AIG killed by CDS collateral calls

As I suspected, AIG's CDS collateral obligations have eaten up the government's initial $85 billion loan commitment, which was recently boosted to $123 billion. AIG's CEO reported that they had sold over $400 billion in CDS contracts.

The WSJ piece below profiles Yale finance professor Gary Gorton, who helped Cassano's group (AIG Financial Products) build their risk models. They note that there is still a chance that the models are ok -- that in the long run losses on the securities they insured may not be large. The problem is that the CDS contracts require the insurer to post additional collateral if the market value of the security in question falls. Since all credit related products are oversold due to rampant fear, this forces collateral calls even on good securities (if there are any). I can imagine that triggers might depend on the value of various CDS indices, which have plummeted during the crisis.

If -- and it's a big if -- AIG's actual CDS payouts are limited, the government and taxpayers stand to make a lot of money over the next 3-5 years. When markets return to normal the profitable ordinary insurance parts of AIG can be liquidated to pay off the bridge loan. In that scenario the big losers are AIG shareholders -- the government, as the lender of last resort, will have bought a distressed AIG for a song. In the bad scenario we will enter a long, harsh recession and AIG will end up paying out on much of its $400 billion in obligations, perhaps exceeding even the long term liquidation value of the firm. In that case the US taxpayer will foot the bill.

WSJ: ...AIG itself has been forced to post about $50 billion in collateral to its trading partners, largely to offset sharp drops in the value of securities it insured with the credit-default swaps. These payments have continued to balloon after the bailout -- raising the specter that the government will eventually have to lend more taxpayer money to AIG.

...AIG's credit-default-swaps operation was run out of its AIG Financial Products Corp. unit, which had offices in London and Wilton, Conn. In essence, AIG sold insurance on billions of dollars of debt securities backed by everything from corporate loans to subprime mortgages to auto loans to credit-card receivables. It promised buyers of the swaps that if the debt securities defaulted, AIG would make good on them.

...The swaps expose AIG to three types of financial pain. If the debt securities default, AIG has to pay up. But there are two other financial risks as well. The buyers of the swaps -- AIG's "counterparties" or trading partners on the deals -- typically have the right to demand collateral from AIG if the securities being insured by the swaps decline in value, or if AIG's own corporate-debt rating is cut. In addition, AIG is obliged to account for the contracts on its own books based on their market values. If those values fall, AIG has to take write-downs.

...Mr. Gorton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances.

The problem for AIG is that it didn't apply effective models for valuing the swaps and for collateral risk until the second half of 2007, long after the swaps were sold, AIG documents and investor presentations indicate. The firm left itself exposed to potentially large collateral calls because it had agreed to insure so much debt without protecting itself adequately through hedging.

...Early on, Mr. Gorton billed AIG about $250 an hour, which likely would have netted him about $200,000 a year, says a former senior executive at the unit. Eventually, his pay was far greater; another former colleague estimates it at $1 million a year.

Mr. Gorton collected vast amounts of data and built models to forecast losses on pools of assets such as home loans and corporate bonds. Speaking to investors last December, Mr. Cassano credited Mr. Gorton with "developing the intuition" that he and another top executive had "relied on in a great deal of the modeling that we've done and the business that we've created."

...As the debt securities created by Wall Street became more complicated, so did the swaps AIG offered. Around 2004, it began selling swaps designed to provide insurance on securities called collateralized-debt obligations, or CDOs, that were backed by securities such as mortgage bonds. Merrill Lynch & Co., then a major seller of the CDOs, was a big client.

So-called multisector CDOs, in particular, were exceptionally complex, involving more than 100 securities, each backed by multiple mortgages, auto loans or credit-card receivables. Their performance depended on tens of thousands of disparate loans whose value was hard to determine and performance difficult to systematically predict. In assessing their risk, Mr. Gorton constructed worst-case scenarios that factored in the probability of defaults on the underlying securities.

In late 2005, senior executives at the unit grew worried about loosening lending standards in the subprime-mortgage market. AIG decided to stop selling credit protection on multisector CDOs, partly due to "concerns that the model was not going to be able to handle declining underwriting standards," Mr. Gorton told investors last December. But by the time it stopped, in early 2006, its exposure to multisector CDOs had ballooned to $80 billion.