AIG And The “Free Lunch Myth”

Yesterday’s WSJ had a rather astounding passage contained within an article on AIG (AIG) and the risk models utilized within their Credit Default Swap business (referred to as their Financial Products Unit):

From the WSJ:

AIG began selling credit-default swaps around 1998. Mr. Gorton’s work “helped convince Cassano that these things were only gold, that if anybody paid you to take on these risks, it was free money” because AIG would never have to make payments to cover actual defaults, according to the former senior executive at the unit. However, Mr. Gorton’s work didn’t address the potential write-downs or collateral payments to trading partners.

AIG became one of the largest sellers of credit-default-swap protection, according to a Moody’s Investors Service report last week. For years, the business was extremely lucrative. In a 2006 SEC filing, AIG said none of the swap deals now causing it pain had ever experienced high enough defaults to consider the likelihood of making a payout more than “remote, even in severe recessionary market scenarios.”

AIG charged its trading partners a fraction of a penny a year for every dollar of credit protection. The company realized, of course, that it might have to post collateral if the market values of the underlying securities declined. But AIG executives believed that such price moves were unlikely to occur, according to people familiar with AIG’s operation.

Graphic courtesy of the WSJ

Well, that sums up the problem in a nutshell: it wasn’t so much that there is anything wrong with CDS in of themselves per se, it’s that some of the people selling them were operating under the misguided notion that they were getting “free money” and would never have to raise any capital to cover the risks they were taking on. In effect they were disobeying a fundamental rule of the Insurance business, you know that rule about setting premiums at a high enough level to cover potential payouts in addition to having enough capital on hand to cover additional risks?

I guess no one ever told the folks at AIG that there was no such thing as a “free lunch”. The irony here is that if some “local businessman” came to a friend or family member of Mr. Gorton  with a similar sounding get rich scheme, he probably would’ve advised them that they were being scammed.

At least I would hope so.

Reading through the article I was reminded of a quote from the TV Show “News Radio” spoken by Jimmy James the multi-billionaire owner of the radio station:

“Beth you sold something of no value that you didn’t own, there is nothing left about business for me to teach you”

After all, what else would you call AIG’s CDS business?

The fact that the regulators allowed this to happen, on top of executives turning a blind eye (as long as their bonuses were rolling in) and none of their investors and/or creditors scrutinized the books enough to raise a red flag about this issue is downright criminal.

But let’s stop kicking the dead horse with the aid of 20/20 hindsight and think about the future:

It’s becoming more and more clear that many aspects of our economy, banking system, etc, operate in much the same fashion as a Ponzi scheme. If the new administration, financial executives, etc, truly want to save us they need to start attacking the Ponzi aspects of our financial systems as if they were a cancer, and replace them with a financial system that is firmly grounded in reality.

I’m sure the above statement may sound like a mere abstraction to some, but if you think about it some of the solutions are obvious:

Regulate CDS just like any other insurance product, in order to prevent a situation where a company is selling risk protection products as if they’ll never have to cover any losses.

Make it unlawful for banks to use CDS as regulatory arbitrage to meet capitalization requirements; in fact just set higher standards for what can qualify as a Tier-1 asset so that banks aren’t using derivatives as capital.

The idea is simple you review the banking and insurance industries and work to eliminate situations where we have de facto Ponzi schemes, and/or financial systems that are a house of cards. Now I’m sure the financial industry will squawk very loudly about this, but considering that they’re coming to the Government for handouts to stay in business it should be easy to shut them up.

You can read more here.

Source:

The WSJ : “Behind AIG’s Fall, Risk Models Failed to Pass Real-World Test” — Carrick Mollenkamp, Serena Ng, Liam Plevin and Randall Smith, November 3, 2008.

Disclosure: at the time of publishing the author didn’t own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn’t be viewed as financial or investment advice.

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