure–when someone who was supposed to deliver a stock or a bond but didn’t. It grew into a service for short-sellers and hedgies. In order to ramp up the profits, AIG had to do two things: bet the fees and collateral and get really, really big. It grew almost 10 fold in less than 8 years. Although betting the collateral might only up the yeild by a few basis points, that can add up to serious numbers when you are running hundreds of billions of dollars.
AIG Ignored Two Huge Risks In The Strategy. Although AIG’s top executives thought the strategy didn’t present undue risks, the strategy is very risky. (1) AIG’s long position in the mortgage backed securities market was essentially unhedged. (2) Investing cash collateral from short sellers meant that AIG was basically shorting cash, investing with borrowed money. It’s a form of leverage. When the short sellers close their positions, you can get caught having to sell your positions to raise the capital to give back their cash. (3) Because the strategy of betting collateral only squeezed an additional 0.2 percentage point in yield, it’s more or less impossible to hedge the strategy. The extra yield would get eaten up by the cost of the hedge.
As Short Interest In Subprime Grew, AIG’s Business Brew. While short sellers like John Paulson started piling up short positions in the American residential real estate, basically betting that housing would come crashing down, AIG was facilitating this. Its business and the size of its portfolio grew in direct proportion to the demand for short sales in these securities. All along, AIG kept doubling down on its positions, going even longer. For years, this strategy produced hundreds of million in profits. Unfortunately, those hundreds of millions were made while taking on tens of billions of risk.
Despite Internal Warnings About Subprime, AIG Kept Building Its Position. When the market began flashing warning signals about loose mortgage lending standards, managers of the separate AIG Financial Products decided to stop writing credit derivatives on securities backed by subprime collateral. AIG Investments, however, kept right on building the position. From a $1 billion portfolio in 1999, AIG ramped up to almost $100 billion by mid-2007.
The Ideology of Dislocation Kept Them From Selling. Like so many other financial disasters, AIG refused to believe the evidence of the markets. It could see that the real estate market had become distressed in the summer of 2007, but it didn’t want to sell the mortgage backed securities at “dislocated market prices.” Why were the prices “dislocated?” That’s code for the prices being below where AIG thought they should be. They had all these financial models that told them you couldn’t have a national housing downturn but yet here we had one. Surely this market misbehavior would correct itself eventually. All AIG had to do was hold fast, keeping borrowing and wait for that turn around. Unfortunately, the market stayed dislocated longer than AIG could stay solvent.
The Short Sellers Come Calling Again. In the end, AIG’s strategy of betting with borrowed money–the collateral their customers had put up to borrow mortgage backed securities from AIG–became a fatal mistake. When short-sellers closed out their positions, they demanded back the collateral. When hedged credit funds decided to exit long positions in the MBS market, they also closed out their short-hedges. AIG had put the collateral into mortgage backed securities, some of which had lost half their value. AIG simply couldn’t meet these obligations. *Ring! Ring* “Hello, Mr. Bernanke? This is AIG. We need to talk.”