The Tragic Story of AIG Financial Products
I have been enjoying the first two parts of The Washington Post's series on AIG's role in the financial crisis. Of all the places where taxpayer money has been wasted in this series of bailouts, the most galling to me is the $150+ billion (so far) to compensate uninsured creditors of AIG. So it is nice to have some reporting from The Post about how we got here. Reading the early sections of Part I of the series (covering the Financial Products division through 1998), we find this:
But it took more than technology to realize their vision. It took a culture of skepticism. The firm set up a committee to examine all transactions at the end of each workday, searching for flaws in logic, pricing and hedges. "Everyone kind of understood what the nature of the game was. . . . This was not a company that involved speculating," said Tom Savage, a mathematician from Drexel who joined the firm in 1988. "So it was everybody's job to criticize and double-check other people's opinions about what was appropriate business and what wasn't."
It is some lesson in organizational behavior to learn how that attitude gave way to practices that led to an epic meltdown of default swaps. The details of AIG's demise don't change my view of what's going on: taxpayer money should never be used to cover AIG's obligations.
The story continues with Part II (covering the division through Hank Greenberg's retirement), and The Post has links to the whole series here.
AIG and Derivatives
One of the reasons the money keeps buzzing off into the void near AIG is that AIG was allowed to go so heavily into derivatives as a counterparty. Here is a quote from an OCC report issued today on banks (not AIG) that gives you feeling for the general magnitude of the problem, even though AIG was only one player in the larger game, it was playing with derivatives from all types of institutions:
...The [OCC] report shows that the notional amount of derivatives held by insured U.S. commercial banks decreased by $6.3 trillion in the third quarter, or 3 percent, to $176 trillion. Interest rate contracts decreased $7.7 trillion to $137 trillion due to acquisition-related elimination of contracts. Although market participants continue to use methods such as trade compression to reduce economically offsetting credit derivatives trades, credit derivative contracts increased 4 percent, to $16 trillion. Ms. Dick noted that "the uncertain credit environment created demand for credit hedges, particularly for counterparty credit risks."
The OCC also reported that net current credit exposure, the primary metric the OCC uses to measure credit risk in derivatives activities, increased $30 billion, or 7 percent, during the quarter to $435 billion. Banks charged-off $92 million in derivatives receivables during the quarter, or 0.02 percent of the net current credit exposure, down from $120 million in the second quarter.
The report also noted that:
* Derivatives contracts are concentrated in a small number of institutions. The largest five banks hold 97 percent of the total notional amount of derivatives, while the largest 25 banks hold nearly 100 percent.
* Credit default swaps are the dominant product in the credit derivatives market, representing 99 percent of total credit derivatives.
* The number of commercial banks holding derivatives increased by 2 in the quarter to 977. ...
While derivatives are neither illegal nor officially frowned upon, it seems surprising that the liability they represent is still growing.
naked puts
in a finance class a professor told me about someone or some people who sold naked puts. Said person also kept an airline ticket to another country in his desk drawer. For a while, it was easy money: keep collecting cash for selling puts that expired worthless . And when the day did come when the puts were in the money, the person who sold the puts would flee to another country.
In this case, one keeps the fed's phone number handy, or a sovereign wealth fund or Buffett.
This needs some explanation
Professor Samwick --"Of all the places where taxpayer money has been wasted in this series of bailouts, the most galling to me is the $150+ billion (so far) to compensate uninsured creditors of AIG."
This sounds like the classic emotional complaint whenever a central bank intervenes in a financial crisis, dating back to the 1800s.
The classic answer is that's why we have a central bank--to intervene to maintain financial-system stability, not to bail out individual creditors (they just got lucky).
Do you believe that AIG's collapse would NOT have threatened the financial system? Or that there was a cheaper way to protect the system? Or that we shouldn't have a central bank? Or what?