AIG and the Free Lunch Myth

Monday's WSJ had a rather astounding passage contained within an article on 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."

click to enlarge

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 and 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.

Sources:

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.

Comments

[mdmrjsds:]

What you describe AIG as doing isn't a Ponzi scheme. The classic Ponzi / pyramid scheme has payouts to earlier joiners coming from later joiners. e.g. Social Security, Medicare

What you describe above is fraud, taking money from customers without providing the value you promised for it. Obviously, AIG had no intention of honoring these contracts if they didn't make provision for them. They were selling empty promises based on the value of their name.

2008 Nov 05 12:12 PM

[billp70964:]

It's a very old story. It comes from arrogance. It comes from utter disrespect of the market. It comes from complete lack of experience with markets.

If you're standing on a trading floor (or in the OTC market) and people bid you for a security and have a seemingly limitless appetite for that security a couple of things should occur.

You should start increasing the price-fast! You should also pay sharp attention to that gnawing feeling in your stomach that these folks know a hell of a lot more than you do about what's going on.

Failing that, you certainly should not be handling anybody's money (maybe even your own) because you've just fit the classic definition of a certified idiot!

We saw "models" go bad in 1987 in the options market when Continental Illinois Bank bought a local options clearing firm and nearly brought down the entire banking system of the US in October of '87.

We saw it again in 1997 with Long Term Capital when their model didn't factor in a major volatility upswing.

As a matter of fact, to a lesser extent, we see this in all derivatives markets every single day. It's essentially trading the volatility in a rational manner that makes smart traders money.

AIG did the polar opposite!

2008 Nov 05 12:33 PM

[JasonC:]

Put writing is popular in stable uptrending markets.

CDS contracts on credits that looked sound were put writing.

Lending on mortgages backed by houses with rapidly rising prices were put writing.

Asset backed lending at razor thin spreads differs from straight lending on risk free assets by the implicit put being written on the value of the collateral.

All lending on terms that involve no upside if things go well but plenty of downside if they don't is put writing.

All leveraged positions in risky assets that have someone else apparently or actually on the hook if things go wrong, while the whole leveraged upside belongs to the risk-taker if they do not, are call positions, and call positions can only be created by someone else willingly engaging in put writing.

All assets are owned and owned exactly once. The net change to all market participants is therefore always the change in the value of everything, without financing or leverage or hedging of any kind. Those activities never control risk, they simply shift it to someone who does not know he is taking it and therefore misprices it.

When a lender sees no risk in a CD loan to a bank, he is rational because he sees an underwriter's guarantee from the authorities. That too is put writing - the authorities promise to take all the losses once they reach the point where they might endanger a bank depositer.

That underwriting can be rational - the authorities do own upside after all, in the form of taxation of every profit. They haven't thrown away all upside in underwriting against downside risks. They did agree to finance the smash phase of the cycle by doing so, and now they are called on to make that good.

One can moan about how horrible it is that someone else may profit from a bet made with borrowed money, but until savers give up the desire for safer forms of investment there will always be a demand for the speculative, junior, call positions --- because those are inseparable from the senior and put writing positions.

It is always possible to fund things with a higher portion of equity, or to blend holdings across all asset classes in a way that captures the total average returns instead of slicing it up and betting on specific positions. The second always amounts to calling the specific range in which future returns will lie, instead of their average or overall direction.

Nobody should be remotely surprised that it is harder and therefore that more bets made that way blow up and wreck the plans of those engaged in them.

Long run average returns across entire capital markets are always going to be easier to predict than narrow bits deliberately made as volatile as possible. But will men be satisfied with them? That is the question.

When capital is not paid to be conducted safely, it does not go away or initially succeed in demanding greater rewards. Instead, risk will be gunned and concentrated instead. This used to be a proverb - "John Bull can stand many things, but he cannot stand 2%".

2008 Nov 05 12:52 PM

[LIGUY73:]

I have a real problem with this statement.
"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?"

There is not one insurance policy issued today that is priced to protect the insurer from a catastrophic loss. If they were, insurance premiums would be through the roof and no one would be able to afford them.

