Did those people at AIG not understand anything about financial risk?

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The Washington Post‘s series on AIG Financial Products, the mostly independent derivatives operation that brought the downfall of the insurance giant, is among the best of the many tales of collapse being recounted in newspapers these days. A passage at the beginning of today’s second installment (part one is here) was especially appalling/compelling:

For months, several executives at AIG Financial Products had pulled apart the data, looking for flaws in the logic. In phone calls and e-mails, at meetings and on their trading floor, they kept asking themselves in early 1998: Could this be right? What are we missing?

Their debate centered on a consultant’s computer model and a new kind of contract known as a credit-default swap. For a fee, the firm essentially would insure a company’s corporate debt in case of default. The model showed that these swaps could be a moneymaker for the decade-old firm and its parent, insurance giant AIG, with a 99.85 percent chance of never having to pay out.

The computer model was based on years of historical data about the ups and downs of corporate debt, essentially the bonds that corporations sell to finance their operations. As AIG’s top executives and Tom Savage, the 48-year-old Financial Products president, understood the model’s projections, the U.S. economy would have to disintegrate into a full-blown depression to trigger the succession of events that would require Financial Products to cover defaults

Yeah, everything’s much easier to see with hindsight, but there are just so many red flags here:

First, that absurdly precise 99.85% figure. One can’t know from the article how the number was presented to AIG executives, or how seriously they took it. Defenders of quantitative finance such as Eric Falkenstein often make the case that the quants who churn out such numbers are well aware of their limitations. But the subsequent actions of both AIG Financial Products and AIG’s top brass would seem to indicate that they took this particular risk assessment to the bank.

Second, the part about the U.S. economy having to “disintegrate into a full-blown depression” for the credit-default swaps AIG was selling to become big money-losers. I was talking a couple of weeks ago to an executive from another big insurance company that thought about getting into selling CDSes but opted against it. Its risk managers also concluded that it would take a systemic financial collapse for the CDS business to go sour. But for them that was a reason to avoid it. Insurance works financially when it protects people from smallish events that occur randomly—like fire, or burglary, or death. The business turns problematic when it gets into regional debacles like hurricanes and earthquakes, and completely untenable when it faces a global or even national disaster. That’s why property insurance policies often include “Act of God” clauses that give the insurer an out in case of earthquake or meteor strike or Rapture. It would have been interesting if AIG had tried to sell credit default swaps with such a clause—we’ll pay up unless credit markets totally fall apart. It didn’t, so it was essentially running a scam. In the situation that market participants most needed insurance against, AIG wouldn’t be able to provide it. At least not without a couple hundred billion in U.S. government aid.

Finally, there’s the apparent disregard for the impact that AIG’s CDS sales, and the growth of the CDS market in general, would have on loan quality. It retrospect, it seems clear that buying credit default swaps allowed many lenders to believe that they could safely lower lending standards—because they’d outsourced the risk to somebody else. That rendered AIG’s historical risk models completely useless. If something like this had never happened before, AIG’s failure to take it into account might be excusable. But consider this tale from an earlier financial insurance pioneer (nabbed from the manuscript of my forthcoming book):

Hayne Leland could see, almost from the moment portfolio insurance popped into his head in the den of his Berkeley house, that there was a catch. The option-pricing formulas upon which he based the strategy depended on the portfolio insurer being a price taker. That is, prices were set by the “pervasive forces” of the market. The actions of an individual market participant were presumed to have no impact at all.

If Leland’s idea hit it big enough, he realized, the actions taken by portfolio insurers trying to cut their clients’ losses during a market swoon might drive prices down even more. “But I honestly thought, ‘How long would it take and how big would we have to become before our trades affected the market as a whole?’” Leland recalled. “It turns out it was only seven years.”

Update Here’s part three of the Post AIG series, with the verdict from Gerry Pasciucco, who was brought in by current AIG management to clean up the mess:

But Pasciucco soon found evidence of a fatal miscalculation. It seems that as Financial Products ramped up its credit-default swap business, its leaders assumed that its parent, AIG, would always be as strong as it was the day it backed the firm’s first big trade in 1987. He said they had failed to prepare for the possibility of a downgrade in AIG’s credit rating.

The executives who had pushed or approved the credit-default swap business had placed too much faith in the math that told them the worst would never happen, that AIG and its deep pockets would be there to usher them through the trouble.

“When the unexpected happens and you have the biggest credit crisis since 1929, you have to be prepared to deal with it, and they weren’t,” Pasciucco said. “There was no system in place to account for the fact that the company might not be a Triple A forever.”