Wednesday, March 03, 2010

John Carney: how AIG destroyed itself

I am checking out John Carney's recent Business Insider piece on the collapse of insurer AIG.

Here's an excerpt from Carney's description of "AIG as a buyer of risk" from, "The Untold Story of How AIG Destroyed Itself":

"AIG’s financial products division became what is known on Wall Street as a “synthetic buyer” of a variety of asset backed securities, including mortgages and infrastructure linked bonds. AIGFP would sell credit default swaps that performed for the company much like an ordinary bond would for a bond investor.

As long as the insured bonds were performing, AIG would receive a regular revenue stream from the buyer that mirrored the regular payments of interest and principle that a bond holder would receive. AIG was able investing in the bonds without actually having to buy them.

Carney goes on to note that AIG had, in effect, taken a synthetic long position in these mortgage bonds by insuring the asset backed securities and writing CDS (credit-default swaps) against them. This gave AIG a regular stream of profits from CDS buyers, though it exposed the firm to huge financial risk (and we all know how that played out).

To further illustrate this point, here's a passage from Greg Zuckerman's new book on the short subprime trade, The Greatest Trade Ever (page 87):

"...Credit-default swaps were tied to actual mortgages - but the number of insurance bets on the subprime loans now were essentially unlimited.

Finally, Burry and other housing skeptics had a way to short the market, while those who were bullish, such as insurance giant AIG, could make extra money by selling the insurance, confident they would never have to pay out. Their acutaries produced sophisticated models that showed the chances of a housing meltdown were minimal".

Ever notice how often references to such "sophisticated models" spring up in the past decade-plus' chronicle of hubris and folly?