AIG's Speculative CDOs in Perspective

The WSJ recently published an article highlighting the speculative nature of approximately 10 billion CDOs insured by AIG. They became an issue because the Maiden Lane III facility, which is buying up the collateral underlying the portfolio of Super Senior CDOs AIG insured, can't buy the collateral in this case. The insured parties don't own it – there is no insurable interest.

The WSJ article mentions “Abacus” and Goldman Sachs (GS). A search on the two terms brings up a Fitch downgrade announcement which is very informative:

Abacus 2005-CB1 is a synthetic collateralized debt obligation (CDO) that closed on Dec. 7, 2005 created to enter into credit default swaps with Goldman Sachs Capital Markets. Abacus 2005-CB1's synthetically referenced portfolio is comprised primarily of subprime RMBS bonds (72.7%), CMBS (20.5%) and other structured finance assets. Subprime RMBS bonds of the 2005 vintage account for approximately 48.7% of the portfolio.

For an definition and explanation, here is a link to Investopedia.

I have reviewed the material available on synthetic CDOs on the internet, and find that these transactions have been relatively common and were generally considered as a useful innovation compared to CDOs constructed with actual assets as collateral. It was more convenient to reference the collateral by a CDS than to actually locate and buy it. In point of fact, it appears that those who held certain assets found it easier or more convenient to offload the risk via synthetic CDOs than to sell the assets.

Of course, if a seller knew certain assets were no good, referencing them in a synthetic CDO was a nice way to place a bet. Synthetic CDOs to a large extent have become part of a huge zero sum game. Frequently no insurance is provided due to the lack of insurable interest. The WSJ is accurate in characterizing many of these transactions as speculative.

A review of the prospectuses for CDOs insured by Ambac (ABK) reveals that some of them permitted synthetic collateral, typically limiting it to a specified percentage of assets. Searching such documents for the word “synthetic” yields numerous instances, scattered throughout page after page of definitions and other contractual provisions. Ambac does not disclose what portion of the CDOs it insures contain synthetic collateral.

MBIA's (MBI) CDO disclosures specifically note certain CDOs as synthetic. According to Jay Brown's Comments on TARP addressed to Hank Paulson, MBIA insured approximately 100 billion of such CDOs. MBIA is not required to post collateral and as such will not be pressured as AIG was.

Brown's take on such transactions is informative: he now regards them as a zero-sum game, large enough to swamp the TARP program if it got involved, and as having no effect on the real economy. This is the stuff that Congress saw fit to protect from regulation. What I see is a mechanism whereby legitimate investors could be duped into providing insurance on risky assets, and frequently without the poor excuse of an insurable interest.

This all gets back to points I have been hammering on, to little avail, for over a year:

1. CDS are insurance and should be regulated as such

2. Regulation should include a requirement of insurable interest

3. Regulation should ensure that those who write Credit Default insurance are adequately capitalized.

Looking at AIG's involvement: what they did, at the time they did it, was widely regarded as a normal and acceptable business practice. In hindsight, it was not. This is the price we pay for innovation untrammeled by regulation.

Disclosure: Author holds a long position in AIG; reducing positions in ABK and MBI.

Comments

[Mr Synthetic:]

The fact that a CDS can be a form of insurance does not imply that they need to be regulated, or that they need to be regulated by the insurance regulator. Shorting a share can also be a form of insurance, yet would you say that they should be regulated by an insurance regulator? I don't think so. In particular, it would be a mistake to do so because insurance regulators typically require capital provisioning using historical default and loss rates, while a CDS gives rise to mark-to-market losses, which are typically far higher: if you provision capital only on a historical basis you'll end up being undercapitalized and risk large unexpected economic losses.

What is important is that investors need to be aware that a CDS doesn't require insurable interest, and therefore they need to question the CDS protection buyer's real motives very carefully: look at the list of deliverables and exclude any that they don't feel comfortable with, and require that the only acceptable proof of default ("notice of Publicly Available information") be an actual trustee report detailing the missed payments, and not a reuters or FT article claiming that there has been a default (or for that matter a sworn statement from a director of the buying institution, that's complete folly!): if a trustee report is not available, it's highly doubtful that there is an actual loss, and even more doubtful that the FT would have any idea at all of the loss amounts.

2008 Dec 12 05:44 AM

[Augustus:]

The fact that the buy of the insurnce did not actually own the specific bonds is not particularly material to the need for the insurance. The buyer may have the basket of similar assets of like quality and use the different basket as the substitute.

Suppose you have hurricane insurance on your home. A storm is forecast. Can I buy from you one half the coverage of your losses, leaving you net 50% insured, when I am not able to instantly buy coverage fro my home? If we agree on a price, it would be possible. No different in the CDS structure.

2008 Dec 12 09:58 AM

[BerkeleyBob:]

What is inaccurate about describing AIG's transactions as those of an unregulated off-shore bookie and not an insurance company? What is inaccurate about finding a resemblance between the obfuscation and "complexity" of AIG's transactions and those of the Enron thieves? There is a vast difference between the legitimate hedging by a commodities producer and even a short seller and the systemic distribution of fraudulent mislabeled CDOs.

2008 Dec 12 12:43 PM

[oldlures1:]

Interesting. The article and comments both provide convincing arguments for and against, but I'm a simpleton of sorts, so I default to the basics - you shouldn't be able to buy insurance without an insurable interest, period.

2008 Dec 16 07:06 PM

[Stupid CDS ...:]

So if I understand this correctly, AIG by the authors admission has the most risk due to their high percentage of synthetic collateral. MBIA only had certain CDO's that were synthetic (reducing their risk when compared to AIG) and Ambac had limited the percentage of synthetic collateral in their CDO (also reducing their risk compared to AIG) yet the author is long on the riskiest company and has reduced his positions in the two companies that took steps to reduce their risk? Am I missing something?

2008 Dec 19 10:55 PM

[Tom Armistead:]

Not really - all three were sitting at the big table with the high rollers.

I have been long based on value I saw when considering various versions of adjusted book value, a nonGAAP metric that looks past mark to market losses and adds the present value of future installments and unearned premium reserves.

My impression right now is that bad bets these companies made in the past keep eating into their pile of chips. Probably the odds favor a profit on any of them from today's prices. If Treasury added capital on terms similar to what it granted the investment banks, a lot of shareholder value could be created.

But there are a host of high quality non-financial companies trading at very steep discounts to any of the standard metrics. Many of them have financial statements that are easy to analyse and demonstrate no "go to zero" type risk. So I am getting out of financial guarantee companies and going to situations where there is equal potential to the upside but far less risk to the downside. I no longer hold AIG in my personal portfolio, ABK I have a small speculative position in options and debentures, and MBI I continue to reduce in favor of other investments.

I haven't done too well kibitzing and placing side bets at the big table so I am moving away from the game.






On Dec 19 10:55 PM Stupid CDS Thingys wrote:

> So if I understand this correctly, AIG by the authors admission has
> the most risk due to their high percentage of synthetic collateral.
> MBIA only had certain CDO's that were synthetic (reducing their risk
> when compared to AIG) and Ambac had limited the percentage of synthetic
> collateral in their CDO (also reducing their risk compared to AIG)
> yet the author is long on the riskiest company and has reduced his
> positions in the two companies that took steps to reduce their risk?
> Am I missing something?

2008 Dec 20 10:36 AM

[User 323840:]

AIG's connection with Goldman Sachs explains why Paulsen was willing to bailout AIG but let Lehman sink.

2008 Dec 21 06:13 PM