Revenge of the Black Swan

“The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy the money.”

–Tom Savage, President, AIG’s Financial Products

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The second part of the 3 part series is now posted, A Crack in The System. This section gets into the details as to how AIG got so buried in the credit default swaps (CDS) business.

Excerpt:

“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.

If that happened, the holders of swaps would almost certainly be wiped out, so how could they even collect? Financial Products would receive millions of dollars in fees for taking on infinitesimal risk.

The firm’s chief operating officer, Joseph Cassano, had studied the model and urged Savage to give the swaps a green light. . . .

Initially, the credit-default swaps business would amount to a fraction of the half-billion dollars in Financial Products’ revenue that year. It didn’t seem to them like a major decision and certainly not a turning point.

They were wrong. The firm’s entry into credit-default swaps would evolve into insuring more volatile forms of debt, including the mortgage-backed securities that helped fuel the real estate boom now gone bust. It would expose AIG to more than $500 billion in liabilities and entangle dozens of financial institutions on Wall Street and around the world.

Who ever could have foreseen that “free money” would backfire?

Call it the revenge of the Black Swan . . .

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Source:
A Crack in The System (part 2 of 3)
Brady Dennis and Robert O’Harrow Jr.
Washington Post, Tuesday, December 30, 2008; Page A01
http://www.washingtonpost.com/wp-dyn/content/article/2008/12/29/AR2008122902670.html