What happened in the CDS market brings us to the fundamentals of frequency and severity analyses. It is an insurance law and a statistical fact that Sever losses do not occur frequently. It seems to me through the following quote,

"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"

that AIG did price these insurance contracts knowing there would be losses. They however didn’t price these insurance contracts to avoid going bankrupt in the face of catastrophic losses.

It would indicate to me that AIG was following standard insurance operating procedure in their pricing.

What AIG should have done to protect itself was to purchase reinsurance on these insurance contracts to protect from the potential for catastrophic losses.

Who knows if such a reinsurance market even exists for these products.

AIG got caught big time from the fallout of the housing market crash. They got caught looking. Before you blame AIG for not seeing this coming, you should know that all banking institutions got caught by the same issue. Singling out AIG is ignoring the systemic issue that companies did not think the housing market would crash as perfectly, and thoroughly as it did.

2008 Nov 05 01:13 PM

[1 of 4:]

"You should start increasing the price-fast! You should also pay sharp attention to that gnawing feeling in your stomach that these folks know a hell of a lot more than you do about what's going on."

Billp's comment is spot on. Also, AIG (and the entire CDS market) violates a fundamental law in the insurance indusrty: you can only sell insurance to those who have an insurable interest. Which means buyers of the CDS must hold the underlying security or debt to have an insurable interest. This restriction alone would have eliminated the speculation and really contained the CDS market.

2008 Nov 05 01:48 PM

[helplessobs...:]

1 of 4 is right, all contracts, that is the side bets, should be cancelled and premiums returned. Bond holders on the other hand need to be paid off if they have lost on their bonds.

2008 Nov 05 08:09 PM

[RTF 360:]

"Obviously, AIG had no intention of honoring these contracts if they didn't make provision for them"

crystal clear observation...Where is the Insurance Commissioner, U.S. Attorney, States Attorney and "bad faith" lawsuits that also include violation of fiduciary duty and personal disgorgement ?


On Nov 05 12:12 PM mdmrjsds wrote:

> What you describe AIG as doing isn't a Ponzi scheme. The classic
> Ponzi / pyramid scheme has payouts to earlier joiners coming from
> later joiners. e.g. Social Security, Medicare
>
> What you describe above is fraud, taking money from customers without
> providing the value you promised for it. Obviously, AIG had no intention
> of honoring these contracts if they didn't make provision for them.
> They were selling empty promises based on the value of their name.

2008 Nov 06 12:38 AM

[BerkeleyBob:]

1 o 4 has it bang on. Nothing wrong with those having an insurable interest hedging against default, future price increases, etc. Please note that AIG was involved in reinsurance transactions which resulted in jail terms. Reinsurance is largely unregulated and true reinsurance is in principal very much like a bookie who balances his risk by selling off some of his wagers. As is similar to the Enron fraud, AIG and the others involved in CDO's etc. were trying to conceal the nature of their transactions by using invented terminology. As is similar to the S&L collapse, the present housing crisis was marked by lax underwriting and bad appraisal practices and the ratification of toxic paper by the rating agencies.

2008 Nov 06 12:05 PM

[Elephant Flop:]

Actually, it does fit the definition of a Ponzi scheme. The "payouts" to increasingly nervous "ground floor" earlier "investors" are the collateral demands
in the above WSJ chart. The scheme collapsed when AIG had no more assets to pony up to the most sophisticated *suckers* in the world.

Or maybe they aren't the suckers since we taxpayers are footing the bailout bill, even as we continue to pay into our own state sponsored Ponzi - trading under the ticker of "social security."

What hurts is listening to Hank Greenberg's Ponzi Polka.

www.indybay.org/newsit...


On Nov 05 12:12 PM mdmrjsds wrote:

> What you describe AIG as doing isn't a Ponzi scheme. The classic
> Ponzi / pyramid scheme has payouts to earlier joiners coming from
> later joiners. e.g. Social Security, Medicare
>
> What you describe above is fraud, taking money from customers without
> providing the value you promised for it. Obviously, AIG had no intention
> of honoring these contracts if they didn't make provision for them.
> They were selling empty promises based on the value of their name.

2008 Nov 11 11:44 AM