We’re still reeling from the report in this morning’s Wall Street Journal that AIG’s risk control model’s failed to take into account the risk that its customers would require more collateral as the credit market’s perception of risk tightened. Here’s what we think happened.
First, let’s review briefly what the Wall Street Journal tells us this morning. AIG issued huge amounts of credit default swaps, often on complicated bundles of credit products. Their risk models, apparently analysed only the likelihood that AIG would be forced to pay off credit default swap policies insuring bond defaults. They did not, reportedly, analyse the possibility that AIG would have to post collateral in the event of the decline in value of bonds that had yet to default–despite the fact that AIG was contractually obligated to do so.
As we understand it, here’s what happened.
- The bonds AIG was insuring declined in value because investors viewed them as riskier. Banks who had purchased credit insurance from AIG demanded that AIG put up additional collateral. Banks were forced to reckon with the risk that AIG would not be able to make good on the insurance contracts it had sold. A huge wave of correlated defaults would obviously make it more likely that AIG itself would fail. Banks, which were already forced to mark-to-market bonds were also forced to mark-to-market the insurance on those bonds. They sought to minimize these mark-to-market write downs by getting more and better collateral from AIG.
- What’s more, the banks sought to minimize their exposure to a possible AIG failure by hedging through credit default swaps on AIG. To put it another way, they bought swap contracts that would pay off if AIG failed, giving them an upside to balance the downside risk of AIG’s failure. But new demand for AIG credit default swaps drove up the price of the swaps. This, in turn, made AIG appear even riskier, which would have forced more hedging and more collateral calls.
- Although the Wall Street Journal doesn’t say this explicitly, at least a portion the assets AIG had put up to collateralize its insurance obligations were likely to have been bonds and swaps themselves. As these assets were marked down, AIG found itself obligated to put up even more collateral. This process is almost mechanical. If your collateral is worth 20 per cent less, you need to put up additional collateral just to get back to your original level of collateralization. This is compounded when customers are already demanding more collateral because the value of the bonds you insured and the value of the insurance you sold are getting written down under mark to market rules.
Don’t blame the banks, which had no choice but to demand more collateral from AIG. As the collateral value dropped, they had to ask for AIG for more collateral just to make the collateral pool whole. As the perceived likelihood of defaults on insured bonds rose, the banks had to seek assurance that AIG would be able to make good on its insurance contracts or at least limit the losses if AIG couldn’t pay up.
In short, AIG found itself in a three-way squeeze as the value of the underlying bonds, the value of the insurance and the value of the collateral were all crushed.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.